For several decades, estate planners have been utilizing family limited partnerships (FLPs) and family limited liability companies (FLLCs) as “creative” planning tools to effectively discount the value of gifts. That practice is likely about to change. If finalized, proposed regulations will impact both personal estates and families with active business operations.
What is an FLP/FLLC?
Think of it as a wrapper. An FLP or FLLC is a way to hold marketable assets, which are transferred to trusts for the owner’s children, while taking discounts for lack of marketability. This wrapper discounts the value of the gift -- typically 25%-40% depending on the liquidity of the assets.
FLP and FLLC transactions are among the most popular business and estate-reduction techniques. Although the IRS has long viewed such strategies as abusive, there hasn’t been enough legislative support to clamp down on them -- until now. Treasury’s proposed regulations, expected to become effective in 2017, specifically target family transfers.
How will the new rules work?
The proposed regulations take direct aim at “deathbed” transfers, where the remaining parent is ill and contributes his or her assets to an FLP. That parent then transfers a small amount of interest to the children, making it impossible to liquidate the company himself, and claims an estate tax reduction in the value of his interest (between 20-50%) in the underlying assets. Treasury’s proposed rules would eliminate this practice by disregarding all transfers or lapses of liquidation rights that occur within 3 years of death. Thus, if the parent in question were to die within three years of the transfer, he or she would still be treated as holding the right to liquidate the company. This would prevent valuation discounts on the estate tax return (if company were sold, a hypothetical buyer could immediately force the company to liquidate and capture the underlying assets).
Treasury’s proposed regulations also take aim at the practice of forming family entities and then contributing assets that are likely to appreciate in value. Here, on the gift tax return, parents report the gift tax value at a 20-50% discount based on lack of marketability. The assets are thus removed from the estate with a reduced gift tax hit (or no gift tax if the amount falls within the lifetime gift exclusion). A popular variation on this theme is to gift a small amount of cash to the children or their trusts and have them purchase the limited partnership interests with that cash as a down payment and issue a promissory note for the balance. This has allowed taxpayers to “leverage” the gift and remove more value from their estates with a comparatively smaller gift tax effect. Again, this practice would become illegal.
The IRS hopes that it can disallow valuation discounts for FLPs and similar entities that are controlled by a single family, or by members of a single family with a small number of outsiders who have been added for the purpose of avoiding Section 2704. It is estimated that the proposed regulations will generate $19 billion in revenue over 10 years (according to the Obama administration’s “Green Book” budget proposal, 2009).
I was planning on forming an FLP/FLLC. What now?
You can still benefit from the existing rules by engaging in FLP/FLLC planning before the regulations become effective in 2017, as Treasury has provided a window of opportunity to use the family entities until the end of the year. Comments on the proposed regulations are being accepted until Nov. 2, 2016, and a hearing is scheduled for Dec. 1, 2016. The final regulations, if not substantially changed, will become effective 30 days later. If you have a taxable estate, now is the time to get your house in order. And, if you have closely-held family business interests, you may want to consider accelerating gifts before the regulations become final (keeping in mind that the new three-year rule discussed above may still result in lapsed rights being included in the transferor's estate).
Note that the IRS is still sensitive to the issue, so any family partnership planning must be done with the utmost care and strictly under the guidance of a highly qualified tax advisor. Other options are available and may make more sense.