It has been said many times before in this column: to win the estate tax game, you must have a comprehensive plan. Really, you must have two plans: an estate plan (death plan) and a lifetime plan. It is the lifetime plan that really lays the groundwork for beating the estate tax.
The best lifetime plan is asset-based, and you can have four types of assets:
3. Qualified funds (i.e., in a 401(k), IRA, etc.)
4. Investments (stocks, bonds, cash, real estate or similar assets, owned alone or with others).
This article zeros in on investments, an area in which many professional advisors are at a loss for what to do and how to do it.
Let’s call our tax hero “Joe,” who has accumulated a variety of investment-type assets worth $12 million. He is married to Mary, and has three children and six grandchildren. Joe has considerable wealth in all four types of assets, but his goals concerning the investment assets in particular are to:
• Reduce or eliminate the potential estate tax
• Reduce income tax on the assets’ income
• Protect the assets from creditors and from ex-in-laws in the event that his children or grandchildren get divorced
• Keep control of the assets.
You’ll Flip Over FLIPs
No question about it, one or more Family Limited Partnerships (FLIPs) are the weapon of choice to accomplish all of Joe’s goals. A FLIP is a partnership consisting of one or more voting general partners who control management and make investment decisions, and limited partners who hold nonvoting units. Unlike irrevocable trusts, a FLIP is a flexible tool that can be amended if necessary to meet the changing needs of your family or circumstances.
Since the limited partnership units are unable to vote or control investments or distributions, they are eligible for valuation discounts. These discounts typically reduce the value of the property transferred to the FLIP in the range of 30 to 40 percent, for tax purposes. We typically take 35-percent discounts (even for stocks, bonds, cash or cash-like assets), which always has been accepted by the IRS.
Discounts are a big deal. For example, if Joe transfers $1 million of investment-type assets, the $350,000 discount (using the 40-percent estate-tax rate) will save $140,000 in estate taxes.
Joe and Mary (both 61 years old) want to shift their investment asset value and the accompanying income to their children and grandchildren free of gift and estate taxes. The following steps show the creation and operation of a FLIP that does the job perfectly:
1. A FLIP agreement creates a general partnership interest which owns one percent of the FLIP and a limited partnership interest which owns 99 percent. To start, Joe and Mary own all interests.
2. Joe and Mary transfer $10 million of various investment assets (after discounts, only $6.5 million for tax purposes) to the FLIP in exchange for the general and limited partnership units. This transfer is tax-free.
3. The general partnership units are retained by Joe and Mary for their lifetimes, while the limited partnership units are gifted over time directly to (or via a trust for the benefit of) the children and grandchildren.
4. As general partners, Joe and Mary control investment and management of the FLIP assets. They must receive adequate compensation for services rendered to the FLIP, but they can hire others to manage and perform required services.
5. Two FLIPs actually are created: one for assets likely to appreciate in value and a second for the rest of the assets. For asset-protection purposes, all the real estate is put into a series of limited liability companies (LLCs), and the interests in the LLCs are transferred to the FLIP.
6. Now the FLIP limited partnership units can be gifted to the kids and grandkids in the most tax-effective way. After considering the comprehensive plan for all the other assets owned by Joe and Mary:
• All of FLIP #1’s limited partnership units were given to Joe and Mary’s three children using as much as $4.8 million of their unified credit—$5.25 million each for Joe and Mary in 2013. Immediately, the appreciating assets and the income from these assets are out of their estate.
• An annual gifting program was started using Joe and Mary’s $28,000 combined annual inclusion for 2013 ($14,000 each). This amounts to a total of $252,000 per year ($28,000 for each of the nine children and grandchildren). At this rate, it will take Joe and Mary seven years to complete gifting the FLIP #2 limited partnership units. (Note that units owned by the children and grandchildren are protected from their creditors or ex-spouses in case of a divorce.)
If you have significant investment assets, one or more FLIPs will help you win the estate tax game. Just make sure you work with advisors who have experience putting together comprehensive estate/death and lifetime plans.