A family limited company is usually financed with specific assets. Real estate provides the ideal investment, but not all assets are suitable for transfer to society. With respect to corporate partners, the shares of the S corporation cannot be owned by a partnership. Partners do not recognize profit or loss when they contribute assets to the company in exchange for their company interests. Additional capital contributions do not generate profit or loss for the partners or the company.
When a partner contributes capital or assets to the partnership, he or she is granted an interest in the partnership based on the partner’s contribution as a percentage of all contributions. Any additional contribution will increase the share of the partner and the other shares must be adjusted accordingly.
Donation of Society Units
The easy division of partnership interests into units provides the ability to transfer assets to family members within the available annual gift tax exclusion of $14,000 per year per donee for 2014-2015 or the equivalent of the gift tax exemption. unified credit is $5,340,000 in 2014 and $5,430,000 in 2015. There are valuation discounts that can be used to reduce the value of partnership units by 20 percent to 40 percent for gift tax purposes.
Three types of valuation techniques are generally used to calculate the fair market value of an interest in a closely held entity. The market method (also known as the comparable sales method) compares the closely held company with its unknown market value to similar companies with known market values.
The income (or discounted cash flow) method discounts to present value the anticipated future income of the company whose shares are being valued. The net asset value (or balance sheet) method generally refers to the value of the company’s assets net of its liabilities.
The market method or income method is most often used when the closely held company is actively engaged in trading or trading. Net asset value is most often used when a closely held company primarily owns real estate or investment assets and does not carry on an active trade or business.
The value of a gift to a recipient is the fair market value of the gift when it is made, not what the fair market value once was or might be someday. In Revenue Resolution 93-12, the IRS accepts that a minority interest in a limited partnership with restricted ownership rights for the limited partner qualifies for a discount to the fair market value of the underlying assets. This allows parents to gift considerably more to their children within gift tax exclusions and without loss of control.
To be eligible for the discount, the limited partner’s interest must be considered a minority interest (discount for lack of control) and/or not freely transferable (discount for lack of marketability). IRC §2036(b) includes gifts in the donor’s taxable estate of corporate stock in a controlled corporation in which the donor retained the right to vote the stock. There is no corresponding tax code section for partnership interests.
Donors may wish to structure limited partnership unit transfers or gifts to qualify for the current unified credit exemption equivalent as noted above. These transfers do not have to meet the criteria as gifts of present interest, but disposal of the estate at death is generally desired. Even if the donor continues to serve as the general partner of the partnership and acts as a fiduciary for all partners, the endowed units of the partnership will not be included in the estate of the deceased donor/general partner.
Operating a family limited company
In their capacity as general partners, parents can accept an equitable salary from the partnership for their managerial skills. They can also establish whether the partnership will preserve or allocate income to its partners or whether they can lend funds to a limited partner. Parents can get money from the partnership to support their current or retirement needs, subject to fiduciary standards (which are lower than those of a trustee). Wages paid to any member of the partnership are subject to withholding as dictated by the IRS and the state in which the partnership operates.
A partnership must file tax returns annually. The Federal return is form 1065 and the State has an equivalent form. Any income received by the partners must be included in their corresponding tax return. Even if the distribution does not occur, the partners must claim the amounts reported on the K1 form provided by the partnership.
Taxes and insurance for a family limited company
Considering income taxes, all assets transferred from the partnership to the partners retain the same nature as with the partnership. IRS Revenue Ruling 83-147 explains estate taxes on life insurance owned by a partnership on one of its partners. The result should be the same as corporate-owned life insurance. If the partnership is the life insurance beneficiary, then the insurance death benefit will be included in the partner’s estate only indirectly by the change in value of the deceased partner’s partnership interest.
To avoid raising the interest of the deceased partner’s partnership for a portion of the life insurance proceeds, the policy may list the adult children as owners and beneficiaries of the policy at the beginning of the policy’s existence. General partners may distribute income to the children as limited partners to pay premiums for the policy owned by the children or the grantor of a trust that the children have created. Grantors could direct the beneficiary’s estate in the event the grantor predeceases the parent, which could help protect the policy’s cash value, if any, in the event of divorce.
The risks of the family limited company
The IRS has issued, without administrative hearings, new regulations under IRC Subchapter K. In short, the IRS will rule out a partnership as an entity if the partnership’s primary function was income tax evasion, either initially or during its operation. The proposed regulations are specific to income tax and do not apply to gift and estate tax assessments. This does not mean that the IRS will not address estate and gift assessments in the future. There are costs involved in forming and maintaining an FLP, including:
• Attorney fees to form the partnership (however, an attorney is not required
• Appraisal fees for the underlying assets and “parts” of the partnership that are gifted to younger generation family members;
• Accounting fees for K-1 partnerships and other financial assets;
Transfer tax costs such as documentary stamps when real estate is transferred. But for many investors, the benefits of well-planned FLPs easily outweigh the risks and costs.