Family Limited Partnerships – the double edged sword (Part 2)
A “family limited partnership” or “FLP” can have a powerful impact on an estate and family. Like a two-edged sword, however, an FLP is an effective weapon when pointed in the right direction, but devastating when aimed the wrong way!
Our farm couple, Bill and Mary, can use an FLP to give part of the value of their farm to their children without losing any control. They establish their FLP with 2% “general” (controlling) interests and 98% “limited” (non-controlling) interests. While living they will give children some of the limited interests.
Aimed at the IRS
The FLP can “leverage” the couple’s gifting because the fair value of limited interests is discounted for lack of control and lack of marketability—the children don’t get a voice in management and they cannot sell their limited partner interests to anyone else. This helps Bill and Mary give a percentage of the FLP to their children, since they are limited by gift tax law on the annual value they can give.
This discounting principal also applies to the limited interests Bill and Mary still hold at death. They may still own 75% of the limited interests of the FLP (having given 23% to children) and the FLP might be, in total, worth $5,000,000. But the value of their 75%, because of discounting, will be something like $2,500,000. The IRS can only assess estate taxes on $2,500,000 instead of $3,750,000.
Aimed at people who sue
What if Bill or Mary has an accident and gets sued? If a jury awarded a large judgment against them and they had no FLP, their land could be taken to satisfy the judgment. However, if they had previously placed the land in an FLP it is generally impossible for the lawsuit to place a lien against their farm. Illinois law provides that the creditor (individual who sued them) can only get a “charging order” against their shares of the FLP; if and when income is distributed from the FLP the creditor gets that income. The creditor might have to wait many years. This fact gives Bill and Mary an opportunity to settle the lawsuit for a much smaller sum.
Careful where you point that thing!
While Bill and Mary are living and still own the 2% general partner interests they maintain complete control. When they die, the control passes with those general partner interests. This demands careful planning. What if they leave the controlling 2% general interests entirely to Tom, the farming son, along with 23% limited interests, and to each of their other three children 25% limited interests.
While the FLP continues, Tom would be able to keep the others from receiving any money or property! As general partner, he could lease the land to himself. The rent would be taxable income to all the partners, but Tom could keep the money in the FLP and buy more land, more land for him to rent and farm. The others would have to pay 75% of the income taxes for rental value of all the land, but they don’t actually receive any income! They might end up begging him to stop, offering to sell him their interests for pennies on the dollar.
Maybe Tom goes a different direction. He sells every bit of the farm and invests the proceeds in the stock market. He could pay himself a handsome management fee of 4% per year—$200,000—and reinvests all other profits, never distributing a penny to his siblings. They will pay income tax each year on their 3/4ths of the net profits from his investing, however.
And they will never have another reunion.
Split up the control of the FLP if you want all children to be treated fairly. Maybe the farming son should have more control, but the non-farmers need a voice, too. If out of the 2% general interests Tom had 0.8% and each of the others had 0.4%, then he would have to treat them fairly in order to get at least one of them to vote for his decisions.
Alternatively, establish the FLP with a fixed termination date that will occur not many years after your death. The non-farmers might have to wait until then, but at termination they will get their share of the property. The farming son can buy out the others’ land, or lease from them directly.
Approach legal tools like FLPs with great caution and experienced counsel. Use appropriate weapons on legitimate enemies. Don’t arm your children against one another!
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Article authored by Curt W. Ferguson and originally published in the Prairie Farmer magazine, June 2006 issue