February 1, 2016
Increasingly, the family limited partnership, or a family owned limited liability company, which could perhaps be collectively referred to as family limited liability entity or FLLE is being employed in planning larger estates. When coupled with the concept of a “minority discount” it contains many attractive features for a family gifting program.
A FLLE typically will have “active” and “passive” participants. These would be called the “general” and “limited” partners or the “manager” and “members” depending on which entity is selected. The general or manager will control the entity. He or she is the decision maker, and the limiteds or members will merely participate in profits and losses, without a say in management.
An owner of a substantial estate can transfer assets, whether stock, bonds, cash, real estate or other interests to a FLLE. This transfer is tax free. The owner, at this phase, will own both the general and limited partnership interests in the entity.
Next, the owner will transfer limited partnership interests or membership interests to his family members. Since he retains total control of the enterprise, the financial responsibility of the recipients is not as large an issue as it would be if the gifts were “outright”. Additionally, the gifts can qualify for a minority discount (see attached).
Example: Father places $1,000,000 in the FLLE. Each child is given a 10% interest. A 35% “minority” discount is taken. The value of the gift to each child is $65,000 for gift tax purposes. Father totally controls the portfolio … all buy, sell etc. decisions are made by him alone. He decides whether the income is to be distributed at year end or not. (Whether it is or not, though, each child will be taxed on 10% of the income, or have a deduction for 10% of the losses). If father chooses to do so, he can pay himself a fee for managing the partnership, thus, in effect, retaining the income from the assets. The children are only taxed on the “net” income, so dad’s fees are deducted before their income is computed.
Upon the death of the owner, only the value of his retained ownership in the partnership is taxed in his estate. If he has transferred 99% of the ownership during his life (and lived the required three years), only 1% of the assets are taxed when he dies.
Minority Discounts
It makes sense, doesn’t it, that a controlling interest in a company is worth more than a minority interest? Of course it does – the minority can’t run the business, help itself to corporate profits, put kids on the payroll, etc. like the majority can. While there might be a market for a majority interest, it would be hard even to sell a minority interest in most small companies. Nonetheless, the IRS ruled for many years, that for purposes of the estate and gift tax, no discount would be allowed for a minority interest, where the family, combined, owned a majority interest. Since 1993 however, in Revenue Ruling 93-12, IRB 1993-7, the Treasury backed off this position, in recognition of a number of Court losses. Henceforth, the family ownership of a majority position will not, by itself, deny a minority discount in valuing stock for estate and gift tax purposes. Discounts of as much as 35% are now being claimed routinely on gift tax returns. Qualified expert opinion on both the value and the discount are necessary, however.
In a 1996 ruling, the United States tax court recognized a 50% interest as a “minority”. It was noted that although a 50% shareholder can block action by other shareholders, this percentage cannot by itself control the corporation.