By John K. McGill, CPA, JD, and Timothy D. Gacsy, CPA, PFS, MBA, MBT
A family limited partnership (FLP) is a form of a limited partnership where members of a family serve as general and limited partners. The general partner(s) control the business while the limited partner(s) have limited liability and no say over daily operations. In the family context, the doctor typically starts out as both the general and limited partner. The doctor can then gift the limited partnership interests to his or her children.
The general partner(s) can gift as much as 99% of the FLP interests to the limited partner(s), keeping as little as 1%. In comparison, a family limited liability company (LLC) is an entity owned by family members who may or may not serve as managers. Regardless of manager status, all family members have limited liability.
Together, FLPs and LLCs provide a unique opportunity for doctors to shift wealth and shelter liabilities. While complex, these structures can be an integral component of a successful financial game plan.
Shifting unearned income for college expense funding
Through the use of an FLP or LLC, a doctor can shift unearned income to his or her college-aged children in order to pay for education costs. When appropriate, a doctor can transfer an office building and/or equipment into an FLP/LLC and then lease it back to the practice at a reasonable rental rate. The doctor can then gift a portion of the ownership interests in the FLP/LLC to his or her college-aged children, shifting the income to the child's tax return. If the children generate more than 50% of their support from their own earnings (salary through the practice or other employment), they will avoid the kiddie tax, and the income from the FLP/LLC will be taxed at their lower tax rate (10%-15%).
Gift and estate tax advantages
The FLP/LLC can also be used to minimize federal gift and estate taxes. By leveraging the annual gift tax exclusion and the lifetime gift tax exemption, doctors will be able to transfer a significant amount of wealth out of their estate tax free. Gifts of interests in an FLP/LLC are subject to federal gift tax. However, doctors can eliminate their actual gift tax liability by transferring FLP/LLC interests in increments that are free from gift tax under the annual gift tax exclusion ($14,000 per donee). Any remaining gift tax liability can be offset through the use of the $5,250,000 lifetime gifting exemption, so transfers that do not fall under the annual gift tax exclusion will be free from gift tax to the extent of a doctor's available exemption.
By taking valuation discounts, doctors can substantially increase the amount of tax-free gifts for gift tax purposes. Since children will own less than a controlling interest in the FLP/LLC, the value of their ownership interests can be reduced to reflect their minority ownership status. The lack of control and lack of marketability discounts can result in a value that is significantly less than the value of the underlying assets. While discounts of 20% to 40% are normal, the IRS has accepted some discounts as high as 60%. Also, distributing assets among family members through the FLP/LLC will remove all future appreciation and income generated on such gifts from the estate.
Asset protection advantages
As a general rule, creditors cannot be satisfied from assets owned by the FLP/LLC. It generally takes a charging order issued by the courts for a creditor to reach an FLP/LLC interest, and even this only requires the FLP/LLC to pay distributions (income) to the creditor instead of the partner/member. As a result, the creditor will be required to pay tax on his share of the FLP/LLC income, regardless of whether or not any distributions are made. Often, creditors who obtain charging orders end up with nothing because they cannot order the FLP/LLC to make any distributions. As a result, a doctor whose personal investment assets are owned by his FLP/LLC is usually able to settle claims with the creditor for pennies on the dollar. Please note that your liability protection from an FLP/LLC varies from state to state, so consult with an attorney to determine the benefits that apply to your situation.
John McGill and Timothy Gacsy provide tax and business planning exclusively for the dental profession, and also publish the popular newsletter The McGill Advisory. The McGill & Hill Group's members and affiliates collectively serve as a one-stop resource for tax and business planning, practice transition, legal, retirement plan administration, CPA, and investment advisory services. Visit www.mcgillhillgroup.com or call 877-306-9780 for more information.
Past DE Articles
