With estate tax rates beginning at 37% and rising quickly to an effective rate of 60%, poorly planned estates can lose over half of everything they own to the government. While no tax is due on the first $600,000 of property, the remainder is taxed very heavily. And the tax has to be paid fast – within 9 months of a person’s death.
The solution to that problem … the way to keep property in your family and not let it go to the government … is by taking firm steps now to reduce estate taxes to the smallest reasonable amount and then to develop a way to pay them.
One of the best ways to reduce estate taxes is for older family members to give property to younger family members during their lifetimes. Property given away during life won’t be subject to an estate tax if the gifts are completed correctly. The problem, however, is that the gift tax rates are identical to the estate tax rates so if you give away a lot of property at one time, you may wind up paying a gift tax that’s as big as the estate tax. That may not be very smart.
It’s very smart, however, to give away as much as you can without paying gift taxes. And that can be quite a bit. First, you can give $10,000 every year to as many people as you want. This is called an annual exclusion. If you’re married, your spouse can join in that gift and boost the tax-free amount to $20,000 per person. Beyond that, you can also give a total amount of $600,000 without any gift tax. This is called the lifetime exemption.
So, if you don’t have a very large estate and if there are a number of people you want to receive your assets, regular annual gifts and your use of the lifetime exemption will probably solve your problem.
However, if your estate is fairly large, if it’s growing quickly in value or if there aren’t a lot of people to whom you want to make gifts, you may not be able to give it away faster than it grows. Or you may not want to give up either the control or the income you receive from some of your assets. Some people with $20 million dollar estates would be very nervous making a $100,000 gift because they think that they just might need the money someday. Or they may have assets which are worth a lot but don’t generate much income – not enough to both live on and make substantial gifts, too.
If you or someone in your family fit any of these categories, then you’ll find our discussion very helpful. You’ll see how you can give away property but retain control and enjoy its income. You’ll see how you can turn low income property into high income assets and generate income tax savings in the process. You’ll also discover how both your annual gift exclusions and your lifetime exemption can be magnified … in other words, how you can give away more than $10,000 per person per year and more than $650,000 … all without paying gift taxes. In other words, how you can make not just gifts, but Supergifts.
A Supergift is any kind of gift which allows you to retain control of and income from the gifted property and where its transfer value – its value for gift tax purposes – is less than what it’s worth in your estate.
Family Limited Partnerships, Residential Trust and Charitable Remainder Trusts are some of the most powerful types. In this segment, we’ll discuss Family Limited Partnerships. We review Residential Trusts and Charitable Remainder Trusts in other segments of our wealth-keeping series.
Now, when you read the word “trusts”, you may have groaned a little. Well, take heart. In plain English, we’ll explain how a Family Limited Partnership can save your family hundreds of thousands, maybe even millions of dollars in estate taxes. What we’ll discuss in the next few pages may make more difference to your family and its wealth than anything else you’ve ever read. So, please read carefully.
Family Limited Partnership A Family Limited Partnership is a legal entity formed under a state’s limited liability partnership law. Some states also permit the creation of limited liability corporations and, in those states, it may be better to use a Family Limited Liability Corporation. However, since both forms of organization can have the same tax advantages, our discussion will focus on Family Limited Partnerships.
The Family Limited Partnership or – FLP for short – is simply a limited partnership in which only members of the same family, a family trust or a wholly owned corporation are members.
The FLP has two kinds of partners: general partners and limited partners. The general partners really run the show: they have complete control over its assets, they determine when assets are brought and sold, they manage the assets, and they even decide when and how much of the partnership’s income will be distributed.
The limited partners have no control over either the assets or the income of the partnership. They also have no authority over the general partners – they can’t fire the general partners or replace them. Their authority is very limited and that’s one reason this kind of organization is called a limited partnership. It’s also called that because the liability of the limited partners is limited to their investment in the partnership. In other words, the limited partners aren’t liable for the partnership’s debts.
A Family Limited Partnership has two big gift and estate tax advantages. First, it allows the donor to make a gift – get property out of his or her estate – and yet control the asset and its income. Second, an FLP permits a donor to discount the value of a gift for gift tax purposes – in other words, a donor might give away property worth $1 million in his estate but its gift tax value might only be $600,000. Let’s look at a case to see how these benefits work.
The Baxter Case Our clients, Harry and Catherine Baxter, have come to us once again for advice. Harry’s 74, Catherine’s 72 and they have two children. They have a $5 million estate that consists of some stocks, bonds, savings accounts and real estate. The majority of their estate is a large farm. The Baxter’s are solidly in a 55% estate tax bracket and they want to reduce their potential taxes.
If Harry and Catherine do no gifting at all, if their assets grow at just 5% per year and if they live for 15 years, their estate will double in value to $10 million. The taxes on a $10 million estate – even assuming that they’ve created a Bypass Trust, – are $4,618,000. That’s about half their estate … and that’s very bad.
Well, let’s give the Baxter’s another chance. Let’s bring them back to life, run the clock back 15 years and try it again. But this time, Harry and Catherine will give their children a $2 million chunk of property. That gifted property, which will grow in value to about $4 million in 15 years, will avoid an estate tax of about $2 million.
Now that’s great for the children, but not so great for Harry and Catherine because the gift produces a gift tax of $320,000, even after using up all of their lifetime exemptions. And the Baxter’s have to pay it, right then and there.
