|FLPs & FLLCs: What are they and how do they work?
by Jon Austin
Perhaps you have recently read about or heard a friend or colleague refer to FLPs or FLLCs and have found yourself wondering about this seemingly new way to save money and/or avoid taxes. This article will hopefully provide a framework for determining what FLPs and FLLCs are, how they work, how to implement one, and some of the concerns associated with using them.
What are FLPs and FLLCs?
Family limited partnerships (FLP) and family limited liability companies (FLLC) have been used by attorneys, certified public accountants, and others for over a decade as a legal means of wealth transfer tax planning. These entities are structured in a similar fashion to a traditional limited partnership or limited liability company, except, in general, they are owned and operated solely by family members. In addition, when structured properly, they enable family members to transfer family wealth and assets from one generation to another and receive discounts on the value of the property transferred, either by gift or at death, and, thereby, receive favorable tax advantages. FLPs and FLLCs have received the IRS's blessing in accomplishing these and other goals, but only when they are organized and operated in a manner consistent with the applicable rules as promulgated by the IRS and the courts.
How do FLPs and FLLCs work?
In general, family members will transfer some of their personal assets (e.g., cash, marketable securities, real estate, oil and gas working interests, etc.) to the entity in exchange for proportionate interests of ownership in the FLP or FLLC. The managing member of an FLLC (or the general partner in an FLP) will in turn manage these assets, which now belong to the entity, according to the terms of the respective governing agreement.
There are several tax and non-tax reasons for using either an FLP or FLLC, both of which are beyond the extent of this article. However, the most sought-after benefit generally has been the ability of an interest holder to obtain valuation discounts for gift and estate tax purposes.
The two most common types of discounts are lack of marketability and lack of control. In short, interests in family-owned entities are typically not traded as public securities. Therefore, there is a small market, if any at all, for such interests. This means these interests are difficult to liquidate and/or sell to a third-party. Consequently, the interests are given a discount as to their market and taxable value. In addition, an individual with a minority interest in the entity has little control over the management of the entity. Therefore, it is common to apply a discount to this minority interest because of the relative lack of control associated with this interest. In other words, because of these two factors, lack of marketability and lack of control, there is often a difference in the fair market value of an interest in a family-owned entity as compared to the value of that same interest if the entity were liquidated and distributions were made based on one's interest. This difference is generally referred to as a "discount." Consequently, the value of these interests are "discounted" for purposes of gift and/or estate tax purposes.
Valuation discounts of FLP or FLLC interests range, in general, from 25% to 40%, depending on numerous factors, such as the type of assets held by the entity. Our firm believes a 30% discount as to the value of an interest is an appropriate benchmark for most entities with diverse asset holdings. Therefore, for purposes of calculating the value of interests transferred by gift and/or left in one's estate upon their death for gift and/or estate tax purposes, a 30% discount, for example, may be applied to the interests and, thus, reduce or avoid the respective taxes associated with either event.
How should one implement an FLP or FLLC?
One of the first steps in structuring an FLP or FLLC is the use of a sound governing agreement. This agreement will set forth how the entity will operate, the rights of the partners or members, distributions, non-tax business reasons for formation, etc. Second, good records must be kept for the benefit of the FLP/FLLC and the interest holder. The records must reflect that the interest holders are not commingling their personal assets with those of the FLP or FLLC. The records must also show that both the interest holder and the entity are receiving what they claim to be receiving, i.e., the entity has received the individual's assets, and, in exchange, the interest holder has received a proportionate interest in the FLLC or FLP. An interest holder must establish that sufficient assets have been retained outside and separate from the entity to support themself. In addition, certain personal assets (such as one's residence) should not be transferred to the FLLC or FLP. Finally, although not conclusive, is the importance of obtaining an accurate appraisal of the FLLC or FLP for determining not only the value of the entity, but also in calculating appropriate valuation discounts. A poor appraisal will lead to an inaccurate valuation discount, which may lead to an audit by the IRS, and, in certain circumstances, an attempt to recover those taxes not paid due to reliance on improper discounts.
What concerns are associated with using an FLP or FLLC?
The IRS has taken a renewed interest in family-owned entities. There has been much litigation in the courts over the past couple of years in which the IRS has challenged successfully the availability and use of valuation discounts. Where FLPs or FLLCs and/or interest holders do not follow the appropriate rules and guidelines, some of which are set forth above, the IRS and the courts will continue to seek, among other things, to disallow the use of valuation discounts.
Despite the IRS's increased focus and scrutiny over the use of FLLCs and FLPs, they continue to be a viable and legal tool for creating substantial valuation discounts in certain circumstances. Even when properly structured and administered, however, the potential remains for an audit by the IRS. Because this potential exists, it is imperative that those considering to use an FLLC or FLP consult competent legal counsel in pursuing this venture. Although there are many " t's" to cross and "i's" to dot, FLPs and FLLCs remain a valid mechanism for transferring family assets and obtaining valuation discounts.