In the 1990s, before the Economic Growth and Tax Relief
Reconciliation Act of 2001 (EGTRRA) was enacted, Family
Limited Partnerships (FLPs) and Family Limited Liability
Companies (FLLCs) rapidly gained popularity with estate
planning professionals as the estate planning vehicles that
offered their clients the greatest amount of flexibility,
control and potential for significant estate tax savings.
Since tax considerations are among the most influential
factors when clients develop a comprehensive estate plan, it
was not surprising that interest in FLPs and FLLPs waned as
IRS challenges and the federal estate tax exemption amount
increased. However, as real estate values continue to rise,
the economy begins to recover and taxpayers continue to win
in Tax Court, business owners will likely become more
motivated to incorporate an FLP or FLLC into their estate
plans.
Is Your
Business at Risk?
During the
presidential election debates of 2000, the need for estate
tax reform was often illustrated by the fact that many
families were forced to sell family farms or family
businesses to pay the estate taxes of the deceased farmer or
business owner. This unfortunate situation arises when
individuals own significant real estate holdings, business
interests or other nonliquid assets, but lack adequate
liquidity to pay any estate taxes that may be due.
Fortunately, estate planning professionals have an arsenal
of techniques available to combat the estate tax liquidity
problem. One of the simplest and most-often recommended
solutions is for the individual to purchase a life insurance
policy payable to the individual’s estate in the amount of
the estimated estate taxes and administrative expenses.
Other techniques — such as installment sales, death
terminating notes, private annuities, Grantor Retained
Interest Trusts (GRITs, GRATs, and GRUTs) and Qualified
Personal Residence Trusts (QPRTs) — may be able to produce
desirable “estate freezing” effects. For individuals who
find the above alphabet soup too restrictive or confusing,
estate planning professionals have begun to renew their
earlier recommendations that a family business entity serve
as the cornerstone of a comprehensive estate plan.
Family
Business Entities Are Versatile
As estate
planning vehicles, FLPs and FLLCs are extremely flexible
entities that offer many benefits not found in the
abovementioned planning techniques. Although FLPs and FLLCs
may sound exotic to some, as business entities, they really
are nothing more than standard limited partnerships or
limited liability companies with the word “family” attached.
The business owner, as general partner or managing member
(depending on the choice of entity), retains complete
control over the day-to-day operations of the business. He
or she controls the timing and amount of income
distributions and the designation of new partners or share
owners. He or she has complete discretion in the management
of the family business, subject only to the “business
judgment rule,” which is far less strict than the “prudent
person standard” to which trustees are held. Family business
entities provide a mechanism in which a portion of the
income generated from the family business, otherwise taxed
at the owner’s marginal tax rate, can be shifted to the
younger generation, where it would be taxed at a lower
marginal rate, thus increasing
the family’s after-tax income. Owners of family business entity
interests who do not actively participate in the day-to-day
management of the business enjoy limited liability for the
business’s debts and obligations. Because the interests in
these closely held family entities are not easily marketable
and restrict the management of the family business, they are
subject to valuation discounts — a feature that is arguably
the most desirable and useful aspect of using FLPs and FLLCs
as estate planning vehicles.
Desirable
Valuation Discounts
Applying
valuation discounts to the family entity interests received
may allow the business owner to immediately reduce the value
of his or her taxable estate upon formation of the business
entity. Additionally, valuation discounts allow the older
family members to transfer larger percentages of family
business entity interests to the younger family members,
while remaining under the current annual gift exclusion
amount of $11,000.00 per donee. By transferring discounted
family entity interests to the younger generation, business
owners are able to reduce the value of the assets includable
in their gross estates much quicker and more efficiently
than they could without forming a family business entity,
while retaining complete control over the business
operation.
The IRS says,
“Abusive”
Not
surprisingly, the IRS has been vigorously attacking the
aggressive use of valuation discounts to reduce the gross
estates of decedents owning interests in family business
entities and has tried to include the fair market value of
all assets contributed to the entity in the decedent’s gross
estate. Fortunately for taxpayers, the IRS has enjoyed only
limited success in the Tax Court on these issues. Just last
November, the Tax Court ruled in favor of the taxpayer in a
case where the IRS had challenged the significant valuation
discounts taken on the decedent’s estate tax return for his
general and limited partnership interests in five FLPs. In
this case, the decedent transferred significant family
business assets to the FLPs shortly before he died. Under
the facts and circumstances of the case, the court upheld
the valuation discounts and further concluded that in
exchange for his contribution of the family business assets,
the decedent received general and limited partnership
interests in “a genuine arm’s length transaction,” which
excludes such assets from his gross estate. While the IRS
has been successful in challenging some FLPs in recent
cases, this significant taxpayer victory, as well as others,
further indicates that with proper planning by qualified
estate planning professionals, family business entities
continue to be invaluable estate planning vehicles.
Cost/Benefit Analysis
The risk of estate tax audits, Tax Court litigation, and the
costs associated therewith, have to be considered when
devising an estate plan that utilizes a FLP or FLLC. Given
the IRS’s present attitude toward family business entities,
and given the current estate taxation scheme under the
EGTRRA, forming a family business entity as a comprehensive
estate plan is not appropriate for every business owner.
However, after fully evaluating your particular situation,
you may conclude that incorporating an FLP or FLLC into your
estate plan provides you with the most flexibility, control
and potential for significant estate tax savings.
