FLPs Are A Tax-Minimizing Option
Though there are other reasons people might choose to set up FLPs, the tax minimization aspect is attractive to many, said Eric Larson, head of BeeneGarter’s Business Valuation Team.
An FLP can be advantageous for a family or individual with significant holdings in real estate, such as commercial property that’s being leased to unrelated parties, undeveloped land or, perhaps, a family cottage.
There are unique challenges in handing down real estate assets, Larson noted. Say a couple owns a commercial property on 28th Street and wants to transfer it to their three children. Real estate is not an asset that is easily divisible, whereas cash or stocks are, Larson pointed out. Giving a fractional interest in the ownership of real estate or giving away small pieces over time is very difficult, he said.
“Sometimes, there are restrictions on a person’s ability to divide the property,” he explained. “If you’re giving away shares in real estate, you basically have to subdivide the property into different parcels that will have to have different deeds. There are a lot of hoops you have to jump through to accomplish that. If you put it in a family limited partnership, you can do that much more easily.”
An FLP is an entity established to hold specific assets for investment and management purposes. A donor can contribute property to the FLP, and membership interests in the FLP can then be gifted from one generation to the next. It’s basically a partnership that’s similar to a company or corporation.
When a donor forms an FLP, he makes a contribution of the piece or pieces of property he wants to hand down. The partnership, or company, then owns the real estate. The donor retains 100 percent of the company and its stock or membership units. Over time the donor can give away small interests in the partnership to whomever he sees fit: He could give away a certain percentage of the real estate assets each year to his children or grandchildren.
“While the kids or grandkids don’t directly own fractional interests in that real estate, they indirectly do because they own interest in the entity that owns that real estate,” Larson continued. “It’s just a mechanism to kind of put the real estate in the ‘shell’ of a company and then have the company give away interest.”
Typically, a manager runs the company, be it the mother, father, uncle or an outside director contracted to oversee it.
Larson said the FLP has grown in popularity over the last 10 to 15 years due to some changes that were made in the tax law. An FLP is advantageous in several ways, Larson said. First, the donor retains some level of control over the entity and its underlying assets. Second, it allows for the gifting of small interests without the mess of fractional real estate interests. Additionally, the use of “valuation discounts’ can offer significant tax savings.
When minority interests in an FLP are gifted, the donor is usually eligible to use valuation discounts. For example, if a donor owns 40 percent of a manufacturing company that’s valued at $1 million, his value is going to be less than $400,000, primarily due to what’s called lack of control and lack of marketability: The minority owner has less control of the company due to his smaller share of it, and his ability to sell his interest in the company is hindered because its value on a prorata basis is significantly less, Larson explained.
There are some drawbacks to FLPs, Larson cautioned. The FLP has to have a legitimate business purpose, and it has to be properly formed and maintained. The IRS is aware of FLPs and recognizes there can be significant tax benefits in utilizing them, so the agency doesn’t look favorably on these tools many times, Larson said. FLPs can’t be set up just to avoid taxes.
“At the outset it’s really important that a qualified attorney draft the documents, set the entity up properly, and work with the client to make sure the partnership is run and maintained properly over time. Little mess-ups somewhere along the way can have huge consequences.”
Larson noted that other assets, such as cash and investments, are also good choices for contributions to an FLP.