This is the second part of a two-part series. Click here to read the first part.

HE SAYS:

As was stated in our last post, a Family Limited Partnership (FLP) can, under the right circumstances, be a very effective estate planning strategy for the transfer of a family business to the next generation; however, it is not something anyone should pursue without careful consideration.

One of the most important steps in forming a FLP is determining the value of the business.  The fact that most small businesses are not very liquid allows the valuation, for purposes of the FLP, to be discounted by as much as 35% to 45%.  The premise is that the value of only a part of the business can be reduced based on the fact that very few people would buy a partial interest in a privately owned family business which does not have a ready market for resale.  This creates the advantage of allowing the business owner to transfer, through the use of the annual gift tax exclusion, interests in the business to his/her children at a faster rate due to the discounted value.

Perhaps, the biggest advantage of a FLP is the applicable tax rate.   Because the income of the FLP is not taxed at the partnership level but is passed through to the individual partners’ personal tax returns, the applicable Federal tax rates for the FLP are based on the individuals’ Federal income tax rates rather than the higher rates generally applicable to trusts.

It must be pointed out that the IRS, in an effort to prevent abuses, has issued regulations that affect FLPs.   In order to qualify for the pass through taxation rules, the FLP must meet the following requirements:

  • the partnership must be bona fide and each transaction must be entered into for a substantial business purpose;
  • the form of each transaction must be respected under substance over form principles; and
  • the tax consequences of each partner must accurately reflect the partner’s economic agreement and clearly reflect the partner’s income.

Since this is a very complicated area of the law, it is highly recommended that you consult with a knowledgeable Accountant, Certified Financial Planner and/or Attorney who specializes in estate planning before you take any action.

WHAT DO YOU SAY?

HE SAYS:

Regardless of where you stand on the debate over whether or not the Federal Estate Tax should be repealed, this tax raises issues that should be of concern to everyone who has worked hard to build a successful small business in the hopes that the business will provide security for their children for many years into the future.  The inevitability of death and taxes can shatter your hopes and dreams.

Upon your death, the “fair market value” of your business will be included in your estate and in 2011 can result in a Federal Estate Tax of up to 35% (plus a NYS Estate Tax of up to 16%) of that value, after the exemptions and assuming no unlimited marital deduction to a spouse is available.  Since most small businesses usually represent the largest asset in an estate and generally do not have large reserves of cash, many families find that they have to sell the business in order to pay the estate tax on the business.

Even if you believe that the real value of your business is not high enough to worry about the impact of estate taxes, it has been my experience that the IRS usually determines the “fair market value” of your business to be higher then the price you might actually be able to sell it for since the “fair market value” is a theoretical accounting value and does not necessarily reflect the real value of the business after taking into effect all of the variables in the marketplace.

Unless and until the estate tax is repealed, this dilemma will continue to plague the hard working owners of small businesses and their families.   The only practical solutions presently available are sound estate planning strategies.

One such estate planning strategy is the Family Limited Partnership (FLP).   A FLP is set up in the same manner as any other partnership.  The business owner transfers the business to the FLP, names himself/herself as the general partner with a very small ownership interest and gradually transfers the remaining interest in the business to the children as limited partners.   The general partner makes all the decisions, including under what conditions power and money will pass to the children, while the limited partners hold most of the equity.

In the next installment, we discuss the benefits and possible pitfalls of a Family Limited Partnership.

WHAT DO YOU SAY?