There are a few different vehicles to consider when contemplating passing on wealth to the next generation; two of the most effective yet overlooked techniques are 1) establishing a Family Limited Partnership or 2) creating an Intentionally Defective Grantor Trust. These are more complicated than just gifting away cash or assets, which is why some families tend to not think of them for their estate plan. The following article lays out the basic components of each technique, and how it could be used to make sure your estate planning is fully maximized for you and your family.
A Family Limited Partnership (FLP) can be used as an estate planning tool to help families transfer their wealth to the next generations all while maintaining control and management of the assets.
An FLP is a holding company with two or more family members in which family assets such as publicly traded securities, privately held securities, real estate, or family business interests are held. The FLP must be established for legitimate business reasons, but in addition to the business reasons, many families also create one as a vehicle to transfer their wealth to the next generation.
The FLP has two types of owners — General Partners (GPs) and Limited Partners (LPs). The GPs do not have to own a majority of the FLP, but can still retain control over the assets. GPs are also fully liable for the risks in the FLP and are responsible for the day-to-day management of the asset(s) that are owned by the FLP. The LPs will typically (but not always) contribute capital to the FLP in an exchange for shares in the asset but have no say in the management of the assets or any liability beyond any capital they have contributed.
Furthermore, within the FLP agreement, a clause can be included that severely restricts or prohibits the ability to transfer shares outside of the family, which is a great feature for the originating generation who wishes to keep the wealth all within the family.
Once an FLP is established, the originating generation can transfer an asset into the FLP in exchange for shares of the FLP. There are two types of shares in the FLP: GP Shares and LP Shares. The original generation will gift or sell LP Shares as they are less valuable than GP shares and allows them to maintain control of the asset. LP shares are considered less valuable because they have lack of marketability and lack of control. Lack of marketability refers to the fact LPs are unable to sell the asset outside of their family and lack of control is because LPs have no say in the management of the asset. These less valuable LP shares allow the originating generation to gift or sell LP shares to future generations at a discount compared to their true market value. Another bonus is the GP retains the ability to control the business, but allows future generations to participate in the financial benefits of the FLP by shifting income from the GPs to the LPs if done properly. Furthermore, once the assets are gifted, they are considering frozen for estate tax purposes and any corresponding appreciation of the assets is no longer included in the estate of the GPs.
An FLP can be a great way to transfer your wealth to future generations, but it is important to note that once you transfer assets into the FLP, it is an irrevocable decision. You no longer are the owner of the asset, the FLP is, as such you should consult with your Dowling & Yahnke Financial Advisor to make sure that the assets that you do retain, will be enough to provide the retirement lifestyle you intend to have. Also, the FLP is a “pass through entity” meaning that any income and/or deductions the FLP produces will be passed through to each partner in accordance with their share of the FLP as either GPs or LPs. Lastly, an FLP does not provide liability protection to the GP, so another entity such as an LLC may need to be created in order to offer liability protection to the GP.
An Intentionally Defective Grantor Trust (IDGT) is an irrevocable trust designed to preserve family wealth by transferring appreciating assets to the trust, which in turn reduces the Grantor’s estate but allows the assets to be passed down through a family via the trust.
The reason it is called an “Intentionally Defective Grantor Trust” is that the trust is defective for income tax purposes but accomplishes the goal of reducing a taxable estate for estate tax purposes. It accomplishes this by transferring the assets out of the grantor’s estate through gifting or by a sale of the assets to the trust. Transferring assets into an IDGT reduces estate taxes in two ways. First, it gets the asset out of the grantor’s estate by placing it into an irrevocable trust, and secondly, any asset appreciation after the transfer into the trust will also be excluded from the grantor’s estate.
The grantor is responsible for paying any income tax that the asset produces (which can further reduce their taxable estate), but when the Grantor dies, the assets will be excluded from their estate if the trust is structured properly. With the Grantor paying the taxes on the income created by the asset, the asset essentially grows income tax free. To sum it up, the trust is great at reducing the Grantor’s taxable estate, with the caveat that the Grantor will be responsible to pay the income taxes the asset produces.
Something to keep in mind is that the transfer of the asset into the trust will be considered a completed gift, and if large enough, may surpass the lifetime gift tax exemption amount. With that said, there is an alternative way to transfer assets into the trust and not run afoul of the lifetime gift tax exemption. Instead of gifting the asset to the trust, the Grantor can sell the asset to the trust. The great thing about this strategy is that the sale will not trigger capital gains taxes because the grantor is effectively selling the asset to themselves from the view of the IRS for income tax purposes. But, if the trust ends up selling the underlying asset, the Grantor will be responsible for paying the capital gains taxes.
The sale of the asset to the trust can be done with a promissory note, but the interest on the note cannot be below “market rate” which in this case is the Applicable Federal Rate (based on the length of the note). Furthermore, the asset must be sold to the trust at full market value or portions of the sale/transfer may be deemed a gift by the IRS.
Another requirement when selling an asset to an IDGT is to make sure the trust is “seeded” with at least 10% of the value of the of the asset being sold to the trust, or the IRS may have a case that the “sale” is just a transfer, and not a bona fide transaction. Finally, one last thing to keep in mind is that the “seed” money will use up some of the Grantor’s lifetime gift tax exemption.
Both the Family Limited Partnership and the Intentionally Defective Grantor Trust can be great estate planning techniques to reduce a taxable estate and pass down wealth. However, both techniques must be structured very specifically to ensure they are implemented and maintained properly, so if you are considering these techniques for your estate plan, make sure to consult a Certified Financial Planner® in coordination with your tax professional and estate planning attorney. If you are looking for a dedicated San Diego Financial Advisor, be sure to contact Dowling & Yahnke Wealth Advisors today to learn more!