A family limited partnership is generally financed with specific assets. Real estate provides the ideal investment, but not all assets are suitable for transfer to society. With respect to corporate partners, the shares of the S corporation cannot be owned by a partnership. Partners do not recognize gain or loss when they contribute assets to the partnership in exchange for their partnership interests. Additional capital contributions do not generate profit or loss for the partners or the company.

When a partner contributes capital or assets to the partnership, they are granted an interest in the partnership based on the partner’s contribution as a percentage of all contributions. Any additional contributions will increase the share of the partner and the other actions will have to be adjusted accordingly.

Donation of Company Units

Easy division of partnership interests into units offers the ability to transfer assets to family members within the available annual gift tax exclusion of $14,000 per year per donee for 2014-2015 or exemption equivalent Unified credit is $5,340,000 in 2014 and $5,430,000 in 2015. Valuation discounts exist that can be used to reduce the value of partnership units by 20 to 40 percent for gift tax purposes.

Three types of valuation techniques are generally used to calculate the fair market value of an interest in a closely held entity. The market method (also known as the comparable sales method) compares the privately held company with its unknown market value to similar companies with known market values.

The income (or discounted cash flow) method discounts to present value the anticipated future income of the company whose shares are being valued. The net asset value (or balance sheet) method generally refers to the value of a company’s assets net of its liabilities.

The market method or income method is most often used when the closely held company is conducting an active business or commercial activity. Net asset value is most often used when a privately held company primarily owns real estate or investment assets and does not conduct an active trade or business.

The value of a gift to a donee is the fair market value of the gift when it is made, not what the fair market value once was or might someday be. In Revenue Resolution 93-12, the IRS accepts that a minority interest in a limited partnership with restricted ownership rights to the limited partner qualifies for a fair market value discount of the underlying assets. This allows parents to gift significantly more to their children within gift tax exclusions and without loss of control.

To be eligible for the discount, the limited partner’s interest must be considered a minority interest (lack of control discount) and/or not freely transferable (lack of marketing discount). IRC §2036(b) includes gifts in the donor’s taxable estate of corporate stock in a controlled corporation in which the donor retained the right to vote on the stock. There is no corresponding tax code section for the interests of society.

Donors may wish to structure transfers or gifts of limited partnership units to qualify for the current unified credit exemption equivalent as noted above. These transfers do not have to meet the criteria as gifts of present interest, but removal of the estate at death is generally desired. Even if the donor continues to serve as general partner of the partnership and acts as trustee for all partners, the gifted partnership units will not be included in the estate of the deceased donor/general partner.

Operating a family limited company

As general partners, parents can accept equal pay from the partnership for their managerial skills. They can also establish whether the partnership will preserve or allocate income to its partners or whether it can lend funds to a limited partner. Parents can get money from the partnership to support current or retirement needs, subject to fiduciary standards (which are lower than those of a trustee). Wages paid to any member of the partnership are subject to withholdings imposed by the IRS and the state in which the partnership operates.

A partnership must file tax returns annually. The Federal return is the 1065 form and the State has an equivalent form. Any income received by the partners must be included in their corresponding tax return. Even if no distribution occurs, the partners must claim the amounts reported on the K1 form provided by the partnership.

Taxes and insurance for a family limited company

When considering income taxes, all assets transferred from the partnership to the partners retain the same nature as with the partnership. IRS Revenue Ruling 83-147 explains estate taxes on life insurance owned by a partnership on one of its partners. The result should be the same as corporate-owned life insurance. If the partnership is the beneficiary of the life insurance, then the insurance death benefit will be included in the partner’s estate only indirectly by the change in value of the deceased partner’s partnership interest.

To avoid increasing the deceased partner’s partnership interest in a portion of the life insurance proceeds, the policy could list the adult children as owners and beneficiaries of the policy at the beginning of the policy’s existence. General partners may distribute income to children as limited partners to pay policy premiums on the children’s property or the grantor of a trust the children have created. Grantors could direct the beneficiary’s estate in the event the grantor predeceased the father, which could help protect the cash value of the policy, if applicable, in the event of a divorce.

The risks of the family limited company

The IRS has issued, without administrative hearings, new regulations under IRC Subchapter K. In short, the IRS will rule out a partnership as an entity if the primary function of the partnership was income tax evasion, either at inception or during its operation. The proposed regulations are specific to income tax and do not apply to gift and inheritance tax assessments. This does not mean that the IRS will not address estate and gift assessments in the future. There are costs involved in forming and maintaining an FLP, including:

• Attorney’s fees to form the partnership (however, an attorney is not required
• Appraisal fees for the underlying assets and the “shares” of the partnership gifted to younger generation family members;
• Accounting fees for K-1 corporations and other financial assets;

Transfer tax costs such as documentary stamps when real estate is transferred. But for many investors, the benefits of well-planned FLPs easily outweigh the risks and costs.