By: Steven Abernathy and Brian Luster

50% or more of a family fortune could end up in the hands of the Internal Revenue Service if it is not properly protected.  Many people plan ahead to avoid overpaying income tax, but what about estate and gift taxes?  Family Limited Partnerships (FLP’s) are an excellent option to lessen their blow.  FLPs offer multi-layered benefits by providing senior family members with several advantages—all without ceding control of the assets to junior family members. Properly structured Family Limited Partnerships allow senior family members to:

• Gift assets to junior family members without ceding control;
• Protect assets from creditors and litigants;
• Bequest assets at a discount, thus minimizing or eliminating estate taxes;
• Reduce income taxes paid, by transferring Limited Partnership interests to lower earning junior family members;
• Lessen estate and gift taxes overall.

Nelson Rockefeller famously said, “The secret to success is to own nothing, but control everything.”  This is the soul of the Family Limited Partnership.  Unlike assets which are divided into equal shares, an FLP has two types of shareholders: 1) general partners, and, 2) limited partners.  No matter how minute a general partner’s interest is, he or she retains control despite the fact that a limited partner may hold a higher percentage of limited shares.  They are limited for a reason—limited partners do not exercise control over their shares.

Here is an example to illustrate how general and limited partnership shares work.  Picture a wealthy 70 year old CEO, whom we’ll call Mr. Saunders.  He owns a primary residence, a Cape Cod vacation home, Maui rental property, corporate stock, brokerage account, and an IRA.  Mr. Saunders and his wife have a few goals: 1) protect all of their assets from creditors; 2) eventually gift their wealth to their two children with as few transfer (gift and estate) taxes as possible; 3)   with respect to their income-producing assets, they want to minimize federal income taxes.

Unfortunately, Mr. Saunders’s made a crucial estate planning mistake—all of his assets are owned in his name.  Should he be sued, his personal assets will be threatened.  Additionally, he has a lot of property within his estate where taxes can be significantly reduced.

Now, let’s correct Mr. Saunders’s earlier mistake by employing a Family Limited Partnership.  First, Mr. Saunders, with the counsel of a trusted tax attorney, has to set up a FLP and capitalize it with the various assets he plans to gift to the kids.  Suppose Mr. Saunders’ Cape Cod vacation home and Maui rental property, each worth $1.5 million, and his corporate stock (worth $4 million) are contributed to a newly formed FLP called the Saunders Family Limited Partnership.  (Note: that the primary residence would be excluded from this since including it would risk Mr. Saunders’ mortgage deduction and capital gains exemption if the home were to be sold.)

In return for the contributed assets, Mr. Saunders and Mrs. Saunders receive small general partnership interests (1% for each of them; 2% total) as well as limited partnership interests (49% for each of them; 98% total) for the aforementioned contributed assets.

The general partnership interests mean Mr. Saunders and his wife retain complete control over their assets—even though they are now held by The Saunders Family Limited Partnership.  The assets however, are no longer owned by either party.  This means that even if a judgment is made in favor of a creditor against either Mr. or Mrs. Saunders, the assets within their FLP cannot be attached to that judgment.  This perfectly illustrates Nelson Rockefeller’s point of “owning nothing.”

FLPs also provide an excellent means to significantly reduce estate taxes.  The secret sauce involves the concept of “discounting,” which enables a grantor to gift assets at a discount to their Fair Market Value.  Picture yourself shopping for a new $100 shirt. As you are in the dressing room, you notice there is a blue chalk stain on the collar.  After bringing this to the attention of the store manager, he agrees to sell you the shirt for $60.  Once home, however, you easily remove the offending stain, yet own a $100 shirt for the price of $60.

Limited partnership interests work similarly.  Two factors reduce the value of the limited partnership interest: 1) the interests’ minority status, discussed earlier, and, 2) the interests’ lack of marketability due to clauses in the partnership agreement restricting the sale of any interest to a non-family member.  The value of the assets has not been reduced—the houses and rental property are still worth the same before and after an FLP’s capitalization.  Like the marked shirt, it is the value of the limited partnership interest that is being reduced.  It is not the assets that are being transferred out of the estate to the kids, but, the interests in the partnership.

Since discount rates can vary, it is vital to have the rate verified by a trusted valuation professional.  Our example will assume the limited partnership interests are discounted by 40%, a typical rate.  So, the two $1.5 million properties are now valued—as pertains to the partnership interests—at $900,000 each (60% of $1.5 million), while the rental property is valued at $2,400,000 (60% of $4 million).

Asset	Actual Value	Discount Rate	Discount Value
Vacation Property	$1.5 million	40%	$900,000
Rental Property	$1.5 million	40%	$900,000
Corporate Stock	$4 million	40%	$2,400,000
TOTAL:	$7 million	40%	$4.2 million

As illustrated above, the actual value of all three assets is $7 million and the discounted value is $4.2 million.

What would happen if the Saunders decided to gift their 98% limited partnership interests to their children?  Instead of using up Mr. Saunders’ entire unified gift and estate tax credit of $5,340,000, and $1,660,000 worth of Mrs. Saunders’ tax credit, the couple would retain the ability to gift an additional $6,480,000 worth of assets to their heirs, free and clear of future estate taxes.

Alternatively, the couple may choose to give away $28,000 of limited partnership interests to each child ($14,000 for an individual) every year by way of the annual gift tax exclusion.  This allows them to not only further save their unified credit amount, but, gift away the interests slowly so as to acclimate the children to their newfound wealth.  While the IRS has weapons to attack the discounted value from an estate tax perspective, most of these attacks can be parried by honoring the partnership formalities.

As an additional benefit, consider that the Saunders Family Limited Partnership now owns a revenue-generating rental property.  Since the Saunders children now own an interest in this building thanks to their limited partnership interest, rental income that flows through to the children will be subject to a much lower tax rate than Mr. Saunders’ bracket since he’s a wealthy CEO and each child earns a modest income.  The shifting of rental income to the kids saves Mr. Saunders money since the estate and federal tax burdens were moved—and therefore reduced.

FLP’s, from a tax-savings perspective, may be one of the most effective vehicles to create a “slow and steady” wealth transfer.  Dynasty trusts also offer an effective tax saving-strategy.  When effectively protected, assets remain in the family—and far less is paid to the tax man on April 15^th.

Brian Luster is a Managing Member and Portfolio Manager of a long/short US event-driven value-oriented hedge fund. Founder and Chief Executive Officer of a Multi-Family Office. Portfolio Manager of discretionary shareholder activist Separately Managed Account strategy. Author of 50+ articles covering investing and multigenerational asset management featured in such publications as Forbes, Barron’s, The Wall Street Journal, The Huffington Post, Private Air Magazine, The American Association of Individual Investors, Family Wealth Report, Medical Economics, Physicians Money Digest, Chiropractic Economics, Medscape, Practice Link, Practical Dermatology, Physicians Practice, Dental Practice Management, Buyside Magazine, and The Bottom Line. For more information, visit www.abernathygroupfamilyoffice.com.

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