In recent years, the IRS has increased its auditing activity. This trend will persist as the government continues to target families it believes are abusing the use of discounts. One of the most beneficial ways to curb wealth transfer taxes is to establish a family limited partnership (FLP). However, structuring and managing a FLP is a complex undertaking, and individuals who wish to transfer wealth to younger family members risk making critical mistakes that could result in audits, penalties, and higher taxes. Consulting with certified appraisers prior to gifting allows you to decrease the cost of wealth transfer without inadvertently triggering red flags.
Transfer taxes can be staggering. There are estate and gift taxes, as well as a generation-skipping transfer tax imposed on gifts to grandchildren and others. A FLP is often used in concert with a comprehensive strategy for gifting non-controlling interests, to minimize these setbacks. A FLP is an estate planning strategy that allows you (as the general partner) to give your assets away to your heirs. The heirs don’t own the assets outright, making them less valuable from a tax perspective. The FLP may contain real estate, a family business, or securities. You retain a small interest as general partner, and the remainder of the assets are transferred, all at once or incrementally, as limited partnership interests to heirs.
FLPs are beneficial because creditors cannot easily penetrate the partnership to seize assets, and, from an estate tax perspective, general partners reduce the value of included assets. For people with sizeable estates, significant private business interests, or real estate that they do not plan to sell, FLPs have become a popular estate planning tactic, more so than conventional trusts, which force donors to forego ownership of their assets. But FLPs are complex and require expert assistance to avoid undo IRS scrutiny. The first, and most crucial, step is to obtain valuations of the underlying assets.
In order for assets to be appropriately discounted through the use of a FLP, their fair market value must first be determined. That’s why it is crucial to engage a valuation professional at the outset of the process. Once those numbers are established, a discount analysis is performed to assess the value of the interests being transferred. Since limited partners exercise no control over partnership assets and the marketability of the assets is limited, the value of the partnership interests is discounted for tax purposes. If, however, a valuation expert is not involved early, a FLP is more likely to be audited, at which time an expert will need to be hired anyway, and the involvement of the IRS will cause the valuation expert’s role to become much more extensive (and costly) than would have been necessary originally. Not to mention potential fines and unforeseen adjustments to your tax liability.
The complexity of managing FLPs goes beyond valuation. The partnership must also follow a number of annual record-keeping regulations, and take steps to avoid classification as an investment company, in which case appreciated assets would be subject to increased income taxes. However, most partnerships can sidestep these difficulties through thoughtful planning and consultation with knowledgeable tax and legal advisors.
FLPs can provide significant transfer tax savings, allow the donor to retain control over the assets, and also enable them to gift a greater amount of partnership interests to a younger generation. If you’re considering a FLP as part of your gifting strategy, be sure to keep the IRS at bay by properly valuing your assets. A reliable and comprehensive valuation is the cornerstone to all successful FLPs.