Wealth Transfer and Asset Protection

Family Limited Partnerships

     The Family Limited Partnership (FLP) has been a popular business entity for wealth management, tax minimization and wealth transfer maximization. Under the right circumstances, FLPs traditionally helped taxpayers remain in control of their wealth even after transferring it to their loved ones. Additionally, many of these transfers were made at a significant discount, thereby further leveraging wealth transfer tax savings. Not surprisingly, while FLPs have been employed as a planning panacea by taxpayers, FLPs have received the evil eye from the IRS and some courts.

Background

     Simply put, an FLP is a Limited Partnership among family members. The FLP is often created by the wealth-owning generation, typically the parents. The FLP creators are initially both the General Partners (GPs) and the Limited Partners (LPs) at the time they contribute assets to the FLP. The lion’s share of the contributed assets is thereafter assigned to the LP shares. Even so, the GPs hold all of the management control over the FLP assets.
     When the FLP assets generate income, the GPs are entitled to compensation for their management services. LPs enjoy an ownership interest only. They have few rights or power and there are restrictions on the transferability of their LP interests. This lack of control (minority interest) and inability to transfer the LP interests freely (lack of marketability) reduces or discounts the value of the FLP assets. In turn, this discounting enables the parents to transfer more wealth (and the future appreciation of that wealth) via their LP interests to younger family members, yet retain lifetime control over that wealth.
     Other benefits include income splitting and asset protection, since FLP income may be spread among multiple family members and creditors of the LPs may be limited in their attempts to reach the underlying FLP assets.

IRS & Judicial Attacks

     Given the powerful tax and wealth transfer benefits available through FLPs, it is easy to see why the IRS and some courts do not like them. First and foremost, an FLP must be created for a business purpose … not just for estate planning. For example, a valid business purpose may be to maintain family ownership and control of assets while they are transferred between generations free from the claims of third-party creditors and probate. Any planning with an FLP must begin with a solid business purpose in substance, as well as in form.
     Like most legal arrangements that offer both tax minimization and wealth transfer maximization, FLPs are subject to an unwritten rule of law: pigs live and hogs get slaughtered. Some examples of hoggish behavior with FLPs include taxpayers who establish deathbed FLPs and/or taxpayers who transfer substantially all of their personal assets and means of financial support to their FLPs (i.e., leaving themselves no other source for income and sustenance). Result: If an FLP is found to be hoggish, then the entire value of the underlying FLP assets may be included in the estate* of the FLP creator by the IRS and some courts.
     As you might imagine, in addition to the FLP’s business purpose, the IRS has traditionally scrutinized the valuation discounts claimed by the taxpayer for the LP interests. Once these gifts are made, the taxpayer must ensure that any discounts attributed to the gifts are substantiated in writing by an appropriate valuation expert and that these discounts are reported on a timely gift tax return. Expert professional valuation assistance is critical to successful FLP planning, implementation and maintenance. It is money well spent.

Practical Considerations

     FLPs are not for everyone. Between legal fees, valuation fees, required state filings and reports, and tax returns (for the FLP, the GPs and the LPs), FLPs may require a substantial commitment in time and resources. Bottom line: Carefully weigh the costs versus the benefits of FLP planning before proceeding.

*Note: Estate taxes are uncertain with every federal election cycle.

Asset Protection

     Statistically and anecdotally, we all know that the number of divorces, lawsuits and bankruptcies is staggering. While no one believes lightning will strike them, wealth created through a lifetime of work, saving and investing can be lost overnight if these forms of man-made lightning do strike. To protect your assets from such disaster, proper risk management strategies should be given careful consideration. These strategies include exempting your assets from the claims of creditors and limiting your liability through legal entities and transferring your risk through insurance.

Exempting Assets

     State and federal laws may exempt some of your assets from the claims of creditors. Depending on your state of domicile (i.e., your legal residence), the equity in your primary personal residence may be protected from creditors. Protection also may extend to your retirement funds and even the cash value of your life insurance.
     Once you have identified the protected asset classes available to you under applicable law, it may be prudent to maximize your protection by converting non-exempt assets into exempt assets. For example, if the equity in your home is exempt from the claims of creditors under the laws of your domicile, then using non-exempt resources to pay off your mortgage may be a smart move.

Limiting Liability

     Many entrepreneurs operate their businesses as sole proprietors rather than through a legal entity, such as through a Corporation or a Limited Liability Company. Whether their business is home-based or in the Fortune 500, these business owners are attracted by the informality of sole proprietorship. They also do not want to incur legal fees to create and maintain a legal entity. However, in addition to other advantages, conducting business through a legal entity may offer substantial risk management benefits.
     While lawsuits brought against a sole proprietorship are really lawsuits against the owner’s personal assets, lawsuits against a properly created and maintained legal entity are really lawsuits against the entity’s assets. Nevertheless, the selection of an appropriate legal entity is critical for managing your risk.

Transferring Risk

     When was the last time you reviewed the details of your liability insurance program with your insurance professionals? Are your policies current? Are the coverage limits adequate and are the deductibles reasonable? Have you scrutinized the policies for loopholes? Remember: the fundamental philosophy of any insurance coverage is to pay a premium you can afford to transfer a risk you cannot afford. Take time to understand both the risks you have retained and the risks you have transferred.

Closing Thoughts

     Managing your risk, like avoiding lightning, requires that you make proper plans in advance of the storm. Take time today to protect your wealth tomorrow.