United States: New IRS Proposals And Their Impact On Family Limited Partnerships

Last Updated: September 9 2016
Article by Amber Gutschlag

A popular estate planning technique for wealth transfer to the next generation has been the Family Limited Partnership (FLP). However, from the standpoint of the IRS, too many wealthy individuals were using the finer points of FLPs to improperly manipulate their taxable wealth for estate tax avoidance.

On August 2, 2016, the IRS proposed new regulations that will affect FLPs and change how they approach the valuation of a partnership interest. These regulations are governed by section 2704 of the tax code, which is the section that specifically addresses improper valuation of assets when transferred to family members through an FLP or LLC.

These changes were designed to address what has been characterized as a tax loophole. Understanding these changes will be critical for anyone with financial interests in FLPs. Future appraisals and transfers will require some very careful review alongside tax and estate planning professionals.

The Original Purpose of FLPs

An FLP provides a structure in which family members may own a piece of an investment (a property, farm, business, or even a portfolio of marketable securities). Instead of transferring the assets outright to other family members as a gift (or upon death), the older generation can transfer a portion of their FLP partnership interest to the younger generation, giving them greater ownership and responsibility as time passes. This is often accomplished by gifting a percentage of the FLP membership interest to younger generations, with a value not to exceed the annual gift tax exclusion.

The partnership interest may be valued anywhere from 15% to as much as 50% less than the value of the assets held by the FLP. There are several reasons for the discount – it is typically deemed harder to sell a partnership interest, there may be restrictions on the ability to sell those interests, and if only a small percentage is involved, the recipient would likely not have enough voting rights to exercise majority control over the decisions of the partnership. These discounts for a lack of marketability and a lack of control result in transfers at a lesser value, leaving more estate tax exemption available for future transfers.

Background to the Changes

The IRS has had its eye on adjustments to section 2704 since at least 2002, when the IRS lost an influential case on the issue, Kerr v. Commissioner. In that case, the Kerr estate valuation stood with certain discounts in place for a lack of marketability.

In every year from 2003 onward, the IRS included a review of valuation discounts for partnerships as a top priority in their yearly Guidance Plan. Congress hasn't taken action on the issue, so the agency is trying to address reported abuses through this amendment to the underlying regulations.

How FLPs Will Have to Change Valuation

The heart of the change is related to how FLPs recognize the valuation discounts. The business entity can impose restrictions on what business owners must do before they transfer their interests to family members. Those restrictions are interpreted as reducing the value of the interests and thus the estate taxes that will be assessed. The new regulations would reign in those valuation discounts, and the business interests will be valued in line with the standard partnership restrictions imposed by state law.

These changes will make it much more difficult to justify valuation discounts based on "lack of control" or "marketability." Those kinds of discounts could be disregarded by the IRS. Note that these changes will affect not just FLPs but also any partnerships or corporations and arrangements considered to be business entities (ex. Limited Liability Companies).

Approval and Debate

It's important to reiterate that these are only proposed changes and comment on them is open until November. After that, the IRS will hold a public hearing on the updated language of the code at the beginning of December. When the Treasury Department and the IRS agree, the updated regulation will be entered into the Federal Register.

Before that happens, there are likely to be many challenges and objections, particularly from tax experts who insist that a change of this magnitude has to come through standard legislative review. In any case, given that the IRS has had well over a decade to consider the implications of these changes, it's likely that some version of these new rules are going to go live sometime in the early part of 2017. If you are currently invested in an FLP, you may wish to accelerate transfers before the new regulations go into effect. Your estate planning counsel or CPA can guide you if action is recommended for your situation.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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