Accounting Income Is Generally Equal To Operating Cash Flow Funding the Family Limited Partnership

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Funding the Family Limited Partnership

A family limited partnership is usually funded with specific assets. Real estate provides an ideal investment, but not all assets are suitable for transferring to a partnership. Regarding corporate partners, S-corporation stock cannot be held by the partnership. Partners do not recognize gain or loss when they contribute property to the partnership in exchange for their partnership interests. Additional capital contribution does not create profit or loss for the partners or the partnership.

When a partner contributes capital or property to the partnership, the partner is awarded an interest in the partnership based on the partner’s contribution as a percentage of all contributions. Any additional contribution will increase the partner’s share and the other shares must be adjusted accordingly.

Visitation of partnership units

Simplifying the division of partnership interests into units provides the ability to transfer assets to family members with the annual gift-tax exclusion available at $14,000 per year for 2014-2015 or the Unified Credit exemption at $5,340,000 and $503,504 in 2014. Valuation discounts can be used to reduce the value of partnership units by 20 to 40 percent for gift tax purposes.

Three types of valuation techniques are generally used to calculate the fair market value of an interest in a closely held entity. The market method (also known as the comparable sales method) compares a closely held company with its unknown stock value to similar companies with a known stock value.

The income (or discounted cash flow) method discounts the stock of the company being valued to represent the expected future income of the company. The net asset value (or balance sheet) method generally depends on the value of the company’s assets.

The market method or income method is often used when a closely held company carries on an active trade or business. Net asset value is often used when a closely held company primarily owns real estate or investment property and does not conduct an active trade or business.

The value of a gift to the donee is its fair market value when the gift is made, not what the fair market value will be at one time or another. In Revenue Rule 93-12, the IRS recognizes that a minority interest in a limited partnership with limited ownership rights to a limited partner qualifies for a discount on the fair market value of the underlying assets. This allows parents to make large gifts to their children within gift-tax exclusions and without losing control.

To qualify for the exemption, the limited partner’s interest must be considered a minority interest (lack of control exemption) and/or not freely transferable (lack of marketability exemption). IRC §2036(b) covers gifts from the donor’s taxable estate of corporate stock in which the donor retains the right to vote the stock. There is no relevant tax code section for partnership interests.

Donors may wish to structure transfers or gifts of limited partnership units to qualify for the existing unified credit exemption as described earlier. These transfers do not necessarily meet the criteria as current-interest gifts, but disposal of the property at death is generally desired. Even if the donor continues to act as a general partner of the partnership and acts in a fiduciary capacity for all the partners, the gifted partnership units will not be included in the estate of the deceased donor/general partner.

Running a family limited partnership

In their capacity as general partners, parents may accept equal remuneration from the partnership for their managerial capacity. They may also establish that the partnership will preserve or distribute income to its partners, or they may loan funds to a limited partner. Parents can receive money from the partnership to support their existing or retirement needs, subject to fiduciary standards (which are lower than those for a trustee). Salaries paid to anyone in the partnership are subject to withholding as determined by the IRS and the state in which the partnership operates.

Partnerships are required to file annual tax returns. The federal return is Form 1065 and the state has a similar form. Any income received by the partners must be included in their appropriate tax return. Even if there are no distributions, the partners must claim the amount reported on the K1 form that is provided by the partnership.

Taxation and Insurance for Family Limited Partnerships

For income tax purposes, all property transferred from a partnership to partners is treated as a partnership. IRS Revenue Ruling 83-147 clarifies the estate taxation of life insurance that is owned by one of the partnership partners. The effect should be similar to corporately owned life insurance. If the partnership is the beneficiary of life insurance, the insurance death benefit will be included in the partner’s estate only indirectly by changing the value of the partnership interest of the deceased partner.

To avoid increasing the deceased partner’s partnership interest with a portion of the life insurance proceeds, the policy may list any adult children as policy owners and beneficiaries at the beginning of the policy’s existence. General partners can distribute income to children as limited partners to pay premiums on policies owned by the children or to fund trusts created by the children. A grantor can direct beneficiary succession in the event of a prior parent which can help protect the policy’s cash value in the event of a divorce.

Risks of Family Limited Partnerships

The IRS issued new regulations under Subchapter K of the IRC without an administrative hearing. In summary, the IRS will disregard the partnership as an entity if the primary function of the partnership is to avoid income tax either at the time of formation or during its operation. The proposed regulations are income-tax-specific and do not apply to gift- and estate-tax assessments. That doesn’t mean the IRS won’t address estate and gift assessments at some point in the future. There are costs involved in creating and maintaining an FLP, including:

• Attorney fees for forming a partnership (however an attorney is not required

• Assessment fees for underlying assets and partnership “slices” gifted to younger generation family members;

• accounting fees for partnership K-1s and other financial assets;

Transfer tax expenses such as stamp duty on transfer of real property. But for many investors, the benefits of a well-planned FLP easily outweigh the risks and costs.

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