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INTRODUCTION
The following materials summarize the potential estate planning benefits resulting from the use of Family Limited Partnerships and Family Limited Liability Companies. Both offer the following benefits:
WHAT IS A FAMILY LIMITED PARTNERSHIP?
A Family Limited Partnership ("FLP"), is a limited partnership like any other limited partnership. The term FLP is used to describe limited partnerships used for family income and estate tax planning. Typically parents form an FLP in which they, or their living trust, is general partner and they (or their living trust) is also a limited partner. The parents make gifts of their limited partnership interests to their children or grandchildren (or trusts for their benefit).
A limited partnership is unique because it offers the partners the ability to avoid personal liability from the operation of the limited partnership’s business. However, the general partner remains liable for partnership debts. The general partner is also responsible for running the business and making all of the day-day decisions. The limited partners, do not manage the limited partnership's day-to-day affairs and should not be liable for the limited partnership's debts (assuming the limited partnership is correctly maintained and the limited partners do not run the day to day affairs of the limited partnership). A creditor of a limited partnership normally only has recourse against the limited partnership’s assets and the assets of the general partner.
WHAT IS A LIMITED LIABILITY COMPANY?
A Limited Liability Company ("LLC") is similar to a limited partnership. In an LLC, the owners are called members. However, unlike a limited partnership, none of the members is liable for the debts of the LLC. An LLC can be managed by one or more of its members, or the members can appoint a "manager" who is like the general partner of a limited partnership. The main differences between a manager and a general partner are that the manager need not be a member (a general partner must be a partner) and the manager is not personally liable for the LLC’s debts. Although an LLC is generally treated as a partnership for all tax purposes, California imposes a separate tax on an LLC's gross receipts. Thus, while an LLC may be a better entity to limit liability, it maybe more expensive to operate as an LLC.
SUMMARY OF BENEFITS
Both FLPs and Family LLCs provide similar benefits when used in the context of estate planning. Set forth below is a brief summary of the benefits, which are based upon the following hypothetical fact pattern:
Mr. and Mrs. Brown are in their mid-sixties. They have two children, each of whom is married, and four grandchildren (two for each child). Among their assets, Mr. and Mrs. Brown own a commercial building (the "Building") worth approximately two million dollars ($2,000,000) and subject to five hundred thousand dollars ($500,000) in debt. The annual cash flow from the Building is approximately one hundred fifty thousand dollars ($150,000). They also hold a portfolio of stocks and bonds worth approximately five million dollars ($5,000,000). Mr. and Mrs. Brown have other sources of income and do not need the income from the Building. They also believe that it is unlikely that they would ever have to consume a substantial amount of the principal portion of their stock and bond portfolio to pay for their living expenses.
The benefits of using either an FLP or a Family LLC for Mr. and Mrs. Brown are described below:
1. Transfer of the Building to a Family LLC.
Mr. and Mrs. Brown could form a Family LLC to hold the title to the Building, and make gifts of membership interests to their children and grandchildren. Since they, or their living trust would be designated the manager of the LLC, they would retain all rights to manage the Building. They alone would make all of the operating decisions, execute leases, initiate repairs and improvements, hire and fire management companies, etc. Also, they would likely retain sufficient interest in the LLC to be able unilaterally to decide whether to retain or distribute cash or whether to sell or refinance the Building.
Since Mr. and Mrs. Brown are each entitled to make annual tax-free gifts of ten thousand dollars ($10,000) to an unlimited number of beneficiaries (twenty thousand dollars ($20,000) combined) they would be able to make annual tax-free gifts of membership interests in the LLC for each of their six beneficiaries. The total value of their tax-free gifts could be one hundred twenty thousand dollars ($120,000). If we assume that the net equity in the Building is one million, five hundred thousand dollars ($1,500,000), a one percent (1%) membership interest is apparently worth fifteen thousand dollars ($15,000). Based upon this value they could give only two-thirds of one percent (1%) interest to each beneficiary. However, since a minority membership interest is subject to a discount because of its lack of marketability, illiquidity and limited management rights, a discount of at least thirty-three percent (33%) would be expected. Accordingly, a gift of a one percent (1%) membership interest would be valued, for gift tax purposes at only ten thousand dollars ($10,000). Accordingly, Mr. and Mrs. Brown, in making gifts totaling one hundred twenty thousand dollars ($120,000) in value in one year, could transfer a total of twelve percent (12%) interest in the LLC, even though, upon liquidation of the LLC, the holders of twelve percent (12%) would be entitled to receive liquidation proceeds worth at least one hundred eighty thousand dollars ($180,000). The transferred interests and any future appreciation thereon should be out of the estates of the Browns for estate tax purposes.
Each time that Mr. and Mrs. Brown made additional gifts to their children, they should be entitled to take into account the minority interest discounts, even if in the aggregate, the total percentage interest held by their children and grandchildren was more than fifty percent (50%). Further, if Mr. and Mrs. Brown eventually surrendered control of the LLC, by resigning as Managers, any interest in the LLC remaining at the time of their death would also be subject to a minority interest discount.
