Asset Protection – Do the Benefits Outweigh the Complexity?

A question I’m often asked is, "How do I minimize the tax due on my estate?" While there are many possible answers to that kind of question, Family Limited Partnerships are one of the most popular ways available for moving assets and money, with minimal tax consequences. And while Family Limited Partnerships are complicated and not without drawbacks, the potential advantages are worth understanding.

There are two main benefits to establishing Family Limited Partnerships: asset protection, and estate planning.

En Garde!

The first, asset protection, is essential for any family member(s) who owns commercial real estate or valuable assets. Let’s consider a hypothetical family. The parent owns multiple shopping centers, and wishes to pass them down to his kids one day. For this parent—and someday, for his kids— it’s very important to ensure that those assets are protected against lawsuits. Where does a Family Limited Partnership come in? Simply put, a Family Limited Partnership is essentially like a protective shield for your assets.

Why? The key term is “limited.” Because the family's interests in the partnership are "limited," a potential creditor cannot gain control of those interests, and cannot force the partnership to make cash distributions. The creditors can only go after the General Partner(s) in a Family Limited Partnership. And General Partners usually have a relatively small interest in the partnership, sometimes as little as one or two percent.

Nix the Tax

The second main benefit of a Family Limited Partnership is estate tax planning. When you pass away, your net assets (gross assets less liabilities) are subject to the estate tax. The Tax Cuts & Jobs Act of 2017 increased the estate tax threshold (that is, the amount your estate must be worth in order to be subject to the estate tax). In 2020, that threshold was $11.58 million. This amount can roll over to a surviving spouse upon the death of the other spouse.

The total estate tax exemption can be upwards of $23 million in 2020. However, the estate tax exemption can vary depending upon political administration, which creates a certain amount of instability in planning one’s estate. Many experts expect President Biden to reduce the estate tax exemption, making more estates taxable upon death. Therefore, now might be the right time to consider a Family Limited Partnership. These vehicles create opportunities for taxpayers to gift interests in assets to their descendants with minimal tax consequences and can allow taxpayers to exclude valuable assets from their taxable estate at death.

How it Works

So how does a Family Limited Partnership actually work? Essentially, Family Limited Partnerships are holding companies, in which multiple family members own interests. Like many partnerships, there are two different types (or classes) of owners: General Partners and Limited Partners.

Howdy, Partner

The General Partner(s) is typically an LLC, and is responsible for managing the assets, cash receipts, transactions, and the like. The General Partner is typically not a family member, but someone close to the limited partners and trusted by them. This partner usually owns a relatively small percentage of the Partnership, sometimes as little as one or two percent.

The Limited Partner(s) are typically the family members involved; our hypothetical shopping-center owner and his children, for example, that I mentioned earlier. Limited Partners may also be offshore trusts set up for the benefit of the family members in question. (These offshore trusts typically have situs skipping powers, which make it economically infeasible for creditors to pursue. The situs is usually established in a country separate from the location of the trust.) In any case, the Limited Partners are “limited” in the sense that they have limited control over most of the activities of the Partnership. They have no responsibilities to manage the investments or be involved in the day-to-day activities of the Partnership itself. Typically, Limited Partners are also formed as LLCs for the purposes of the Partnership.

Interesting Gifts

The Partnership now makes an investment, either by purchasing assets, such as stocks, or by exchanging interest in the partnership for such assets upon formation. Once the investment is stable and profitable, the Limited Partners can begin gifting their Limited Partnership interests to their descendants and heirs. The amount of the gift can be up to the annual gift tax exclusion amount. For 2020, the annual gift tax exclusion is $15,000 per person, or $30,000 per couple.

Let’s look at an example. A father who has a Limited Partner interest in a Family Limited Partnership could gift $15,000 worth of his Limited Partner interest to each of his kids, each year. If he has four kids, that means he could gift up to $60,000 of interest to them annually. And if his four kids each have spouses, then he could gift up to $120,000 of partnership interest annually to the eight of them, all without paying any taxes on the transfer.

While the income generated by the gifted interest(s) is taxable to the children, it would not add to the parent’s taxable estate at death. This ability to gift interests in properties and assets tax-free makes Family Limited Partnerships extremely popular for families during estate tax planning.

A Steal of a Deal

The IRS allows taxpayers to discount the value of the limited interests in Family Limited Partnerships because the Limited Partnership interests are so, well, limited. Limited Partnership interests contain no voting power, have no control over the assets, and often hold very illiquid assets. Most Family Limited Partnerships allow for uneven distributions so the Limited Partner truly has no control over the distribution of the assets. Because of these limited rights, the value assigned to the interests transferred can be discounted when it comes to estate and gift tax calculations. For example, a gift of $10k worth of Limited Partner interests might result in only $8k being counted against a taxpayer’s annual gift exemption, or their lifetime estate tax exemption. These discounts can make a Family Limited Partnership even more appealing.

Womp, Womp

As mentioned, there are some negative aspects to Family Limited Partnerships. The most difficult part of a Family Limited Partnership is the added complexity of tax compliance requirements. For each state in which you own property, each level of LLC will have an administrative filing requirement, in addition to (potentially) an income tax filing requirement in that jurisdiction. For example, if you get a K-1 from an asset held in California, the Limited Partner has to file a California income tax, and also pay the annual tax filing fees for being an LLC active in the state (for 2020, the annual fee was $800). Each of the Limited Partner investors (which are LLC’s themselves) would have this responsibility, as would the General Partner.

All Things Considered

While the tiered ownership structure of a Family Limited Partnership adds protection to your assets, it adds to your legal and tax bill. For many, the added expenses, the high tax complexity, the requirement of keeping detailed books and records, and the work required to be legally compliant overshadows the potential benefits. However, each family situation is unique. We encourage all of our clients to consider a Family Limited Partnership. Asset protection and estate tax planning are critical to long-term financial stability. Few vehicles offer the benefits and opportunities of a Family Limited Partnership. If you need more info, then contact me and I will be happy to put you in touch with my trusted advisors.