A popular and powerful estate planning tool may be under attack by the Biden administration.
As a way to pay for President Biden's Build Back Better Act, the House Ways and Means Committee recently released its proposed plan.
The plan includes many changes to the Internal Revenue Code that directly impact gift and estate tax planning.
Even though the plan is still in negotiations, one of the likely casualties upon passage will be some of the current estate planning benefits of the Family Limited Partnership.
What is an FLP?
An FLP is a business entity created under state law to hold and manage property.
The state gives the partners liability protection. And the IRS currently allows tremendous tax planning opportunities for estate planning.
The partners can be individuals or other entities such as trusts and limited liability companies (LLCs). The FLP must have at least one general partner, and the GP is liable for the partnership’s debts and liabilities. The other partners can all be limited partners.
In addition to tax benefits, the FLP limits the liability to the limited partners and the FLP. The limited partners are personally insulated from liabilities arising within the partnership. And the FLP is also protected from liabilities that a limited partner may incur outside the partnership.
Parents Gift the Property But Keep Control
Many parents own property that they want to begin transferring to their children for tax reasons. But often, parents want to retain control and management of the property during this process, which could take years depending upon the tax planning.
The parents can form the FLP with themselves (or another entity such as an LLC they own) as the general partner and name their children (or trusts created for their children’s benefit) as limited partners.
The parents transfer the property into the FLP and gift shares or partnership interests to their children. They have the flexibility to gift the interests to the children all at once or overtime. This way, parents can begin gifting but still maintain control.
It’s the Same Asset - But Now the Value is Less
But the real tax advantage comes because the IRS allows the family to create fractional interests in the FLP and distribute them among the limited partners.
None of the limited partners have any right to control the management of the property in the partnership. The general partner still retains that right.
The simple but powerful strategy is that an asset with one owner is worth more than the same asset with many minority owners.
Before the parents transfer the property into the FLP- they are the only owners.
Once the property is in the FLP, there are many minority owners of the FLP. Having many minority owners makes the value go down.
So the value of the FLP is less than the value of the original gifted assets.
The same asset now has a reduced evaluation. This reduction in value is currently allowed by the IRS.
This strategy can currently result in significant transfer tax savings, which is one primary benefit of using an FLP. However, this benefit is under attack in the current proposal.
Parents Control the Partnership While Children Learn
Another benefit is that the FLP allows the general partner to continue managing the property while the children benefit from its income.
And the children as limited partners can learn how to manage and be prepared for the day when the general partner either dissolves the partnership or management changes hands to one or more of the limited partners.
State Law Usually Helps Strengthen the Protection
State laws typically protect the partnership and its assets from lawsuits against the limited partners.
A creditor’s only remedy against a limited partner’s interests is often the right to receive partnership profits and distributions payable to the debtor-limited partner.
The creditor usually has no right to inspect the partnership’s books, vote as a limited partner, make management decisions, or force a sale of the limited partner’s interest or liquidation of partnership property.
This feature makes limited partnership interests unattractive to creditors. It encourages them to settle with the limited partner debtor for much less than they would if the partnership interests were easier to attack.
And the family can increase the asset protection if they transfer partnership interests to trusts for the benefit of chosen beneficiaries,
The Capital Gains Attack
In early 2021, the Biden administration released the Green Book, more formally known as the General Explanations of the Administration's Fiscal Year 2022 Revenue Proposals.
This year's Green Book highlights the Biden administration's proposed tax law changes in hopes of raising revenue.
The Green Book’s primary attack on FLPs is that a transfer of a property to an FLP would cause the recognition of capital gains on that property. This will subject the transferor to capital gains taxes effective January 1, 2022.
Additionally, the proposal will cause a capital gains recognition event on any appreciated property that has not been taxed in the past ninety years.
According to the Green Book, the earliest date for the recognition event is December 31, 2030.
For example, suppose Doris purchased one hundred shares of corporate stock for $1 per share thirty years ago. The fair market value of the stock is now $101 per share.
Under the proposed law, if Doris forms an FLP and transfers the stock into it, she will trigger recognition of the $10,000 in capital gains and be subject to capital gains taxes in that tax year.
On the other hand, suppose Doris had transferred that stock into an FLP on January 1, 1940, and the shares appreciated to $101 per share by December 31, 2030 (ninety years later).
The IRS would consider the expiration of the ninety years as a recognition event. The excess of the fair market value over Doris's tax basis in the stock will be subject to capital gains tax in that year.
Proposed Exclusions
The proposal treats FLP benefits harshly. But there are several exceptions.
If the proposal becomes law, exclusions apply in the following scenarios:
- Transfers to a spouse or a charity will not trigger a recognition event ( a carryover basis would apply).
- Capital gains on tangible personal property will be excluded.
- The $250,000 per person personal residence exclusion on capital gains would still apply and will still be portable to a surviving spouse.
- Exclusions for certain small business stock will still apply.
- A new $1 million-per-person capital gain will be excluded for other appreciated property transferred by gift or passed at death. A deceased spouse’s unused exclusion could be transferred to their surviving spouse to potentially shield up to $2 million of gains per married couple.
- Family-owned or family-operated businesses could delay recognition of gains until the family stopped owning or operating the business. And the family will then have up to fifteen years to make payments on the taxes due after the recognition of the gains.
What to Do Now
Estate and tax laws can offer significant benefits, but they are complex and constantly changing.
Congress has not accepted the current Biden administration proposals and will likely make changes before enacting the law.
But it appears likely that the estate planning landscape will be changing significantly, including the current tax and estate planning benefits of the FLP.
An FLP might be an important part of your well-thought-out estate plan.
San Diego Legacy Law is a qualified estate planning attorney in San Diego, California.
We are familiar with all federal and California estate and trust laws and how they can best help you achieve your estate planning goals.
Call today for a free consultation and learn your next best steps.