In the past few years, the family limited partnership has been a focus of Internal Revenue Service efforts to curb abusive tax shelters. The IRS maintained that a family partnership wasn't real; it was a tax dodge.
The agency had suddenly realized that family limited partnerships, sometimes called FLIPs, aren't just for the rich anymore. It's a solid tax strategy that advocates a way to protect a family's assets, potentially cutting in half or more what's owed on an estate-tax bill -- assuming there are any estate taxes to worry about.
That prompted the IRS to send out a flurry of "advisory notices," telling people that the agency may invoke a section of the tax code that allows it to disregard FLIPs because of potential abuses.
My response to this? Hogwash. If you or your family members have created a FLIP or are considering one, don't let the chest-thumping get in your way. As long as your motivation is to protect your assets from creditors or manage your assets more effectively -- just as in any limited partnership -- you're starting out on solid ground.
To understand a FLIP, you have to understand the basic structure of any limited partnership. After all, a FLIP is merely a traditional limited partnership where all the partners are family members. Remove the family relationship, and a basic FLIP is a basic limited partnership.
All limited partnerships have one thing in common: They all are run by general partners only. Under the law of all 50 states, by definition, no limited partner has any vote or voice in the running of the partnership business. A general partner, who may own only 1% of the partnership assets, will control 100% of those assets.
In a family situation, the parents put their assets into the partnership. They start by being both the general partners and the limited partners. Then, under the most common and simplest form, they gift their limited partnership interests to their children. Let's see what they have really done . . .
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Several effects on the gift and estate tax
First, even though the parents have given away the limited partnership interests, they, as the general partners, still retain full control over all the assets in the partnership. The limited partners (who become the general partners upon the death of both parents) own and have title to the limited partnership interests. But they have no voice in the management of the partnership. In effect, the parents have given up ownership of the assets but have retained control. This does several things with gift and estate taxes:- Except for the 1% retention, the assets are out of the parents' estates. A completed gift has been made to their children. A gift tax may be due on the value of the gift. The parents, however, can use their unified gift and estate tax credit to pay that tax. In 2009, this credit, between both parents, shelters the tax on as much as $7 million ($3.5 million x 2). It is scheduled to become unlimited in 2010. In 2011, it's scheduled to fall back to $1 million per parent -- unless Congress votes to extend it. My best guess is that Congress will make the $3.5 million credit permanent before the end of the year. (See "2010: The best year to die?")
- Since the gift has been completed, all appreciation on the assets is out of the parents' estates. Assuming both parents are age 40 when the transfer is made, and that one lives another 40 years, we have excluded 40 years of appreciation from the parents' estates. Further assuming a $7 million transfer and a rate of appreciation of only 7.2% per year, $112 million has been excluded from the parents' estates, and they have saved approximately $45 million in estate taxes. (Assuming there is an estate tax.)
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Where the IRS gets really annoyed
Even if the parents die immediately after making the transfer and even if there is no appreciation in the assets, there is an immediate and substantial transfer-tax saving. Stay with me on this -- it's complicated.Remember that the parents gifted the limited partnership interests to their children, not the assets in the partnership itself. While the limited partners own the assets, they have no control over those assets. Because they have no control over those assets, the value of the limited partnership interests (the value of the gift) is less than the value of the assets transferred.
