Clients who own closely held or family businesses are facing proposed federal regulations that could have a dramatic impact on their estate planning.
The Treasury Department issued proposed regulations designed to curtail the use of so-called “valuation discounts” by owners of closely held and family businesses. The rule takes effect when it is published after a Dec. 1 hearing.
The discounts have been permitted due to the market reality that an asset or a share of stock that is conveyed with little or no control to the holder should be worth less than an asset or share of stock without such limitations.
Known as “lack of control and/or marketability discounts,” these valuation adjustments have permitted family business owners to discount gifts of business shares or units by 35-45 percent. Discounting the value of the gift also reduces the gift tax due on the transfer. Reducing the estate and gift tax credit needed to cover the gift leaves more credit available to offset estate taxes due at the death of the last of the couple to die. In 2016, that credit was $10.9 million equivalent for the husband and wife.
The proposed regulations will not take effect until December 2016 at the earliest. So advisors should consider valuation discount opportunities for their clients who own family businesses. The family limited partnership (FLP) is one of the most popular intergenerational transfer techniques that typically incorporates valuation discounts. It should be considered in any family business succession strategy.
Family Limited Partnership
A family limited partnership must have one or more general partners. These usually are the parents, a trust or corporation controlled by the parents, and one or more limited partners, who usually are the parents, children or grandchildren. General partners manage and control the partnership. In some circumstances, the general partners can have personal liability for debts and obligations of the partnership in excess of their investment.
Limited partners, on the other hand, cannot be involved in the day-to-day operations of the partnership. In addition, they cannot have personal liability beyond their investment in the partnership.
Life Insurance Trust Substitute
An FLP may purchase life insurance on the life of one or more partners as a partnership asset. It is important to have other investment assets as well to show that the partnership has a true business purpose.
In this kind of partnership, the insured — usually one or both parents — will retain a low-percentage interest in the partnership, and other family members will retain a high-percentage interest. Thus, when the insured dies, only the portion that is equal to their interest in the partnership will be included in their estate.
The family limited partnership affords some degree of protection from creditors. Suppose, for example, that a limited or general partner is sued by a creditor on a matter unrelated to the partnership.
Further suppose that there are assets in the partnership worth $1 million and the creditor obtains a $200,000 judgment against Partner A, who is a 1 percent general partner and a 60 percent limited partner, with other partnership interests being held by other family members.
In most states, the most the creditor can do is obtain a charging order against Partner A’s interests in the partnership. This means that the creditor can assume Partner A’s right to receive distributions from the partnership. However, if, according the terms of the partnership agreement, no distributions are made, the creditor must recognize the income that Partner A would have otherwise had to have recognized but will not receive any distributions from the partnership.
Obviously, this is an unfavorable position for the creditor to be in, having to recognize income without actually receiving any distributions from the partnership. Even if state law permitted a creditor to eventually reach the underlying assets of the partnership, the extra steps required to do so might make the creditor think twice before making the attempt.
Crossing T’s and Dotting I’s
Care must be taken to structure and operate the partnership so that the general partner/creator does not treat the assets in the partnership as their own assets as though the partnership does not exist. Failure to do so may result in all of the general and limited partnership assets that the general partner owns — plus the current value of partnership assets they gave away in previous years — being included in their estate as a retained life interest.
Nor should the general partner/creator have the unilateral power to make distributions from the partnership, especially distributions that favor the general partner over the limited partners.
Time Is Running Out
The proposed regulations may become final and take effect as early as Dec. 31. If you have any clients with children and closely held family businesses, share with them as soon as possible the power of FLPs to leverage family business succession strategies.