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Lowering your taxes can be a family affair

Last December's extension of the Bush-era tax rates as part of the Tax Relief Act of 2010 has not, at least so far, translated into lower tax bills for many woodworking professionals, shops or businesses. The estate tax is also back, although not at record highs. Fortunately, there is an increasingly popular tax strategy that can both reduce annual tax bills and ease the future bite of estate taxes.

The family limited partnership, or FLP, has proven itself an extremely valuable tool for both business and estate planning. What other tool can ease or even eliminate the tax bite often associated with transferring the business - or its income - to family members while keeping the owner's current tax bills to a minimum?

On the downside, the Internal Revenue Service makes no secret of its dislike of FLPs. However, as the courts continue to point out, FLPs are a perfectly legitimate multiple tax-reducing strategy, if used properly.

The definition

An FLP is simply a limited partnership consisting of the members of a family. A limited partnership has both general partners (the ones who actually run the partnership) and limited partners (who are passive or non-involved investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond the money they've invested - their capital contributions.

Typically, a partnership is formed by the older generation, usually the parents, who contribute assets to the partnership in return for both general partnership units and limited partnership units. The parents can then embark on a plan of giving unlimited partnership units to their children and grandchildren while retaining the general partnership units that actually control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, rental real property, marketable securities, shops and, of course, the family woodworking business. Thus, the parents might retain control of the business and draw a salary or wages from it, while sharing the profits with other family members who are taxed on those profits at a lower tax rate than the parents/owners.

The partnership agreement usually governs how partnership income is to be divided among the partners. Generally, both the general and the limited partners will share in income and cash flow based on their respective share or percentage of interest in the partnership. Of course, although income tax liability passes through to each partner automatically, actual cash does not have to be distributed to the partners until the general partners decide to make an actual payout or distribution.

In this manner, the general partners retain control over the assets in the FLP, while the limited partners are granted very limited rights. Limited partners also have restrictions on their ability to sell or transfer their partnership units to others, preventing units from being transferred outside of the family.

Valuation discounts

To create a partnership, property and assets are normally transferred into the partnership entity. This frequently involves a transfer tax at the state level. Because only rarely is there an established market for the sale of limited partnerships, not to mention the lack of control that limited partners have, the limited partnership interests are often valued at a "discount" for transfer tax purposes. Valuation discounts for limited partnership interests, i.e., reductions from the net asset value of the partnership, can range from 15 to more than 50 percent. It is a similar story when valuing assets for estate tax purposes.

The tax benefit of the discounted value of the partnership interests, coupled with significant non-tax benefits such as liability protection and centralized management, have contributed to the popularity of limited partnerships as has the ability of the contributing partner to participate in the management of the partnership as a general partner.

The government's gripes

Not too surprisingly, as family limited partnerships or FLPs grew increasingly more popular, the IRS began attacking their tax benefits. The initial attacks came in the form of a series of IRS rulings raising a variety of legal arguments often involving extreme situations with terminally ill individuals and transfers made by family members via power of attorney.

The IRS frequently argued that the creation of an FLP involved a "gift" of the limited partnership interest. Because assets transferred into the partnership, and the limited partnership interest received in exchange, were usually valued at a discount, the value of the assets transferred into the partnership usually exceeded the value of the limited partnership interest. The IRS contended that the reduction in the contributing partner's net worth was a "gift" by that partner.

Two rulings by the U.S. Tax Court shot down that argument. In one case, the U.S. Court of Appeals for the Fifth Circuit upheld the taxpayer's position despite the IRS's contention that the value of the assets transferred to the partnership should have been included in her gross estate because the transfer was not a bona fide sale for full and adequate consideration.

In another case, the U.S. Court of Appeals for the Third Circuit agreed that it is not always necessary to have a so-called "arm's length" transaction.

The IRS continues to challenge FLPs with limited success. That should not deter any woodshop owner or woodworking professional with an honest desire to transfer their business, or its income, to family members. After all, IRS challenges have not been successful in eliminating FLPs, nor have they severely affected any woodworking business owner who closely adhered to the rules.

Avoiding scrutiny

As mentioned, IRS auditors frequently scrutinize the "facts and circumstances" of FLPs, often honing in on the "economic-substance" doctrine in our tax laws that generally, allows the IRS to ignore a transaction that has no business purpose apart from tax considerations. This challenge can be met by documenting a legitimate non-tax purpose for transfer of assets to the entity.

Other strategies for avoiding or combating the scrutiny that FLPs are often subjected to include:

  • Observe the business formalities set out in the basic partnership agreement, including maintaining capital accounts, corporate minutes and other records;
  • Avoid commingling business and personal assets;
  • Avoid transferring personal-use items, especially residences or vacation homes, to the FLP, unless the partners pay market rent to the partnership for their use of these and other personal items;
  • Retain sufficient assets outside the FLP to meet personal obligations;
  • Avoid making distributions that are not in proportion to members' interests.

Do as Doe does

John Doe owns a woodworking business, otherwise known as the "family business," that has been in the family for more than 50 years. Included in the family business is a small parcel of land, some buildings, including the shop, and a couple of vehicles with a value of about $5 million.

John Doe is focused on keeping the business in the family and avoiding the management issues usually associated with fractional ownership. With the assistance of an experienced professional, he organizes a limited partnership to hold the physical assets - the land, buildings and vehicles - of the family business. John Doe and his son, Ralph, who will manage the property after John's death, are the two general partners, together owning a 1 percent interest equally.

John contributes the family business to the partnership for a 99 percent limited partnership interest, while Ralph contributes cash or other assets for his interest.

Assuming that a 40 percent discount can be sustained when valuing the partnership interest, the value of John Doe's estate is reduced by $2 million (the difference between the family business being valued at $5 million and the family limited partnership interest being valued at approximately $3 million after the 40 percent discount). That can mean estate tax savings of $700,000.

Transferring assets or income-producing property to children or other family members can be a valuable tax planning and tax-reducing tool. Income can be shifted to an individual in a tax bracket lower than that of the donor. Because of its significant tax and non-tax advantages, the FLP remains a popular entity - one that every woodworking professional, shop or business owner should consider. Naturally, the advice of a competent adviser should be sought - if only to avoid doing battle with the IRS.

Mark E. Battersby is a freelance tax and financial writer based in Ardmore, Pa.

This article originally appeared in the March 2011 issue.

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