October 17, 2016 — If the recently proposed Treasury Regulations regarding IRC § 2704 are approved and finalized, such regulations would appear to eliminate almost all minority (lack of control) discounts for closely held entity interests, including active businesses owned by a family.
A family limited partnership, or FLP, can allow a taxpayer to leverage two federal tax devices in conjunction with a technique known as “discounting” in order to reduce the amount of federal tax imposed at the time of that person’s death.
Tax Devices
Federal tax laws impose a tax, called the Estate & Gift Tax, upon a person’s right to give his/her property to others, without compensation, while that person is alive or after that person’s death. Fortunately, however, two federal tax devices can reduce the amount of the Estate & Gift Tax: the so-called “Lifetime Exemption” and the “Annual Exclusion.”
The Lifetime Exemption permits a person to give away a total of $5.34 million of assets, which amount is adjusted for inflation annually, during that person's life and after his/her death. In the case of a married couple, the Lifetime Exemption is double $5.34 million, or $10.64 million, as of 2014.
In addition to the Lifetime Exemption, federal tax laws also allow a person to annually give up to $14,000, also adjusted annually for inflation, to non-spouses, such as children. Gifts that qualify for the Annual Exclusion are not counted against the Lifetime Exemption. For example, a married couple with two (2) children can give each of those children $28,000 ($14,000 per child) of the couple’s assets, for a total of $56,000, per year without affecting their Lifetime Exemption.
Discounting
The theory behind discounting is fairly simple: all of the partial interests in a single whole are worth less than the whole, when combined. For example, the total value of all the materials used to build a house is less than the value of the completed house. A similar principle applies to ownership of real property, ownership of a business, etc.
In terms of an FLP, this enables the owners of some types of assets to transfer partial interests in those assets to others while substantially discounting the values of the transferred assets. For example, if a person owns 100% of a business worth $5 million and transfers 10% of that business to his daughter, the value of that 10% interest is likely substantially less than $500,000.
In conjunction with the Lifetime Exemption and the Annual Exclusion, discounting can permit a person to significantly reduce the value of his/her taxable estate through the use of an FLP. For example, if the married couple with two children mentioned above owns a business worth $15 million, about $4 million of which would be subject to the Federal Estate and Gift Tax as of 2014, they can significantly reduce the value of their taxable estate by contributing their ownership interests in their business to an FLP controlled by the couple, which contribution is a non-taxable event, and subsequently giving non-controlling, limited partnership interests in the FLP to their children. In addition to the discounting permitted, the gift(s) can also leverage the Lifetime Exemption or Annual Exclusion to potentially reduce the value of the couple's taxable estate, which could substantially reduce or eliminate any Federal Estate & Gift Tax.
This brief overview of some important considerations associated with family limited partnerships is by no means comprehensive. Always seek the advice of a competent professional when making important legal decisions.
Douglas K Cook is a tax attorney with over 40 years of experience as a practicing attorney. Although Douglas K Cook's office is located in Mesa, Arizona, he represents clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.
