having to pay capital gains taxes and,
upon death of the shareholder (a limited
partner of the FLP), estate taxes would
be payable based only on the value of
Shareholder X's interest in the FLP
(which owns the QRP). If the rights of the
limited partners in the FLP are restrict-
ed, the value of the partnership interest
can be discounted. In some cases, FLP
units can be valued for estate tax pur-
poses with discounts for lack of market-
ability and minority interest that total
more than 30 percent. This discounting
effect greatly reduces estate tax liability.
For example, assume the shareholder
forms a FLP and contributes his or her
stock to the FLP in exchange for a 70
percent limited partnership interest.
If the FLP thereafter sells the stock to
an ESOP and reinvests the proceeds in
QRP, the shareholder will avoid having
to pay capital gain tax on the sale. More-
over, assuming the shareholder's rights
as limited partner are restricted and
that the FLP has a legitimate business
purposes, the value of his interest in the
FLP will be discounted for estate and gift
tax purposes. If the FLP achieves a 30
percent valuation discount, the share-
holder will have effectively converted
an illiquid limited partnership interest
valued at $14 million, resulting in a sav-
ings of about $2.7 million in estate taxes
upon his or her death.
The shareholder can further reduce
the estate tax burden by making gifts of
FLP interests to children. Under the an-
nual exclusion rules of the Code and the
discount rules, a FLP unit is also valued
at less than the value of the underlying
FLP assets. The shareholder might also
consider using some or all of his lifetime
gift exclusion to transfer the discounted
FLP interests to children. For example,
if over time the shareholder gave $3
million of FLP interests to children using
a combination of annual exclusion gifts
and unified credit gifts, the combined
total estate tax savings from using the
FLP would be an impressive $4,050,000.
The use of FLPs in estate planning
must be done carefully. In recent years,
the IRS has successfully challenged
discounts taken on partnership interests.
Often these outcomes result from poor
planning (for example, the partnership
was formed on the death bed). The cases
have established important principles,
however. In general, for the FLP to work,
it must have a business purpose indepen-
dent of the desire to reduce estate and
must give up direct and indirect control
of the FLP (e.g. the shareholder cannot
be the general partner or have control
over the general partner).
Since one reason to form a FLP is to
achieve valuation discounts, it is neces-
sary that the FLP general partner (usu-
ally a newly formed corporation) hire an
appraiser to value the FLP units. The
amount of the discount is a decision for
the appraiser and is dependent on the
specific design of the FLP. FLPs can be
designed to be restrictive or liberal with
respect to voting, income and distribu-
tion rights. The more restrictive the
FLP, the greater the valuation discount.
If done properly, the utilization of a
FLP can be an effective way for reduc-
ing a selling shareholder's estate taxes
as it relates to his QRP.
Many Primerus firms have the
expertise to plan and use FLPs to
minimize estate taxes. Combining this
expertise with ESOP expertise can help
closely held business owners protect
more of the value they have worked so
hard to build.