8944 / What estate and gift tax planning opportunities are available through use of the family limited partnership structure?

In order to appreciate the tax planning opportunities afforded by using a family limited partnership (FLP), the estate tax and the current limitations on transferring wealth in a tax-advantaged manner warrant a brief overview. In Holiday v. Commissioner,1 the tax court succinctly described the relevant estate tax code provisions when examining transfers:

Estate tax is imposed on the transfer of a decedent’s taxable estate.² The taxable estate consists of the value of the gross estate after applicable deductions.³ Except to the extent provided in sections 2033 through 2046, the gross estate includes “all property, real or personal, tangible or intangible, wherever situated.”⁴ The value of the gross estate includes the value of such property, to the extent of the decedent’s interest in it, at the time of death.⁵

Section 2036 is intended to include in a decedent’s gross estate inter vivos transfers that were testamentary in nature. Accordingly, a decedent’s gross estate includes the value of all property that the decedent transferred but retained the possession or enjoyment of, or the right to the income from, for the decedent’s life.⁶ This rule, however, does not apply in cases where the transfer was a bona fide sale for adequate and full consideration.⁷

The core concept in estate planning is simple: estate tax is levied upon asset transfers at death. Therefore, to reduce the tax burden on one’s estate, a taxpayer often seeks to transfer value outside of his or her estate prior to death. Gifting property eliminates future growth of the estate and any income produced from gifted property is not included in the donor’s estate.

However, individuals seeking to transfer wealth face a common problem—the amount he or she is able to transfer that is exempt from gift tax is limited by the annual gift tax exclusion and gift tax credit. The annual gift tax exclusion for 2025 is $19,000, which allows an individual to give away up $19,000 per year ($38,000 for a married couple that elects split gift treatment) per donee without triggering the gift tax.⁸ The lifetime transfer tax exemption for 2025 is $13.99 million, which means that the first $13.99 million of a decedent’s estate is exempt from transfer taxes.⁹ This amount will be increased to $15 million in 2026.

Because the value of the decedent’s gross estate includes the value of property at the time of death,¹⁰ estate and gift tax planning strategies aim to accomplish two goals: reduce the gross estate through transferring assets prior to death and minimize transfer taxation. For high net worth individuals, the annual gift tax exclusion and lifetime transfer tax exemption may be insufficient for accomplishing these goals, although the expanded exemption eases that burden for 2018-2025.

Accordingly, FLPs have developed to provide taxpayers a new avenue to transfer wealth and minimize transfer taxes while also accomplishing non-tax goals. The tax advantages of a FLP are best illustrated with a simple example involving A and his two children, B and C. A contributes real estate valued at $10,000,000 to a newly formed partnership. In exchange for his contribution of assets, A receives a 1 percent general partner interest and a 99 percent limited partner interest in the partnership. A then transfers a 49.5 percent limited partner interest to both B and C. Assume that the discount for lack of control is 10 percent and the discount for lack of marketability is 15 percent. This transfer would be valued for estate and gift taxes purposes at $7,500,000, ($10M – ($10M × 25%)). The value of the underlying real estate is still worth $10,000,000, but the value for transfer tax purposes has been reduced by the combined 25 percent discount. Further, A still has control over the management of and cash flow of the property as the general partner. Assuming A is successful in substantiating his 25 percent discount, he has removed $2,500,000 from his taxable estate with no diminishing value to the asset transferred to his children. Further discussion regarding the available discounts to FLP interests are discussed in Q 8945.

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Planning Point: Clients who have created family limited partnerships (FLPs) as estate planning mechanisms may wish to reevaluate the benefits provided by the FLP structure in light of tax reform. Many FLPs are formed in order to reduce estate taxes, but the doubled estate tax exemption from 2018-2025 may mean that these clients will no longer be subject to the estate tax at all. Typically, FLPs involve a lifetime gifting strategy that can permit the donor to retain a degree of control over his or her assets. However, making these gifts means that the donor foregoes a step-up in basis at death. If the client who formed the FLP will no longer be subject to the estate tax, he or she may wish to dissolve the FLP in order to obtain that step-up in basis. These clients should be aware of the potential for taxation under IRC Section 731 if the FLP distributes cash or marketable securities in excess of basis, in which case the distribution will be treated as ordinary income. Taxation can be avoided in several scenarios, such as if the property is distributed to the same partner who originally created it, or if the partnership is an investment partnership and distributions are made to eligible parties.

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