For many years, family limited partnerships (FLPs) have been a popular vehicle for consolidating and managing family wealth while reducing gift and estate taxes. Now that fewer people are subject to these taxes, an FLP may have lost some of its appeal as an estate planning tool. But with individual income tax rates at their highest level in years, it’s important to not overlook an FLP’s potential as an income tax planning tool. Transferring limited partnership interests to children or other family members in lower tax brackets can reduce a family’s overall tax liability.
Using an FLP as an income tax planning tool
For many years, family limited partnerships (FLPs) have been a popular vehicle for consolidating and managing family wealth while reducing gift and estate taxes. Now that fewer people are subject to these taxes (thanks to lower estate tax rates and higher exemption amounts), an FLP may have lost some of its appeal as an estate planning tool. But with individual income tax rates at their highest level in years, don’t overlook an FLP’s potential as an income tax planning tool.
Higher income taxes reduce the amount of wealth available to pass on to your heirs, which can have a big impact on your estate plan.
Tax hikes under PPACA and ATRA
The Patient Protection and Affordable Care Act of 2010 (PPACA) and the American Taxpayer Relief Act of 2012 (ATRA) increase individual income taxes in several ways beginning this year. Among other things, the combined acts:
- Increase the top marginal rate to 39.6%,
- Increase the tax rate on capital gains and qualified dividends from 15% to 20% for taxpayers in the 39.6% bracket,
- End the 2% payroll tax holiday that was in effect in 2011 and 2012,
- Impose a 3.8% Medicare tax on net investment income and an additional 0.9% Medicare tax on earned income for certain high-income taxpayers, and
- Restore limits on itemized deductions and personal exemptions for certain high-income taxpayers.
At the same time, ATRA made the $5 million federal gift and estate tax exemption permanent ($5.25 million this year, adjusted for inflation). This takes some of the pressure off families to implement sophisticated estate planning strategies, but the previously listed tax hikes make income tax planning more critical than before.
Transfer income with an FLP
Typically, to take advantage of an FLP, one or both parents form and fund a limited partnership and transfer limited partnership interests to their children. The parents receive a general partnership interest, which allows them to retain management control. Because limited partnership interests lack control and are relatively unmarketable, they can be transferred at deeply discounted values for gift and estate tax purposes.
Even if gift and estate tax planning is less of a concern, however, an FLP may provide an opportunity to take the sting out of higher income tax rates. By transferring limited partnership interests to children or other family members in lower tax brackets, you can reduce your family’s overall tax liability.
For this strategy to work, you must structure the partnership carefully to ensure that your children receive “real” ownership interests. Generally, under IRS rules, this means that partnership capital must be a “material income-producing factor” and that the children receive legitimate capital interests. If distributions of income to limited partners are disproportionate to their ownership interests, or if their rights with respect to the FLP are unduly restricted, the IRS may view the FLP as a tax avoidance scheme.
Even if an FLP is structured properly, the “kiddie tax” can undo its benefits. Under the kiddie tax, if you transfer an FLP interest or other income-producing property to a child under the age of 19 (24 for certain full-time students) the child’s income from such property in excess of $2,000 (in 2013) is taxed at your marginal rate.
Look at the big picture
An FLP can be an attractive tax planning tool, but it’s not right for everyone. Be sure to examine the potential benefits in light of your overall business, tax and estate planning goals.