Part 2 – Dissolving a Family Limited Partnership or LLC
In Leawood, LLCs and Family Limited Partnerships are typically use to reduce the valuation of assets in order to avoid the estate tax. FLPs, as well as LLCs, can be used to transfer more assets to the second generation.
As we can see here, there are several issues when dealing with LLCs and FLPs in the estate planning and business succession process.
Today’s article is part 2 of the series on this dissolution of assets.
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Once you’ve evaluated the relevant pros and cons of continuing the FLP, it’s now time to consider the options available. These might include:
Keep Status Quo
Perhaps after a complete analysis weighing all relevant factors, you’ll conclude that the existing FLP structure is a reasonable balance of all client considerations.
Revise the Investment Strategies
It may be feasible through a more carefully crafted investment policy to reduce the unrealized appreciation inside the FLP, thereby reducing the benefits of a basis step-up on death. In such instances, the FLP may remain intact as is, and perhaps the only document change might be a revised investment policy statement. For example, if the FLP contains only a portion of the family investment wealth, which is likely, then perhaps the FLP asset can over time be shifted more towards income then growth or actively managed growth investments so that unrealized appreciation is limited.
Restate Governing Document to Eliminate Discounts
The FLP may still serve as a convenient investment vehicle. For example, there may be a large number of family members, family trusts and even other family entities that have all pooled their liquid assets in the FLP as a single investment vehicle. This use may still be relevant, but the discounts are a negative from a tax planning perspective. It might be a relatively simple step to eliminate discounts while retaining the structure intact. This may continue to afford investment management advantages and save the cost and complexity of restructuring all the existing investment accounts and relationships. If the governing document is amended to provide that any member can receive his pro-rata share of the entity underlying assets on 60 days advance written notice, it would seem implausible for the Internal Revenue Service to argue that discounts could apply. A very serious negative to this approach is that it would also eviscerate any asset protection benefits previously afforded by the use of the entity because a creditor could make a similar demand. If the family members aren’t reasonably concerned about liability protection, this might afford a reasonable, simple and easy to implement means of eliminating discounts while retaining some benefits of the FLP. What if the parent/partners want to eliminate the discount to maximize basis step-up but a child/partner is a physician worried about the loss of malpractice protection by this change? If some of the family members do have concerns about liability, malpractice or divorce, it may be feasible for them to contribute their FLP interests to an irrevocable trust in advance of this change to the governing documents. While they would lose the additional layer of protection the FLP level of planning might have afforded, the asset protection from the irrevocable trust might suffice, and this might afford the family overall a better planning result.
Restate Governing Document to Reduce Estate Discounts
It may be feasible to take a somewhat narrower approach to the modification of the governing documentation that might facilitate retaining the FLP structure, a significant degree of asset protection for many equity owners and the elimination of the discounts for the senior family members. Consider an FLP in which the parents are in their 80s and want to garner a full basis step-up through an Internal Revenue Code Section 754 basis adjustment without the negative implications of discounts. However, junior family members and children are concerned about retaining asset protection benefits and, perhaps, even discounts to leverage inter-vivos gift plans. What if the governing instrument were amended to provide that solely in the event of death, the executor of the deceased partner/member’s estate shall have from the instant of death the right to put the value of the entity interests to the entity in full redemption of the deceased partner/member’s interests at the undiscounted value of the underlying FLP assets. This right shall continue from the moment of death until 60 days following the appointment of the executor or personal representative of the deceased partner/member’s estate (but perhaps in no event for more than 180 days following death). This type of provision would seemingly make it difficult for the IRS to argue that a discount could apply to the valuation of a deceased partner/member’s interest. The hoped for advantage of this approach over the one suggested in the preceding paragraph is that for younger partners, the statistical likelihood of death is sufficiently remote that meaningful asset protection benefits would remain for them. As a partner ages or as a partner’s health declines, the existence of this put right on death means that a creditor of the older/ill partner’s estate will be paid pursuant to the put right so that asset protection for the older partner will decline and at advanced ages be nearly nil. But this, for many clients, is the natural progression of asset protection worries: highest at younger ages and less decades following retirement.
Example: Assume a younger family member, a physician age 40. But for the redemption at undiscounted value at his death, it seems the approach should be viable as it arguably shouldn’t substantially undermine that younger living family member/partner’s asset protection. This approach can’t be used as a default resolution of the FLP discount challenge, but when there are senior family members well under the exemption amount, it could provide a viable family planning option unless there was a real asset protection worry by the older family members.
Partial Liquidation of Senior Family Member’s Interests
If the parents’ tax planning will benefit from removing appreciated asset from an FLP structure to obtain a basis step-up, but the remaining family members might still benefit from the entity, a partial liquidation of the parents’ interests might suffice to accomplish everyone’s goals. A partial liquidation might be planned by assets rather than by a partner’s interests. For example, the FLP might hold appreciated securities and a family vacation home. A partial liquidation of the securities to obtain a basis step-up to the extent that the distributed securities are included in the parents’ estates may be advantageous. The family vacation home might be held for generations to come, so that a basis step-up would at most have an academic benefit. However, the use of the FLP structure might provide valuable management, control and other benefits to the continued holding of that property.
Recapitalize the FLP
It may be possible that the parents who formed the FLP are no longer subject to an estate tax. Perhaps they’re subject to a state estate tax in a decoupled state, but that tax may be less than the capital gains costs to heirs of losing a basis step-up as a result of discounts. However, two of their children may be licensed professionals (for example, CPA, attorney or physician) so that the asset protection benefits afforded from holding significant assets in an FLP as a minority limited partner could have important asset protection benefits. The fact that they don’t have to incur the cost of creating their own structure, have trusted family members who may control management and can then use FLP interests to fund their own irrevocable trust plans may all be significant advantages. In these instances it may be advantageous for the family unit as a whole to recapitalize the FLP. Children facing liability and malpractice risks might contribute significant portions of their non-pension assets to the existing FLP. Consider lien and judgment searches and completing solvency affidavits in advance of the funding. The parents, who may have initially formed and funded the FLP a decade or more ago, in anticipation of estate-planning valuation discounts, might reduce their equity interests in the FLP to minimize the discounts that might reduce the income tax basis step-up on their deaths. Thus, the children might contribute significant new assets, and the parents may receive a distribution of existing appreciated FLP assets. However, in contrast to the approach used by many, the parents’ interests wouldn’t be entirely liquidated nor would their involvement with the FLP end. The FLP, in being repurposed as an asset protection tool for the next generation, may benefit from the parents owning partial interests, as that may prevent any one child from having a controlling interest in the entity (for example, a member-managed LLC) and thereby strengthen that child’s asset protection benefits from the structure. The parents may not intentionally be placed in a position of serving as manager or general partner. In the past, when the parents were seeking discounts from the FLP structure, tax advisors would have counseled against the parents serving as managers or general partners for fear that the IRS would assert that they retained control and argue for inclusion of the entity in the parents estate under IRC Section 2036. In a carefully crafted repurposed FLP, it may be advantageous for the children’s asset protection benefits to have a parent rather than the child in control. Depending on the circumstances, the old Section 2036 worries may not be relevant to the parents’ planning.
Complete Liquidation of FLP
In some instances there may be no perceived benefit of retaining the FLP structure. The intended heirs may really have no meaningful asset protection concerns. The FLP may hold primarily highly appreciated securities that would benefit from a basis step-up, and the parents’ estates may be safely below the federal estate tax exemption level, especially with consideration of portability.
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