The family limited partnership (LP) or limited liability company (LLC) is a gifting and asset protection vehicle that can enable someone to make gifts of units (or interests) to children (or irrevocable trusts for their benefit) while maintaining management and control of the LP or LLC as its General Partner or Manager.
As an example of how this strategy could be used, you could create an LP or LLC and as the initial partners or member make contributions of cash and/or other property to the LP or LLC. The LP or LLC could be structured so that you initially own all of the partnership interests or membership units. The partnership interests or membership units would have a right to vote or control the LP or LLC.
Following the creation of the LP or LLC, you could gift the LP or LLC interests to your children (or trusts for their benefit) and admit the transferee(s) to the LP or the LLC as a result of gifts of the LP or LLC interests. It may be possible to value the gifted LP or LLC interests for gift tax purposes using discounts to the underlying fair market value of the LP or LLC’s assets due to the lack of voting rights and control afforded to the members and restrictions on transferability of the partnership interests or membership units that would be included in the LP agreement or LLC operating agreement. To justify such discounts, or to determine the fair market value of the gifted interests where the LP or LLC holds illiquid assets, we recommend having the value of gifted units determined by a professional appraiser so that a written appraisal can be filed with the gift tax return, which would be required to be filed by April 15 of the year following the year of the gift, even if the gift is valued within the annual exclusion amount.
The following are some additional considerations that would be relevant:
1. In contrast to an irrevocable trust, which we recommend should have at least one independent trustee, the General Partner of the LP or the Manager of the LLC with two important exceptions can control exclusively the investment policy of the LP or LLC. If the interests are gifted to the children or trusts for their benefit, you may be restricted from having exclusive power over decisions relating to distributions from the entity or liquidation of the entity to avoid inclusion of the transferred interests in your estate upon your death. In such event, we typically recommend using an independent, unrelated special manager or partner or have a supermajority of unrelated, uncontrolled partners or members to make these decisions. Alternatively, you could sell the interests to the children or their trusts for adequate consideration to avoid the loss of control over these important decisions.
2. In general, the General Partner of the LP or the Managers of an LLC could be subject to a “business judgment” rule that is more lenient than a “prudent person” or “prudent investor” standard generally applicable to trustees. While our trust instruments give trustees broader investment powers than those provided under the prudent person rule, an LP or LLC may be the more appropriate vehicle to hold or reinvest in an undiversified portfolio of relatively high-risk investments. Nonetheless, the General Partner or Managers will have fiduciary duties owed to the other partners or members, which duties include the duties of loyalty and care that normally apply to trustees.
3. The family LP or LLC vehicle can make it easier to make gifts of interests in property over a period of years.
4. In general, gain is not recognized on the contribution of appreciated property to an LP or LLC, provided that the LP or LLC is not an “investment company” within the meaning of the tax law. Transfers of appreciated property that result in diversification to the transferor will trigger recognition of gain. Thus, the strategy should be implemented in a manner that does not result in the LP or LLC meeting the definition of an investment company, or, alternatively, in a manner that does not result in diversification.
The following are some advantages and disadvantages to the family LP or LLC approach:
Advantages:
- Subject to the exceptions described above relating to voting for distributions and liquidations, the General Partner of the LP or the Manager of the LLC will be able to control the activities of the entity.
- The LP or LLC can make investments in other entities, such as a new venture (but cannot own an interest in an S corporation).
- The LP or LLC provides centralized management.
- An LP or LLC interest is somewhat protected against the claims of the member’s creditors.
- LP or LLC’s are not taxable entities for income tax purposes.
Disadvantages:
- Complexity and additional costs.
- In addition, the courts have recently sustained IRS challenges to FLP’s where the formalities were not followed and in other circumstances that require careful planning. Depending on the overall plan for investing, the additional costs and complexity may be justified.
- Treasury and Congress have contemplated major changes to these rules over the years that would severely restrict the ability to engage in valuation discounting of gifts or other transfers of minority interest within a family group. Consequently, the benefits of using this technique may be limited by a significant change in these rules.