Each year, the LLC would allocate its income or loss based upon the relative participation percentages held by each of the members. As a result, each child and/or grandchild (or trust for the benefit of children or grandchildren) would receive a K-1 from the LLC reporting their distributive share of income or loss. Mr. and Mrs. Brown, as the managers, would have the power to determine reasonably whether the LLC's cash flow should be distributed to the members, or retained in the LLC. Typically, in this situation, Mr. and Mrs. Brown would be expected to distribute at least enough cash flow to the members to pay the income tax on their distributive share of LLC income. However, the ability to control cash distributions gives Mr. and Mrs. Brown significant discretion with respect to the cash available for their children and grandchildren. In contrast, if Mr. and Mrs. Brown simply deeded fractional interests in the Building to their children or grandchildren, the Building would then be held by all family members as co-tenants, and each co-tenant would automatically be entitled to receive outright their pro rata share of cash flow from operations.
One of the reasons for Mr. and Mrs. Brown to transfer the Building to an LLC is to limit their potential individual liability with respect to the Building. Although it is likely that they would have property and liability insurance to protect most catastrophic circumstances, the use of an LLC would prevent any creditor of theirs with respect to the Building from reaching their other personal assets to satisfy any claim, unless the Browns sign a guarantee or obligate themselves personally on a debt. For example, if a tenant was injured in the Building and was awarded damages in excess of the insurance coverage, their claim would be limited to the assets of the LLC. Ordinarily, such creditor would not be able to reach Mr. and Mrs. Brown's other assets to satisfy a claim. In contrast, if an FLP were used to hold title to the Building, the creditor could reach all of the assets of the general partner. Therefore, if Mr. and Mrs. Brown individually or through their living trust acted as the general partner, all of their assets could be reached to satisfy creditor claims.
Additionally, transfers of membership interests to children, as opposed to transfers of cash, provide a measure of asset protection for the children. Creditors are less likely to satisfy judgements against children or grandchildren with their membership interests in a limited liability company (or with a limited partnership interest in an FLP). If the interest of the children or grandchildren are held in trust, the assets are further protected, both from creditors, and in the event of a divorce.
2. Contributions of Stocks and Bonds to a Family Limited Partnership
The same general principles described above relating to the contribution of the Building to the LLC apply to the contribution of stocks and bonds to an FLP. However, since liability is generally not an issue with respect to holding stocks and bonds, there is no reason not to use an FLP instead of an LLC, and thereby avoid any possible additional costs due to the tax imposed by California on an LLC's gross receipts.
In this case, let us assume that Mr. and Mrs. Brown wish to contribute two million, five hundred thousand dollars ($2,500,000) of their portfolio to an FLP, in order to make tax-free gifts utilizing their applicable credits. Under current law, each of Mr. and Mrs. Brown can transfer during their lifetime, or at death, six hundred fifty thousand dollars ($650,000) tax-free to any beneficiary. This amount will gradually increase to one million dollars ($1,000,000) by the year 2006.
Upon formation, Mr. and Mrs. Brown's living trust will be the general partner holding a one percent (1%) interest and a limited partner holding a ninety-nine percent (99%) interest. If they wish to give away the maximum amount tax-free, they would transfer a limited partnership interest valued at one million, three hundred thousand dollars ($1,300,000). However, as in the case of gifts of membership interests in an LLC described above, gifts of minority interests are subject to discount. Accordingly, Mr. and Mrs. Brown could transfer up to eighty percent (80%) of the limited partnership interests, which after discount would be valued at approximately one million three hundred thousand dollars ($1,300,000). Although upon liquidation of the partnership, the value of the interest transferred to Mr. and Mrs. Brown's children and grandchildren would be worth two million dollars ($2,000,000), the aggregate value of the partnership interests given to their children and grandchildren would be subject to a discount in a range between thirty percent (30%) and forty-five percent (45%) (depending upon the appraisal and the facts of the particular transactions).
Since Mr. and Mrs. Brown through their living trust would act as the general partner, they would continue to make all decisions with respect to the stock and bond portfolio. They alone would determine which stocks and bonds to buy and sell. They alone would determine whether to distribute cash to the partners, and in what amount. Each year the partnership would issue a K-1 to each of the partners reflecting their distributive share of partnership income or loss. If Mr. and Mrs. Brown transfer eighty percent (80%) of the limited partnership interests to family members, eighty percent (80%) of the partnership income would be allocated to such members and eighty percent (80%) of all distributions would be made to family members. If, however, it is essential for Mr. and Mrs. Brown to receive one hundred percent (100%) of the partnership income distributions, there are other techniques that may be used based upon the family limited partnership that does not involve gifts to family members.
3. Closing Comments.
a. In the examples above, the annual gift tax exclusions were used for the transfer of membership interests in the LLC and the applicable credits were used for the transfer of partnership interests in the FLP. However, both the annual exclusion gifts and the applicable credits can be used either alone or together in either type of entity as a means to achieve tax-free transfers of ownership interests in family entities.
b. In recent years the Internal Revenue Service has begun to focus on these techniques for potential abuse. They have issued a number of rulings challenging the benefits achieved under circumstances that they believe are improper. However, they have not fared well in litigation of the amount of discount that ordinarily applies to minority held interests. There have also been several legislative proposals to eliminate the use of a discount in transfers of minority interests to family members under certain circumstances. Thus far, none have been enacted.
c. As set forth above, the forgoing is only a general explanation of how FLPs and Family LLCs are used for estate planning. These materials are not a complete or exhaustive description of all of the facts and issues that must be considered when using these techniques. Further, for each individual, there are always specific facts and circumstances which must be considered. Accordingly, no one should rely upon any of the information described above as legal advice. Anyone who is interested in any of the techniques described above should consult with a lawyer who has experience in these matters.
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