Finding the silver lining in economic clouds: family partnership and marketable securities

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John P. Dedon

As bad as balance sheets appear in these dire times, if we strain we can find the silver lining. There is a silver lining for business owners, primarily parents and grandparents, who are considering generational transfers to reduce their taxable estates. Business owners can take advantage of hard economic times by removing marketable securities from their taxable estates. The combination of low stock values, and market and minority discounts resulting from using family limited partnerships (FLP), can result in substantial estate tax savings. 

Business owners may be reluctant to part with ownership in their primary asset — their closely held company.  The company also may not have declined in value as dramatically as their public stock portfolio. On the other hand, the depressed stock market presents a unique opportunity to make current gifts and save significant gift and estate taxes. Therefore, if the business owner’s estate is still substantial because, in part, the value of the closely held company remains high, now is the time to gift marketable securities. 

There are a number of gifting tools available. One tried and true transfer tool with a long history is the FLP. In an FLP, the senior generation typically contributes the bulk of the assets and retains control as the general partners.  (The general partnership interests are analogous to voting stock of a corporation.)  They gift limited partnership interests to children and grandchildren. These limited partnership interests, which represent equity in the FLP, do not have any voting rights. The absence of voting rights and control often result in discounted asset values for estate and gift purposes. 

Taxpayers and the IRS have had many battles regarding whether FLPs can be used to reduce estate taxes, either by lifetime gifts or upon death.  Broadly stated, taxpayers assert FLP restrictions prohibiting limited partners from freely selling or controlling the FLP assets significantly depress the value of the limited partnership interests, and hence the partnership assets.  These “market and minority” discounts typically reduce the partnership asset values anywhere between 20 percent and 50 percent, depending on the type of asset, income generated from the asset, and other factors.  The IRS’ positions are varied, including: 1) there is no business purpose for the FLP, instead it is only a device to artificially reduce gift and estate taxes; 2) purported transfers are illusory because the transferors retained indirect control; 3) the formalities were not observed, such as FLP bank accounts were not opened, capital accounts, schedules, and tax returns were not prepared; 4) pro rata distributions to the partners were not made; 5) the discounts were too high, and on and on. 

Notwithstanding these IRS assaults, FLPs are still a valid planning tool if created properly and implemented appropriately.  A recent case supports using FLPs to reduce gift taxes even if the FLP consists only of marketable securities. In this case, the taxpayer contributed solely Dell Computer stock.  The court rejected the 49.25 percent discount claimed by the owners for the gift of limited partnership interests to their children. However, the tax court did allow discounts exceeding 20 percent, simply because the business owner used an FLP to gift limited partnership interests rather than gift the Dell stock directly. The court rejected the IRS’ position that the transfers were indirect transfers of the Dell stock and the FLP should be disregarded. The court also disagreed with the IRS position that Internal Revenue Code Section 2703 trumps the FLP agreement and treats limited partnership interests as freely transferable, thereby eliminating any market and minority discounts. 

What does this case mean to business owners seeking to reduce gift and estate tax?  Consider this example:

Mr and Mrs. Business Owner have a successful company and they want to retain 100 percent control and equity. They also have marketable securities that were worth $12 million in 2006. In 2008, their portfolio fell 25 percent to $9 million. They want to gift roughly one-third of the stock portfolio to their children. 

They first create an FLP, next they contribute the marketable securities to the FLP, and then they gift FLP limited partnership interests to their children. They obtain an appraisal which discounts the limited partnership interests by 31 percent, so that the FLP assets are worth $6.2 million.  They gift 30 percent of their FLP limited partnership interest to their children, which is worth only $1.9 million for tax purposes.  The underlying asset value, however, is $2.7 million. 

If the assets bounce back to $12 million, they have removed $3.6 million from their estates.  By taking advantage of the FLP and discounts, the estate tax savings based on a $9 million valuation is almost $400,000 (tax savings on a transfer of $1.9 million instead of $2.7 million).  If the portfolio bounces back to $12 million, the estate tax savings are approximately $800,000 (tax savings on a transfer of $1.9 million instead of $3.6 million).  These savings do not take into account the future appreciation also removed from the estate.

In sum, FLPs satisfy a number of advantages.  They can provide asset protection for assets inside the FLP; they can maintain assets for future generations by providing a management structure; and as discussed above, FLP’s provide significant estate tax savings for individuals seeking estate tax relief without losing complete control over the assets.

John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at www.dedononestateplanning.typepad.com.

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