A Little About Me
I'm Heath Oberloh. I'm an attorney at Lindquist & Vennum, PLLP in Sioux Falls, SD, and the world's first ever certified Legacyologist*. I work with clients to...
Now that the tryptophan has worn off, its time to make that holiday checklist.
1. Decorate the tree;
2. Hang the lights;
3. Buy presents;
4. Establish FLP and gift interests;
5. Take advantage of low interest rates to transfer wealth to next generation.
While Santa’s elves are scurrying to fill the wish lists, estate planners are rushing to take advantage of one planning technique whose days may be numbered and a second technique whose numbers are at historical lows.
FLPs, or family limited partnerships, take advantage of discounts available to closely held entities to reduce the value of the assets inside the FLP for estate and gift tax purposes. This technique allows a client to reduce the value of those assets in her estate and also allows her to gift interests in the FLP to the next generation with less of a tax hit. The IRS hates FLPs and has taken numerous pot shots at them over the last few years. And, President Obama’s proposed budget for next year indicates an attempt to eliminate some of the benefits of an FLP. All this combines to make it prime time to fund an FLP, lock in those discounts and make gifts before the end of 2010.
Another wealth transfer technique that is hot right now is to take advantage of the ridiculously low interest rate environment. One simple way to do this is to structure loans between parents and children. The minimum interest rate that must be charged is currently 1.53% on notes paid back over 9 years.
A second more aggressive technique to take advantage of low interest rates is a GRAT, or grantor retained annuity trust. With a GRAT, the client transfers assets to a trust in exchange for the trust’s promise to make a series of annuity payments back to the client, with the remaining balance of the trust going to the client’s children. A $1,000,000 GRAT with a 10 year term would generate a $382,264 taxable gift to the children if the interest rates were at 5%. Now, however, with the interest rates at 1.8%, that taxable gift would be only $273,816. When assets inside the trust appreciate at a rate higher than the annuity payout, the benefits of the GRAT increase significantly.
The third technique that takes advantage of the low interest rate environment is the sale to a defective trust. This is one of the best labels ever created – why would you create a defective trust? Well, its only defective from an income tax standpoint, and what it allows the client to do is sell assets to a trust created by the client, the ultimate beneficiaries of which are the client’s children. The trust pays the client for those assets with a note accruing interest at, you guessed it, the low IRS interest rates. Assuming the assets inside the trust appreciate at a rate higher than 1.53%, value is passed to the kids tax free. In addition, because the trust is “defective”, the client pays the income tax on the income of the trust, rather than imposing that obligation on the beneficiaries of the trust – another tax free gift by the client to the beneficiaries.
Next time you’re waiting in the checkout line, grooving to Kenny G, remind yourself to take advantage of these year end planning techniques, which may be gone before you have time to return those Zhu Zhu pets.
Family Limited Partnerships, or FLPs, have been the subject of much debate in the last several years. FLPs are generally used to protect and preserve legacies by transferring assets to future generations at significant discounted values. They are also effective to maintain centralized management of assets and protect those assets from the claims of creditors such as the ex-spouses of children. And the IRS HATES them! They have come up with all sorts of ways to attack them, but the good news is that taxpayers continue to score significant wins.
The Williams’ family scored a huge victory in a recent FLP case, to the tune of a $40 million refund and a 47.51% discount on the valuation of assets contributed to the FLP. All this and the real kicker is that Mrs. Williams died before the assets were re-titled into the name of the FLP.
In early 2000, Mrs. Williams began discussing the formation of several family limited partnerships to hold some of the $300 million worth of real estate, mineral interests and other investments she owned. On May 9, 2000, Mrs. Williams sign the limited partnership agreement and the documents to form a separate LLC, which was to be the general partner of the limited partnership. Records kept indicated that they planned to contribute approximately $240 million worth of bonds to the FLP.
On May 15, 2000, Mrs. Williams died. The partnership account into which the bonds were to be transferred had not been opened, and the general partner had not been funded. Thinking the partnership had not been properly established, Mrs. Williams’ advisors did nothing further relating to the partnership for nearly 12 months. They even filed the estate tax return without disclosing the partnership or claiming any discount on its value. They paid estate tax of more than $140 million.
A few months later, after attending a seminar on FLP issues, the advisors decided to change course, they formally transferred the assets into the FLP, formalized all other records, and filed a claim for a $40 million refund of estate taxes that had been paid.
The court determined that the FLP had been validly formed under Texas law and that Mrs. Williams’ intent to contribute the bonds to the partnership was sufficient to legally transfer those assets into the partnership – even though they had not formally transferred the assets into the partnership. The court concluded that the partnership was formed for a “significant and legitimate non-tax business purpose” – specifically “the desire to consolidate and protect family assets for management purposes and make it easier for these assets to pass from generation to generation.” The $40 million reduction in estate taxes was “merely incidental.” [cough!]. Nowhere but Texas, could a judge make that statement.
The “good factors” emphasized by the court include:
- the extensive discussion and efforts regarding the formation of the partnership;
- the substantial amount of personal assets that were retained outside the partnership; ($100 million or so);
- the desire to protect family assets from ex-spouses (one of Mrs. Williams’ children had gone through a messy divorce; and
- the validly executed partnership agreement, which provided that each partner’s interest was proportionate to capital contributed, each partners’ capital account was to be adjusted to account for contributions and distributions and each partner was to receive the balance of his or her capital account upon liquidation.
The Court also approved the estate’s proposed discount of 47.51%. Of particular note is that the majority of the partnership interests were actually owned by two trusts established at the death of Mrs. William’s husband. Upon her death, the partnership agreement provided that the partnership interests became “assignee” interest, losing many of the voting and control rights.
- Documenting the legitimate non-tax business purposes remains a key issue. Protection of assets from future ex-spouses of children and grandchildren and providing for the efficient management of family assets has been once again approved as a legitimate non-tax business purpose.
- When the dispute with the IRS is framed as a claim for a refund, the taxpayer has more flexibility in filing in a court that has been more friendly to the taxpayer than the tax court has been. An executor can file in any jurisdiction in which the executor resides, so if a corporate fiduciary is used, the estate has flexibility in determining where to file for a refund.
- As my former partner Bill Day would say, “if you don’t try them all, you don’t get any.” The estate’s expert seems to follow this rationale, as his proposed discount exceeds the 25-30% discount that is usually considered safe. If you don’t ask, you don’t get it. If the willing buyer-willing seller standard supports the discount, go with it!
Family limited partnerships have been and will remain an effective way to protect and preserve legacies by dramatically centralizing management of assets, protecting those assets from claims of the kids’ creditors and “incidentally”, reducing the taxable value of clients’ estates. The key has been and will continue to be establishing the legitimate non-tax business purpose for the entity.