Abstract: Family limited partnerships (FLPs) and family limited liability companies (FLLCs, are useful wealth-transfer techniques. Unfortunately the IRS is currently challenging wealth transfers involving FLPs and FLLCs on two fronts: gift tax and estate tax. What are the issues? What can you do about them?
New IRS Challenges to Contend With
Strategies for FLPs and FLLCs
Unincorporated family entities, such as family limited partnerships (FLPs) and family limited liability companies (FLLCs) are popular and useful wealth-transfer techniques. Unfortunately the IRS is currently challenging wealth transfers involving FLPs and FLLCs on two fronts: gift tax and estate tax.
Most previous challenges focused on the large discounts taken for intrafamily transfers of FLP or FLLC interests. But the IRS also began attacking estate tax returns of decedents who transferred FLP or FLLC interests during their lifetimes while retaining at least a partial interest at death. The IRS’s position now is to include the entire value of FLP or FLLC assets in a decedent’s estate.
Because of these IRS challenges, many parents and grandparents are reconsidering their FLPs or FLLCs. Should they retire from the FLP or FLLC after it achieves its principal purpose or die owning part of it and risk an IRS estate tax audit? Although these suggestions have estate tax benefits, they also can create income tax issues: Redemption or dissolution within the first seven years may inadvertently trigger a taxable event for income tax purposes. But there are ways to avoid tax on redemption or dissolution.
FLP and FLLC fundamentals
Parents or grandparents like FLPs and FLLCs because they can contribute highly appreciated investment assets — such as business interests, real estate and marketable securities — to an FLP or FLLC and then transfer part or all of their partnership or membership interests to younger family members at substantial gift-tax discounts. The parents or grandparents can control the underlying assets as the FLP general partners or FLLC managers, while transferring significant amounts of wealth. When they die, their remaining interests are redeemed and the FLP or FLLC is dissolved.
But what about the tax on redemption or dissolution? It stems from built-in gains. (For our purposes, let’s assume that a limited liability company [LLC] is taxed the same as a partnership, so references to FLPs also apply to FLLCs.) When you contribute appreciated assets to an FLP, your tax basis in your interest equals your contributed assets’ book values immediately before the transfer, thereby preserving the built-in gain. If you later give part of that FLP interest to your children or grandchildren, they succeed to your built-in gain proportionately to the transferred interest and are treated as having contributed that property.
For example, let’s say Steve and Janet contribute real estate with a built-in gain of $100,000 to an FLP and transfer a 25% FLP interest to each of their two children. Each child acquires $25,000 of the built-in gain, reducing the parents’ share of that gain to $50,000, and each child is treated as having contributed 25% of the real estate.
This rule helps ensure that when an asset is distributed to a partner, all partners realize their shares of built-in gain on the asset portion they are treated as having contributed. But contributing partners recognize no built-in gain:
o On distribution of property they initially contributed or are deemed to have contributed, or
o If the distribution occurs more than seven years after the property’s initial contribution.
These exceptions allow some tax-savings opportunities.
Avoiding gain recognition
What can you do to avoid triggering gain recognition on an FLP property distribution? Here are some strategies:
Pro-rata distributions. When each partner receives no more than his or her share of the appreciated assets in a distribution, no gain recognition results. The distribution is subject to tax only to the extent the received property exceeds each partner’s basis in his or her FLP interest.
If, in our earlier example, the partners want to avoid gain recognition, each child should receive — as part of any FLP property distribution within seven years of the FLP’s formation — no more than 25% of the real estate he or she is deemed to have contributed.
Grantor trusts. Rather than initially contributing FLP interests to your children or grandchildren individually, you may give FLP interests to a grantor trust or series of grantor trusts benefiting them. Then you and the trust are treated as one person for income tax purposes, and the entire built-in gain still rests with you. So you can distribute property non-pro rata to yourself and the grantor trust without triggering tax on the built-in gain.
Leveraged partial redemption for cash. Before distributing any property, an FLP may borrow enough money to redeem all but a small part of your FLP interests. If the debt proceeds are then used to redeem part of your FLP interests, as the redeeming partners, you should have enough basis in your remaining FLP interests to avoid income tax on the cash distribution. In general, if the debt is nonrecourse and you guarantee the loans, you should bear the economic risk of loss. That is, their basis in the FLP interest will be adjusted upward by the loan amount. For the redemption price to reflect a discount for lack of marketability and control, the redeeming partners’ interests should be “decontrolled” before redemption.
Taken as a whole, this leveraged partial-redemption technique is similar to a sale to a grantor trust but with two advantages at your death: It avoids the risk that gain will be realized because the trust will cease to be a grantor trust. And, your remaining interest will receive a basis adjustment.
Triggering tax
FLPs and FLLCs remain viable wealth-transfer options. But there may be situations where you want to get out and redeem your interests or dissolve an FLP or FLLC altogether. You must then carefully evaluate a strategy to distribute any built-in-gain property among the partners or members. Otherwise, any redemption or dissolution within seven years of formation may inadvertently trigger tax on the built-in gain. If you’re considering retiring or liquidating your FLP or FLLC, we’ll be glad to discuss your options with you.
Sidebar: How does the IRS view single-member LLCs?
Single-member limited liability companies (LLCs) are generally disregarded entities for tax purposes. If an interest in a single-member LLC is transferred and the LLC welcomes a second member for tax purposes, the new member is treated as having received a proportionate share of the underlying LLC assets that he or she in turn contributes to the LLC in exchange for an LLC interest. So the built-in-gain rules and recognition of gain on a transfer of an LLC interest don’t apply to a single-member LLC.
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