Family limited partnerships are generally funded with certain assets. Real estate makes an ideal investment, but not all assets are suitable for transfer to a partnership. Regarding corporate partners, S-corporation shares cannot be held by the partnership. Partners do not recognize a gain or loss when they donate property to a partnership in exchange for their partnership interests. Additional capital contributions do not result in a gain or loss for the partner or partnership.
When a partner contributes capital or assets to a partnership, the partner is assigned an interest in the partnership according to the partner’s contribution as a percentage of all contributions. Each additional contribution will increase the partner’s share and the other share must be adjusted.
Partnership Unit Award
Easy division of partnership interests into units offering the ability to transfer assets to family members in the annual gift tax exemption available which is $14,000 per year per beneficiary for 2014-2015 or equivalent integrated credit exemption is $5,340,000 in 2014 and $5,430,000 in 2015. There is a valuation discount that can be used to reduce the value of the partnership unit by 20 to 40 percent for gift tax purposes.
Three types of valuation techniques are commonly used in calculating the fair market value of an interest in a closely held entity. The Market Method (also referred to as the comparable selling method) compares closely held companies with an unknown share value with similar companies with a known share value.
The income (or discounted cash flow) method discounts the present value of the anticipated future earnings of the company whose shares are valued. The net asset value (or balance sheet) method generally relies on the value of a company’s assets after deducting its liabilities.
The market method or the income method is most often used when a closely held company carries on an active trade or business. Net asset value is most often used when closely held companies primarily hold real estate or investment assets and do not engage in active trading or business.
The value of the gift to the recipient is the fair Market value of the gift when it was made, not the fair Market value of the past or maybe someday. Under income rules 93-12, the IRS accepts that a minority interest in a limited partnership with limited ownership rights to a limited partner is eligible for a discount on the fair Market value of the underlying asset. This allows parents to give their children more in the gift tax exemption and without losing control.
To be eligible for a discount, the limited partner’s interests must be considered a minority interest (uncontrolled discount) and/or not freely transferable (discounted lack of marketing capability). IRC 2036(b) includes a gift in the taxable property of a donor-owned company’s stock in a controlled company in which the donor retains the right to vote. No part of the tax code is appropriate for partnership purposes.
Donors may wish to arrange for a transfer, or gift, from a limited partnership unit to qualify for the current equivalent unified credit exemption as previously stated. This transfer does not have to qualify as a gift of interest, but the abolition of the estate at the time of death is usually desirable. Even if the donor continues to serve as the general partner of the partnership and acts in a fiduciary capacity for all partners, the granted partnership unit will not be included in the estate of the deceased donor/general partner.
Operating a Limited Family Partnership
In their capacity as general partners, parents may receive a fair salary from the partnership for their managerial capacity. They can also determine whether the partnership will retain or allocate revenue to its partners or they can lend funds to limited partners. Parents can get money from the partnership to maintain their existing needs or retire, subject to a fiduciary standard (which is lower than that for a trustee). Salaries paid to anyone in the partnership are subject to deductions as determined by the IRS and the State in which the partnership operates.
Partnerships are required to file a tax return every year. Federal returns are form 1065 and State has equivalent forms. Any income received by partners must be included in the appropriate tax returns. Even if no distribution occurs, the partner must claim the amount reported on the K1 form provided by the partnership.
Taxation and Insurance for Limited Family Partnership
When considering income taxes, all assets transferred from a partnership to a partner remain of the same nature as the partnership. IRS Income Decision 83-147 describes the taxation of life insurance estates held by a partnership in one of its partners. The result should be the same as the company’s life insurance. If the partnership is the heir of the life insurance, then the death insurance benefit will be included in the property of the partner only indirectly with changes in the value of the interest of the partnership of the deceased partner.
To avoid increasing the partnership interest of the deceased spouse with a portion of the life insurance income, the policy may list adult children as owners and beneficiaries of the policy at the beginning of the policy’s existence. General partners can distribute income to children as limited partners to pay the premiums of policies owned by children or trustees that have been created by children. The grantor can direct the succession of recipients in the event that the grantor dies older than the parents which can help protect the cash value of the policy in the event of a divorce.
Limited Family Partnership Risk
The IRS has issued, without administrative scrutiny, new regulations under Section K of the IRC. In short, the IRS will ignore a partnership as an entity if the primary function of the partnership is income tax evasion either at its inception or during its operation. The proposed regulations are specific to income tax and do not apply to gift and property tax assessments. This doesn’t mean the IRS won’t be discussing estate and prize valuations for some time to come. There are costs involved in establishing and maintaining an FLP, including:
• Attorney’s fees to form a partnership (but no lawyer required
• Valuation fees for the underlying assets and for partnership “slices” awarded to younger generation family members;
• Accounting fees for K-1 partnerships and other financial assets;
Transfer tax fees are like a documentary stamp when transferring real property. But for many investors, the benefits of a well-planned FLP outweigh the risks and costs.