Family Limited Partnerships (FLPs) have long been a favored tool in estate planning, offering a way to transfer wealth between family members while minimizing tax liabilities. One of the key benefits of FLPs is the ability to use discount valuations, which allow for a reduction in the taxable value of the transferred interests. This strategy not only preserves wealth but also offers significant tax savings.
In this article, we will explore what FLPs are, how discount valuations work, the types of discounts available, and how they can be applied within the context of estate and gift tax planning. We will also touch on the IRS’s perspective and recent legal developments affecting the use of discounts in FLPs.
What is a Family Limited Partnership?
A Family Limited Partnership (FLP) is a legal structure typically used for estate planning purposes. It is similar to a traditional limited partnership, where the partnership is made up of general partners (GPs) and limited partners (LPs), but it is specifically designed to manage family-owned assets.
In an FLP, the general partners (usually the parents or older generation) retain control over the day-to-day operations and decision-making. Meanwhile, the limited partners (usually children or younger generations) have an ownership interest but no control over the partnership’s decisions. The main benefits of this arrangement include:
- Asset Protection: FLPs help protect family wealth from creditors and legal claims.
- Estate Tax Reduction: Transferring partnership interests can reduce the size of the estate, lowering estate taxes.
- Family Succession: FLPs facilitate the smooth transfer of wealth and management responsibilities between generations.
How Does a Family Limited Partnership Work?
When a family sets up an FLP, they typically transfer assets such as real estate, investments, or business interests into the partnership. The older generation serves as the general partner, retaining control over the assets and decision-making processes. Over time, they can gift limited partnership interests to younger family members.
The value of these gifts is determined based on the percentage ownership of the partnership being transferred. However, because the limited partners do not have control over the FLP’s operations or the ability to easily sell their interest, the value of these interests is often discounted.
What is a Discount Valuation?
A discount valuation is a method used to reduce the taxable value of a transferred interest in an FLP. The concept behind discounting is simple: if the interest being transferred is not easily marketable or does not carry decision-making power, its fair market value is lower than the proportionate value of the FLP’s total assets.
For example, if a parent transfers a 10% interest in an FLP that holds assets worth $1 million, the nominal value of that interest would be $100,000. However, after applying discounts (such as lack of control and lack of marketability), the taxable value of the transferred interest may be significantly lower — perhaps only $70,000.
These discounts are crucial in estate and gift tax planning, as they reduce the value of taxable gifts and lower the overall estate value, leading to substantial tax savings.
Types of Discounts in FLPs
There are two primary types of discounts commonly applied to FLP interests: the lack of control discount and the lack of marketability discount.
Lack of Control Discount
The lack of control discount reflects the fact that limited partners in an FLP do not have the ability to influence the partnership’s operations. They cannot make decisions about how assets are managed, how profits are distributed, or when the partnership should be dissolved. As a result, the value of a minority interest in an FLP is often lower than a proportionate share of the partnership’s total value.
The discount for lack of control can range from 15% to 40%, depending on the specific circumstances of the FLP and the assets it holds.
Lack of Marketability Discount
The lack of marketability discount applies because limited partnership interests are not easily sold or converted to cash. Since there is no active market for FLP interests, finding a buyer is often difficult, and even if a buyer is found, the terms of the FLP agreement may restrict the transfer of interests.
This discount typically ranges from 10% to 30%, based on the difficulty of selling the interest and any restrictions in the partnership agreement.
How Discount Valuations Apply in Estate and Gift Tax Planning
One of the primary advantages of using discount valuations in FLPs is the significant reduction in the taxable value of transferred interests, which helps minimize estate and gift taxes. Here’s how:
- Gift Tax: When limited partnership interests are transferred to family members, the donor is subject to gift tax if the value of the gift exceeds the annual gift tax exclusion. However, by applying discounts for lack of control and lack of marketability, the value of the gift can be significantly reduced, potentially keeping it below the taxable threshold or reducing the overall gift tax liability.
- Estate Tax: When the general partner dies, the value of their estate includes their ownership interest in the FLP. However, if part of the estate consists of limited partnership interests that have been transferred to heirs, the estate’s value will already have been reduced by the applied discounts, lowering estate tax liabilities.
For example, an FLP holding assets worth $10 million may transfer a 20% limited partnership interest to a family member. Without discounts, the value of the gift would be $2 million. But with a 30% combined discount for lack of control and lack of marketability, the taxable value would be reduced to $1.4 million, saving $600,000 in taxable value.
What About Retirement Plans?
One of the more attractive retirement tax planning strategies involves using the discount valuation strategy to reduce the tax impact of a Roth IRA conversion. Finding a way to move pretax assets to Roth at a discount is an exciting opportunity.
Converting pretax retirement funds (and assets) to Roth (after-tax) is a taxable event. If one can mitigate the taxes owed, the more beneficial the asset is. Converting a depressed asset is one way to save on taxes. Another is the discount valuations for FLPs.
IRS Scrutiny of FLPs and Discount Valuations
The IRS is fully aware of the tax-saving benefits provided by FLPs and discount valuations, which has led to increased scrutiny in recent years. The IRS may challenge the size of the discounts applied or argue that the FLP was created solely for tax avoidance rather than legitimate business or estate planning purposes.
To successfully apply discount valuations, the FLP must meet several requirements:
- Legitimate Purpose: The FLP should have a clear, non-tax-related purpose, such as asset protection or succession planning.
- Proper Structure and Documentation: The partnership agreement must be properly drafted, with clearly defined roles, responsibilities, and restrictions for general and limited partners.
- Consistent Adherence to Formalities: The FLP must be operated as a real business, with regular meetings, recorded minutes, and adherence to partnership terms.
Legal Cases Impacting Discount Valuations
Several key legal cases have shaped the IRS’s stance on discount valuations in FLPs. These cases highlight the importance of proper FLP structuring and adherence to formalities:
Estate of Strangi v. Commissioner (2003)
The IRS successfully challenged the use of discount valuations because the court found that the FLP was created solely for tax avoidance purposes and lacked any legitimate non-tax reason for its formation.
Estate of Kelly v. Commissioner (2012)
In this case, the court upheld the application of discounts, recognizing that the FLP was properly structured and had legitimate business purposes, including asset protection and management efficiency.
These cases emphasize that while discount valuations are a powerful tool, they must be used carefully and in accordance with legal requirements.
Best Practices for Applying Discounts in FLPs
To ensure that discount valuations withstand IRS scrutiny and legal challenges, consider the following best practices:
- Establish a Legitimate Purpose: Ensure that the FLP has clear, non-tax-related objectives, such as business continuity, asset management, or family succession planning.
- Maintain Formalities: Operate the FLP like a legitimate business, holding regular meetings, keeping detailed records, and adhering to partnership terms.
- Seek Professional Valuation: Work with a qualified appraiser who specializes in FLP valuations to determine appropriate discounts based on the specific circumstances of the partnership.
- Avoid Aggressive Discounts: While discounts are beneficial, applying overly aggressive or inflated discounts can attract IRS scrutiny. Be realistic and use market-based data to support the valuation.
Conclusion
Discount valuations in Family Limited Partnerships offer significant tax advantages by reducing the taxable value of transferred interests. When properly applied, discounts for lack of control and lack of marketability can lead to substantial savings in estate and gift taxes. However, careful structuring, documentation, and adherence to legal formalities are crucial to ensure that the FLP and the discounts withstand IRS challenges.
As estate planning strategies continue to evolve, FLPs remain a powerful tool for families looking to preserve and transfer wealth efficiently. By understanding and applying discount valuations correctly, families can maximize tax savings while ensuring smooth transitions of their assets across generations.
