The Potential Impact Of Proposed Sec. 2704 On FLPs & Family Transfers

August 14, 2016

Robert Katz, CFP®Seth Corkin, CFP®

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What is a Family Limited Partnership (FLP)?

An FLP is a limited partnership created under state law with the primary purpose of transferring wealth to younger generations/heirs during one’s life while retaining control of the assets and ensuring wealth transfers to the intended individuals and charities. The FLP takes advantage of gifting strategies and potentially steep valuation discounts on limited partner interests for lack of control and lack of marketability.

How does an FLP work?

One or more family members transfer highly appreciating property to a limited partnership in return for 1% general partner (GP) interest and a 99% limited partner (LP) interest. The GP has the sole management rights of the partnership while LPs are passive investors with no control over the management of the partnership.

  • No income or gift tax consequences are incurred upon the creation of the partnership because the entity is owned by the same person who owned the property before the transfer.
  • Once the FLP is created, the owner of the GP and LP interests (the transferor) values the LP interests.
  • Typically, there are transferability restrictions on the limited partnership interests AND limited partners have very little control over the management of the partnership – therefore, limited partnership interests can be valued with a substantial discount.
  • The transferor (and GP) begins an annual gifting program using the valuation discounts, annual gift tax exclusions, gift splitting (if applicable), lifetime exemptions, or a loan and forgiveness program to transfer LP interests to the family’s younger generation.

Why are FLPs beneficial?

FLPs have several unique features that make them extremely powerful from a financial planning perspective:

  • Asset control – the original transferor can maintain control of the property in the limited partnership by retaining a very small GP interest.
  • Asset protection – the structure may help protect family assets from various creditors.
  • Shifting of income – a limited partnership is a flow-through entity for income tax purposes and LPs may be subject to a lower tax bracket than the transferor.
  • Valuation discounts:
    • Minority(control)discounts –stems from the inability to control the business. Recent studies have revealed that the average discount is ~30% and can be higher depending on the circumstances.
    • Marketability discount – appropriate for lack of an existing market since interests are not traded on a public exchange and it may be difficult to find a ready buyer in a timely manner. Typical discount ranges from 10-35% (cases have been reported where the discount was as high as 90%).

What’s changing?

The Treasury department has issued newly Proposed Regulations under IRC Section 2704 that would severely limit these beneficial valuation discounts for any type of family business transfer where the family will retain control before and after the gift/bequest.

What now?!

The IRS public hearing on these regulations will be on December 1st, 2016 and, if approved, there will be a review period before the final issuance. Various industry experts speculate that the proposed regulations could become final as soon as year-end 2016, although the process could be delayed to mid-2017 or later. Therefore, limited time may remain to take advantage of this wealth transfer strategy and the related valuation discounts before the new rule comes into play.

We would be happy to talk with you and your estate planning attorney about the potential impact of the proposed regulations on your situation and the planning issues they may present. Please contact Robert and/or Seth in our Wealth Strategies group (617-536-0333) if we can be of any assistance.

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