Our final point of discussion regarding the newly proposed tax bill relates to limited partnerships. Limited partnerships are a common tool for estate planners and are usually called family limited partnerships (or FLPs) in the estate planning context. FLPs allow the senior generation to transfer wealth downstream while often retaining some control over the transferred wealth. Under current law, they also allow for valuation discounts on the assets held in the FLP, which helps move more wealth down the generations in a tax-advantaged way. This strategy typically consolidates the family’s wealth into a partnership, where the senior generation owns the large majority of the partnership interests. The senior generation will then give limited partnership interests to their children (or more commonly, trusts for their children), taking advantage of valuation discounts for lack of control/lack of marketability as to the transferred limited partnership interests. This results in transferring more wealth than the gift/estate/GST exemption would otherwise allow because of the discounting.
If passed into law, the currently proposed legislation creates a tsunami of destruction to FLP discount planning. Interestingly, the bill before Congress does not specifically target FLPs but instead provides that a valuation discount will not be allowed for any entity interest to the extent that its assets are “nonbusiness assets.” The bill defines a nonbusiness asset as a passive asset that: “(i) is held for the production or collection of income, and (ii) is not used in the active conduct of a trade or business.” This would likely include stocks, bonds, and real estate held for growth or rental income. The limited partnership interests would be valued at the full market value of the nonbusiness assets for the purposes of transfer taxes instead of receiving a valuation discount. Indeed, the IRS has long challenged the use of discounts in this wealth transfer strategy, but the courts to date have routinely upheld the validity of such discounted transfers in appropriate circumstances.
Eying the punishing winds ahead, many taxpayers seek a deadline for accomplishing this strategy. Unlike the 1/1/22 lowering of the gift/estate tax exemption, this proposal would take effect upon date of enactment. This leaves little time to get a new FLP drafted, funded, and gifted. However, for families that already have an FLP in place, now is the perfect time to consider making additional contributions to the partnership and gifts of the subsequently created limited partnership interests.
Be assured that future use of FLPs can still be a powerful estate planning tool. The most attractive non-tax feature is generally the control they offer. The senior generation can retain some control of the assets by acting as the general partner (often through an LLC) and thus can still buy, sell, and manage the assets. Representing the general partner, the senior generation can also have some control over distributions to the limited partners. An additional FLP benefit is the ability to provide efficient asset management and consolidation, offering enhanced investment opportunities. In addition, an FLP can restrict the rights of third parties (creditors and divorcing spouses) to acquire interests in partnership (family) property. FLPs also avoid potential fractionalization of ownership and provide for ease of succession in management of partnership property.
Let’s batten down the hatches, trim the main sail, and get those estate planning affairs in order.