Protect your assets with Family Limited Partnerships (FLIPs)

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What are FLIPs?

Its a rocklike strategy for families worrying about estate taxes. FLIP cuts the estate-tax bill sometimes by half or even more. Its also useful to manage your assets very effectively.

Now, you may be aware of ‘limited partnership’. Just make it only for your family members and it is called FLIP. Limited partnerships, as per the law of all 50 states, is managed by only general partners. Limited partners do not have any right in the management of family business. Lets take an extreme case where only one general partner owns 1% of the total partnership assets. Still he has a 100% control over all assets of the partnership.

The same principle is extended to FLIPs. Usually, the parents put in their assets into partnership. Both of them are general partners with a very small interest. And their children are limited partners. So by doing this, they gift limited partnership interests to their children.

Even if they have very little interest in the partnership, they are general partners. The limited partners own the title of the partnership interests. However, the general partners (parents) have a full control over the assets of the partnership. Limited partners have no voice in the management. In short, the general partners have given up their ownership of assets, but they have kept the control in their hands. This is an excellent tax planning for gift and estate taxes.

Now the gift has been made to the children by this arrangement. So the gift tax is applicable to these gifts. However, both the parents can make full use of their tax credits to pay this tax. This credit is $7 million for 2009 ($3.5 million for each partner). This credit will become unlimited for 2010! Most of the tax liability is covered by this credit.

Now, the gift is complete when the partnership is formed, so the appreciation in the value of assets thereafter goes automatically to children. Suppose the parents make this partnership at the age of 50 and they live up to 80. In that case the appreciation of 30 years is excluded from the clutches of estate tax. Just assume a transfer of $3 million and the rate of appreciation to be just 7%. In that case, about $45 million are taken out from the assets of parents and the family has saved approximately $22.5 million in estate taxes! (as per present rates)

Even though the parents die soon after forming the limited partnership, and there is no appreciation of the assets, still there is a substantial saving of tax.

Look, the parents have gifted the interests in the limited partnerships to children, not the assets. So the limited partners do not have any control over the assets. So the value of this interest is lower than the value of the assets. So a discount must be allowed on the value of the assets. Many court decisions have upheld this and even IRS agrees. For estate, the discount is big, while for liquid assets (like cash) the discount is naturally small. Generally IRS allows 40% discount, based on the nature of assets. Continuing the above example, where the assets transferred are $3 million, the credit exclusion will be $1.8 million. This is $1.2 million more with the limited partnership.

However, keep in mind the value of the estate. If the value is more than $2 million, then there is a real tax benefit. If you have estate valued less than that, then don’t go for this arrangement.

The primary objection IRS takes is on the rate of discount. If you try to claim outrageous 90% discount, then you will have to face the tax audit and further consequences! Please don’t try to cheat in this way.

Another point is about taxes on income. Since the children are controlling 99% of the interests of partnership, the tax rate will be lower. This is because the children are usually in the lower tax bracket (say 25%) than the parents (say 35%) This reduces the tax burden by 10 points. If the partnership is generating say $100,000 a year, then almost $99,000 is taxed at the hands of the kids at lower rates.

Thus FLIP provides a solid protection to the assets of the parents. Only 1% is exposed to the creditors as against 100% before forming a FLIP.

With the increase in the exclusion amount it is discouraging for the taxpayers to go for FLIPs. However, from 2011, the exclusion may be fixed at about $2 million. In any case, the benefits of credit protection and income tax reduction are the strongest points for having a FLIP. After all, its your money!


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