Keeping a business in the family is one of the more significant concerns for family business owners wanting to pass their company to the next generation. Tax-wise, succession planning is best begun long before the business is to be transferred.
Owners can take advantage of the tax benefits of gradually transferring ownership using a family limited partnership (FLP). This partnership allows ownership to remain with the current owner until ready to release the business to the next generation.
How FLP’s work
Establishment of an FLP consists of transferring ownership of interests into a partnership in exchange for both general and limited partnership interests. Then, limited partnership interests are transferred to children of the owner.
This allows the owner to retain the general partnership interest, which may be as little as 1% of the assets. Despite limited interest, as a general partner, you can still run the day-to-day business decision and operations.
Income tax benefits may come with FLPs. The income of an FLP will flow through the partners for income tax purposes. Your children may be in a lower tax-bracket, potentially reducing the amount of income tax paid overall by the family.
Transfer of the FLP interests removes value from your taxable estate. Also, the future business income and asset appreciation associated with those interests move to the children taking eventual ownership.
Children own limited partnership interests, meaning that they have no control over the FLP, and therefore, no control over the business itself. They cannot sell their interests without the owner’s consent or the force of FLP’s liquidation.
Often FLP interests can be valued at a discount because they lack an outside market and control of interests. This means that greater portions of the business can be transferred without requiring the gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 gift tax inclusion.
Transfer of interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. The Tax Cuts and Jobs Act raised the exemption to a record-high of $11.18 million, meaning 2018 may be a particularly good year to take advantage of this. The exemption is scheduled to be indexed for inflation through 2025 and then drop back to an inflation-adjusted $5 million in 2026. Congress could extend the higher exemption, however, using as much of it as possible now is tax-smart.
When considering an FLP, you should be aware of the risks. We can help you to determine if an FLP is right for you. Contact us at 949-860-9902 3 or click here, and we will contact you.