Wilsey Estate Planning Blawg

FLP-GRAT: An Awesome Combination

Last post, I described the way a Grantor Retained Annuity Trust (“GRAT”) works. Today, I want to explain how a client can leverage their $1,000,000.00 lifetime gift tax exemption with a Family Limited Partnership (“FLP”) and a GRAT. The combination works like this.

The client will place a significant amount of assets into a FLP (please review my November 3, 2006 article on FLPs if you have any questions on their use). These partnership interests will be subject to a significant discount because of the lack of marketability and other discounts. The client will then gift between 95% and 99% of those assets to a GRAT. When the assets are valued in the GRAT, the annuity paid back to the grantor will be based on the discounted value, not the value of the underlying assets.

Let’s put some numbers to this. Client forms a FLP and places $1,000,000 of assets into such entity. The client receives an appraisal and values the assets at a 35% discount, or $650,000. These discounted assets are then placed into a GRAT for a period of 20 years. The GRAT is deemed to have received assets totaling $650,000, and therefore must pay an annuity of at least $35,815.00. The client will need to file a gift tax return on a gift of just $225,524.20, the value of the remainder. However, if this GRAT lasts the 20-year term, then the actual remainder going to the children, assuming a 12% return, will be $7,065,734.00! All for less than a quarter of the client’s gift tax exemption!

What the client has done is leveraged the use of their $1,000,000 exemption as much as possible to move assets outside of their estate and lower their estate tax burden. Using the above numbers, the use of the client’s entire $1,000,000 gift tax exemption could move up to $31,330,269.00 out of their estate, without incurring a dime of gift tax.

This strategy is very powerful, and should be considered with any wealthy client who is interested in reducing their estate tax burden as much as possible.

The Latest on Family Limited Partnerships

            The latest victory by the IRS against heavily discounted family limited partnerships, Estate of Rosen v. Commissioner T.C.M. 2006-115, gives further insight into the proper structure of Family Limited Partnerships (or “FLPs”). Far from rendering FLPs illegal or dangerous, this ruling simply gives us further instruction on the proper use of FLPs, and how to make them less susceptible to IRS attack.

            A FLP operates as a vehicle to use a parent’s annual gifting exclusion (currently $12,000) and lifetime gift tax credit (currently $1,000,000) to make gifts to family members. However, these exemptions are leveraged by the fact that the gifts are discounted to reflect minority and lack of marketability discounts. For instance, if the underlying assets of a FLP are $1,000,000, and gifts made of partnership interests in the FLP are appraised to have a discount of 25%, then a 10% gift would be worth $75,000 rather than $100,000. The gifts act as a powerful tool to move assets out of a client’s estate and into the hands of their loved ones, free from estate tax.

            In Rosen, the decedent’s daughter, operating under a power of attorney, executed a FLP on behalf of her mother, who was suffering from dementia. The daughter transferred over 95% of her mother’s assets to the FLP. The daughter, acting under the durable power of attorney, began making significant gifts on behalf of her mother of Limited Partnership interest in the FLP to family members. The idea was to get much of the FLP interests out of the mother’s estate and into the hands of family members on a discounted basis.

After the transfer of the assets to the FLP, the mother still needed money to (1) pay living expenses and (2) provide annual gifts to her children and grandchildren. The family attorney recommended that the family get around this problem by having the FLP loan the mother the money.

            The court ruled that the entire FLP was includible in the decedent mother’s estate, because she retained the right to income, possession or enjoyment of the property in the FLP. This ruling is based on the premise that because the decedent put all of her assets in the FLP, and as such needed such loans to pay basic living expenses, there was a prearranged agreement to give the decedent assets as needed. The court focused on the fact that the decedent and her daughter were not really involved in the planning process, and that the family attorney basically drafted the FLP paperwork without their input. The court also ruled that the FLP had no legitimate business purpose other than the avoidance of tax.

            This ruling should not discourage FLPs, and should encourage clients that, if properly done, FLPs are still a legitimate choice for moving assets outside of estates. Here are some guidelines for making sure FLPs are respected:

1.      The FLP should have a legitimate business purpose. Examples include centralized management and asset protection. Neither element was present in the Rosen case.

2.      Family members should be involved with the drafting attorney in determining the terms of the FLP.

3.      Parents should retain sufficient assets outside of the trust pay living expenses.

4.      Parents should not receive distributions from the FLP other than those determined by their interest in the FLP. For instance if mom owns 75% of a FLP and the kids own 25%, then mom should get 75% of any distributions and the kids should get 25%

5.      Have assets other than marketable securities and cash. Clients with significant real estate holdings continue to be perfect candidates for a FLP.

6.      Maintain the formalities of the FLP. Make sure meetings are held, minutes are kept, and personal expenses are not paid by the FLP.

The point is that FLPs are useful estate planning devices, when properly done. The controversy, and the negative court cases all involve poorly planned FLPs. I am not aware of any case where a properly planned FLP has been successfully attacked by the IRS. If you have any questions about this, or any other estate planning topic, please call me at (858) 546-4377 or email me at wardwilsey@wilseylaw.com.