Have you ever felt like you were sitting in a quagmire of new tax regulations, wondering if you will ever emerge from the fog of confusion? Not only that, but finding a way to benefit from the tax changes seems as elusive as the morning dew. But just when you feel all hope is lost, [insert dramatic superhero music] the Family Limited Partnership (FLP) gallops in to save the day.
The 2017 Tax Cuts and Jobs Act (TCJA) Affects Everyone
Before we ride off into the sunset, let’s take stock of the key elements of the latest tax reform. The TCJA aims to offer tax cuts for individuals and businesses of all types. However, it is important to note that several of the regulations affecting individuals and small businesses expire at the end of the 2025 tax year, which may affect how you plan for taxes.
Some of the most notable changes include:
- Individual tax rates were lowered, so that the top tier for individuals is capped at 37% from 39.6% (temporary)
- Corporate tax rates were lowered from a top tier of 35% to a flat 21% (permanent)
- Estate and Lifetime Gift Tax deductions have a higher limit (roughly doubled compared to prior law). Now a married couple can gift up to approximately $22 million in their lifetime without incurring the 40% estate and gift tax! (temporary). More on the estate and gift tax changes here.
- Small Businesses Owners (this includes eligible partnerships, S-corporations, sole proprietors, trusts and estates), according to the new Section 199A, may deduct 20% of applicable business income from their taxable income (limitations apply if income exceeds $315K for joint filers). Along with the 2.6% reduction in the top individual tax rate, this could represent significant savings. At its highest potential, the new law reduces the effective tax rate from 37% to 29.6% for qualified business income. More on the effects of this change here.
Saddling up a Tax Saving Solution
When an individual creates a Family Limited Partnership (FLP), she establishes an entity into which assets can be transferred to, (including ownership of the family business) and removed from, her estate. She can then allow anyone in her close family to own an interest in the partnership, allowing them to purchase a percentage of the assets. However, FLPs allow the general partner (person who establishes the FLP) to retain full control over the assets. The other partners (limited partners) have no control in how the assets are managed, but are entitled to their fair share of the profits.
Here is how FLPs have always helped individuals save on tax payments:
- Valuation Discounts: When limited partners have a minority interest in the business, and no control over the assets, the IRS has been known to recognize up to a 50% reduction in the value of the assets since an independent buyer is not likely to pay as much for a minority share in a family business for which he has no control.
- For example, let’s assume your appraisers feel that they can justify a 30% reduction in value of the partnership share. In that case, a gift of $1 million could potentially be recognized, for tax purposes, as $700,000 or less.
- Note that the IRS pays careful attention to those valuation discounts, and how they are derived, so thorough and professional appraisers should be employed to avoid drawing the attention of the IRS.
- Estate Tax Reduction: By putting your assets in an FLP, you move the assets from your estate. When you die, no estate tax will be owed on those assets, since they are not technically yours. If the assets appreciate significantly (such as the value of a business increasing), you save even more! The additional money is already in the hands of your heirs, and not sitting in your estate, waiting to be taxed.
- For example, let’s say you give a 10% interest in the family business to your son Justin, worth $1 million at the time of the gift. If the family business is wildly successful, and that same 10% interest is now worth $10 million, that is $10 million that is given to your son, but not included in your taxable estate.
- Lower Tax Brackets: Because some of the income you might otherwise have received from the assets is now split between you and your heirs, you spread the cost of taxes across the multiple parties. This could result in more money staying within the family (and less within Uncle Sam’s family) if some of the family members are in a lower tax bracket.
Here is how FLPs help protect your wealth:
- Control: Unlike some other vehicles for wealth transfer, the general partner can continue to manage all the assets and ensure that wealth is preserved and increased. The general partner can even receive a management fee from the FLP for their role in stewarding the partnership’s assets.
- Creditor/lawsuit Protection: Assets in an FLP are not technically yours, so creditors, ex-wives, and other plaintiffs (some businesses are more prone to lawsuits than others) may have a harder time accessing them. For example, you may receive a judgment entitling creditors to your share of the payouts from an FLP. Since you retain full control over the assets, you may choose not to issue payouts until the statute of limitations expires, and they are no longer entitled to your share of the income.
- Avoid probate: Assets in an FLP have a clear outline in terms of ownership, so heirs can save on legal bills when it comes time to divide the estate.
- Succession planning: An FLP can be established to clearly define how management and ownership of the family business will be handed over to heirs, ensuring a smooth transfer from one generation to the next.
Now let’s Lasso in those Tax Reform Savings
In addition to the money-saving benefits listed above, FLPs can help wealthy individuals benefit from at least two of the recent tax law changes mentioned above.
- Estate tax change: By giving a percentage interest in your FLP before 2026, you take advantage of the higher deduction limit, enabling you to avoid paying gift tax on any amount below about $22 million (for couples). Coupled with the valuation discount (let’s say it is 30%), you could potentially give up to $31.4 million without incurring the lifetime gift tax.
- Section 199A: If your new FLP provides you with income (excluding wages), you may be able to deduct 20% of this income from your taxes from 2018-2025. Restrictions and limitations may apply, so it is important to discuss the details with your advisers to determine whether you would qualify for the deduction and how much you can claim. More on this here.
- Example: Let’s say you had $10 million in qualified business income in 2019, and are eligible to take the entire deduction. You could save 7.4% (37% top individual tax rate-29.6% tax rate on qualified business income) or $740,000 in taxes each year.
Establishing and managing an FLP is not for the faint of heart. It will take time and money to set up, but it can be very rewarding. Experienced, professional advisors should be employed from beginning to the end to ensure your organization is complying with applicable laws. If you would like to discuss how to harness this solution for your affluent clients, family or friends, feel free to reach out to someone on our team. It is our goal to make a measurable difference in your financial life.
Note: the statements above should not be considered financial, legal or tax advice, but ideas for careful consideration with your trusted financial advisors and lawyers. For current tax or legal advice, please consult with an accountant or an attorney.
About Axia Global
Michael Roney, founder of Axia Global, has worked alongside the best financial and legal professionals in the field to craft profitable solutions for even the most complex wealth preservation and estate planning cases. Together, the team at Axia Global has nearly a century of combined experience in the financial services sector.