Family Limited Partnerships (FLPs) and other closely held family entity structures have been a staple in estate plans amongst high net worth families for decades. An FLP is a type of partnership that typically holds a variety of assets such as stocks, bonds, real estate and business interests. An FLP is comprised of a General Partner and Limited Partners. The general partner typically maintains a minimal ownership stake, often 1% or less, but retains full control over the entity. Whereas, limited partners typically own the lion’s share of the economic rights, but have no control. The ability to separate ownership from control is an attractive feature of the FLP structure. The reason being is valuation discounts are often awarded to transfers of limited partnership interests on two fronts;
- Discounts are granted based on a limited partner’s lack of control over partnership affairs.
- Discounts are issued due to the lack of marketability of a limited partnership interest.
The lack of control and lack of marketability constraints often result in valuation experts issuing discounts ranging from 20% to more than 40% when limited partnership interests are gifted, transferred or sold. Other attractive features of FLPs include consolidated management of family assets, asset protection and the ability to gift and transfer partnership interests at a discount.
Over the years the IRS has repeatedly tried to challenge the validity of discounts when applied in the context of gifting or transferring interests in closely held family entities. The IRS has recently issued proposed regulations under Section 2704 that will drastically alter valuation discounts if finalized near its current form.
Several key takeaways from the proposed regulations are:
- Covered entities are broadly defined to include a variety of family owned entities including FLPs, LLCs and corporations. The million-dollar question is whether or not the proposed regulations will apply only to family entities holding passive investment assets, or will they also apply to active trades and businesses that are family owned?
- There is a new three-year lookback rule on lifetime gifts and transfers for minority interests. Discounts awarded for lifetime gifts and transfers will likely be reversed and included in the deceased transferor’s gross estate if death occurs within a three-year window from the date of gift or transfer.
- Default State law restrictions will no longer be considered when valuing interests in closely held entities.
- There are additional “disregarded restrictions” that will no longer be allowed when valuing a closely held entity.
- Families who plan on gifting or transferring a significant portion of their closely held entity to charity will likely benefit from the new proposed regulations; reducing or eliminating discounts will provide for a larger charitable deduction.
It is important to note the regulations are merely proposed at this point. The IRS has scheduled a public hearing on December 1st to further address the proposed regulations. Most commentators feel the IRS is overstepping their bounds and will be hard-pressed to prevail without legislation from Congress. Even if they are successful, the commentators feel the proposed regulations will not likely become final until sometime in 2017 at the earliest.