Even worse, the property happens to be Harry’s farm. He loves that place, he built it from the ground up, and the idea of not running it anymore just about kills him. In fact, it’s so painful that he’s just going to forget the whole thing and let the kids figure out how to pay the taxes when he dies.
Here’s a better way. Harry and Catherine form a Family Limited Partnership which has 1 general partnership unit and 99 limited partnership units. Then, they transfer the farm into the partnership and get all of those partnership units – both the general unit and the limited units – in exchange. This is an income tax free transfer. At this point, they don’t own the farm but they own the partnership which does.
So now they give away all of the limited partnership units – 99% of the partnership and they keep the general partnership unit.
What have they accomplished? Well, they just moved $1,980,000 … call it $2 million … out of their estate – $2 million that would have grown to $4 million in 15 years. And, by doing that, they’ve just cut their estate tax bill by $1,540,000. That’s a pretty good start.
But they’ve done that without losing any control. As the FLP’s general partners, Harry and Catherine still run the farm. They still control the asset and the income it generates. In fact, they even get to take a salary from the partnership for managing it so they’ll still enjoy some of the income which the farm produces. And yet, 99% of the farm is out of their estate. This really is like having your cake and eating it too. Now, you may be saying “Hey that’s great … but what about the gift tax. Won’t that wipe out a lot of the benefit?” Good question.
Valuation Discount: The Tax Saver Remember that Harry and Catherine owned a $2 million farm. But they didn’t give the farm to the kids. First, they exchanged it for units of a Family Limited Partnership and then they gave away the limited partnership units. Sure, the limited partnership units represent 99% of the partnership’s assets. But are they worth $2 million?
The federal tax code says that gifts will be taxed based on their fair market value on the date of their transfer and that “fair market value” is what a knowledgeable buyer and a knowledgeable seller would exchange for them.
The IRS says the gift’s value is “the fair market value” determined by a prudent buyer and seller, based on all relevant facts and reached in an “arm’s length transaction”.
So, let’s imagine that the Baxter children came to you one day after they were given the limited partnership units and they offer them to you. What would you pay for these units after you realized that?
• You’ll have no control over the partnership or the assets in it.
• You’ll have no control over or right to the income it produced.
• You’ll have to pay income taxes on almost all of the partnership’s income even if the general partner didn’t distribute any of it to you.
Are you ready to write the Baxter kids a check for $2 million?
Of course you aren’t and neither is anyone else … and even the IRS understands that. That’s why they allow an adjustment to the $2 million gift.
The precise amount of adjustment allowed will vary from case to case and it may need to be determined by a professional appraiser. However, a 40% discount is not uncommon. So, applying a 40% discount to this gift reduces its gift tax value to $1,200,000.
Since Harry and Catherine haven’t used any of their lifetime exemptions until now, this gift doesn’t trigger any gift tax.
Let’s review. When Harry and Catherine made no gift, they had a $10 million estate and their children lost over half of it to federal estate taxes. But, by transferring the farm to the partnership and then giving 99% of the partnership to the kids, the Baxter’s reduced their taxes by over $1.5 million which means that the kids ended up with almost $7 million instead of $5.4 million. Do you think it’s worth a little work now to save that kind of money?
In our example, you saw how a piece of real estate could be placed in an FLP but so can almost any other kind of asset, including stocks, bonds and many family businesses.
Paying the Taxes Even after this gift, the Baxter’s will have an estate tax of about $3 million. Now that shouldn’t be ignored – we should determine the most effective way to pay it. When we look at all the alternatives, we’ll probably conclude that life insurance will be the most efficient and least costly way to pay the tax. Even for people in their mid-70’s life insurance will often cost about 30% less than all of the other tax payment options.
We frequently recommend placing life insurance in an irrevocable trust because, by doing that, we can keep the insurance free of both estate taxes and we can also accomplish that result with a Family Limited Partnership. Here’s how. Let’s assume that the partnership earns income of $100,000 every year – that’s a return of about 5% after-tax. It uses that income to fund a $3.1 million life insurance policy on Harry and Catherine.
When Harry and Catherine die, their kids will get all of the money in the Bypass Trust, all of the money in the FLP and all of the money in Harry and Catherine’s estate. The FLP owns the $2 million farm and over $3 million in cash – cash which came from the insurance policy.
While they’ll owe estate taxes on Harry and Catherine’s estate, the insurance provides enough cash to pay it and, because it was owned by the FLP, the policy will be 100% income-tax free and 99% estate-tax free.
The net result is that even after paying the estate tax; the kids will wind up with $8,022,000. $8,022,000 … compares that to only $5.3 million without the partnership and $6.9 million without life insurance. With life insurance in an FLP, we’ll be able to reduce the Baxter’s net shrinkage to less than 20%.
Clearly, Family Limited Partnerships and Family Liability Corporations can produce tremendous tax savings. To accomplish this, you need the help of an experienced attorney, accountant, financial planner, insurance agent and appraiser. With potentially millions of dollars in tax savings at stake, you don’t want to make an error that the IRS uses later to blow those savings away.
But, if you create and operate a Family Limited Partnership correctly, it can pass a very large share of your property on to your family, instead of letting it go to Washington, DC. It’s a very powerful estate-saving tool which you should consider carefully.