Recently released Treasury Department regulations specifically target estate tax valuation discounts for limited partnership interests in family limited partnerships, or “FLPs.” It’s widely argued that these new rules eliminate these discounts. While I feel certain that most in the estate planning community are diligently working to find a viable structure circumventing the new rules, I also believe that the Service will use these new provisions as justification for a new anti-FLP pogrom, placing any attempts to circumvent these new rules squarely in the IRS’ litigation crosshairs.
But the estate planning community is missing the forest for the trees. Even without valuation discounts, partnerships – be they general, limited or in some other form such as an LLC – offer tremendous benefits that we should consider when weighing the option of which entity to use for an estate planning transaction.
A single tax layer: this benefit alone is worth the price of admission. I’ll show the benefit using an admittedly extreme example. Assuming a maximum corporate tax rate of 35% and a maximum personal rate of $77,485 + 39.6% of all income over $250,000, it’s conceivable that more than 50% of a company’s income could be paid in taxes before ending up in the shareholder’s bank account. This example doesn’t take deductions and other benefits into account. But that’s not the point: instead, it simply shows that 2 layers of tax mean a fairly large amount of money will move from the business to the government before ending up in the client’s hands.
In contrast, there is only one layer of tax with a partnership. Using the above example, we see a maximum rate of $77,485 + 39.6% of all income over $250,000, eliminating the 35% entity level tax, sending a larger amount of money to the partners. This example explains why, after its introduction in the 1990s, the LLC became the most popular business structure. And it’s also a primary reason why using a partnership tax based entity for a family business entity makes tremendous sense.
Finally, a partnership looks very enticing when compared
to the greatly compressed tax rates associated with trusts.
An Entity Governed by Contract: corporations are statutory creatures: owners must follow – and painstakingly document their adherence too -- many rules and regulations. In contrast, contract law governs the relationship between the partners and limited partners, granting the parties tremendous latitude to determine how they will interact with each other. Save for base partnership concepts such as the duty of loyalty and duty of care, partners are free to construct their affairs however they see fit. This benefit lowers the compliance burden placed on the owners.
Disproportionate Participation and Distributions: Let’s assume that a father and son want to form a partnership. The father can contribute 60% of the original capital with the son contributing the other 40%. This type of allocation is part and parcel of pass-through entities, where partners routinely have different interests in the entity.
But it gets better. Let’s assume that a father forms a family LLP and includes his children as limited partners. Because he’s in a higher tax bracket, he wants the tax free income from the portfolio’s municipal bonds while his children, being younger, need some or all of the portfolio’s capital appreciation. Using a tool called “disproportionate allocations” it’s possible to achieve this type of allocation so long as they have “substantial economic effect” – a term of art in the partnership tax world. While an explanation is far beyond the scope to this article (and, in fact, is the subject of at least one long chapter in most partnership tax text books), suffice it to say that customized internal cash flows at the partnership level are very common.
There is no denying that, should these new regulations survive the public comment period, a powerful estate planning tool will be lost to the legal community. But that doesn’t mean planners should stop using partnerships. This brief article touches on 3 of the most commonly known benefits of pass-through entities. There are many more.