A new Tax Court case appears to create a blueprint for passing assets to heirs through a family limited partnership (FLP).
Alert: The new case upholds a formula clause for valuing the FLP interests passed to other family members. (Wandry, TC Memo 2012-88) The IRS has sometimes successfully challenged such clauses in the courts, but this time the Tax Court sided with the taxpayers.
However, the Wandry case is only a Tax Court Memorandum opinion. The IRS may yet appeal the decision or Congress could shoot down the technique. Until then, it’s fair game.
Here’s the whole story: When you set up an FLP, you transfer assets, typically interests in a closely held business or investment real estate, to a limited partnership. You may act as the general partner while other family members, such as adult children, are named as limited partners. The older generation then gives shares to younger family members like grandchildren.
Although the transfers are potentially subject to gift tax, you can take advantage of the annual gift tax exclusion. For 2012, the gift tax exclusion covers transfers of up to $13,000 per recipient ($26,000 for joint gifts by a married couple). Any remainder may be sheltered by the lifetime $5.12 million gift tax exemption (up from $5 million for 2011). Note that the lifetime gift tax exemption will revert to only $1 million, beginning in 2013, if Congress takes no action.
The FLP tax-saving device may be especially beneficial for small business owners. Reason: The owner can remain involved in daily operations while establishing a succession plan. In addition, the assets transferred to the FLP are protected from business creditors.
Icing on the cake: The value of the gifted limited partnership shares may be discounted for gift tax purposes because there’s no available market for those shares. Based on other cases, the discount might be as high as 30% or more if established by an independent appraisal. As a result, you can transfer even more assets to other family members without dire gift tax consequences.
The IRS and taxpayers often butt heads if the valuation is low-balled. Now the new Tax Court case could give taxpayers an edge.
Facts of the case: The Wandrys, a couple living in Colorado, each gave units in an FLP to other family members in 2004. To avoid paying gift tax, they specified that the gifts should equal the dollar amount of their gift tax exemptions and exclusions.
At the time, the lifetime gift tax exemption was $1 million and the annual gift tax exclusion was $11,000 per recipient, adding up to a total of $1,099,000 in reported gifts.
However, the tax return schedules described the gifts to the children and grandchildren as percentage interests in the FLP, rather than specific dollar amounts. The couple’s accountant derived those percentage interests based on an appraisal valuing a 1% interest in the FLP. The IRS audited the couple’s 2004 gift tax returns and determined a deficiency based on the percentage interests listed on each spouse’s gift tax returns.
When the IRS challenges such valuations, it may assess additional tax if the value increases after the gifts are made. But the Tax Court ruled that the couple intended to give gifts equal to the exemption and exclusion amounts under the clause. Favorable tax result: No gift tax is due.
Using a valuation clause like the one in the Wandry case provides some certainty in an uncertain process.
Tip: Such valuation clauses often include a “spillover” provision with any excess value created by the clause going to charity. But in this case, there was no spillover feature.
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