The
Benefits of Combining Family Trusts with Limited Partnerships
or Limited Liability Companies
by Steven B. Gorin, Esq.
and Benjamin G. Carter, Esq.
Thompson Coburn
LLP
Suite 3500
1 Firstar Plaza
Saint Louis, MO 63101-0000
Real estate owners
can achieve significant asset protection and estate
and gift tax savings by transferring their ownership
of real estate into appropriate entities and then
gifting fractional interests in the entity to an irrevocable
trust for the benefit of the owner’s descendants.
Choice of
Entity
To achieve
maximum transfer tax and asset protection benefits,
real estate owners could transfer their real property
to either a limited liability company ("LLC"),
a limited partnership ("LP") or a combination
of each. Both the LLC and the LP are creatures of
state statutory law and must register with the Secretary
of State.
Generally,
LLCs are taxed as partnerships. Thus, they can avoid
the double taxation faced by a C corporation. In many
cases, a partnership can liquidate without the tax
that would be imposed on a corporate liquidation.
Additionally, the members of an LLC are not liable
for the debts, obligations or other liabilities of
the LLC.
The LP/LLC
model offers added asset protection benefits and can
be structured in a number of ways. First, an LP may
register as a limited liability partnership ("LLP"),
which in most states provides complete liability protection
for the general partners(s). Second, instead of using
an LP with an LLP registration, an LLC could be used;
however, depending on state laws, an LP may offer
transfer tax advantages over an LLC. Third, the LP
can own the LLC which would in turn own the real estate.
Fourth, the LLC or an S corporation can serve as the
general partner of the LP. The limited partners of
an LP are not personally liable for the debts of the
partnership, but the general partners are personally
liable. Therefore, having a general partner that is
either an S corporation or an LLC reduces the exposure
for the individuals involved.
Basics of
Federal Estate and Gift Tax Law
Federal tax
law imposes a tax on transfers by gift (the gift tax)
and by bequest (the estate tax). Under current law,
the gift and estate tax systems work together. First,
the law provides an unlimited gift and estate tax
deduction for transfers between spouses. Second, the
gift tax law allows each individual to make up to
$10,000 in gifts to any individual per year – this
is called the annual exclusion, and the tax law allows
married couples to treat any gift made by one spouse
as being made one-half by each of them. Thus, a married
couple may give $20,000 per year within the annual
exclusion. Third, the estate and gift tax systems
provide a $675,000 exemption called the "applicable
exclusion amount" for gifts (in excess of the
annual exclusion amount) and bequests to persons other
than a spouse. This amount is scheduled to increase
to $1,000,000 in 2002. A husband and wife, together,
because of the applicable exclusion amount, currently
may pass up to $1.35 million (increasing to $2,000,000
next year) of assets to their children and grandchildren
without the imposition of gift or estate tax.
Finally, federal
law imposes a separate tax – called the generation
skipping transfer tax ("GSTT") – on gifts
to grandchildren and other persons from younger generations
(who might not even be related to the grantor). Individuals
can make up to $1,060,000 of these generation skipping
transfers without the imposition of GSTT. The GSTT
is imposed at the highest estate tax rate and is in
addition to any estate or gift tax imposed on the
transfer.
Using Family
Trusts
Instead of
making direct gifts to individuals, taxpayers can
make gifts to irrevocable trusts (referred to as "Family
Trusts" below). Generally, gifts to a trust do
not qualify for the annual exclusion. However, if
the beneficiaries of the trust have an immediate right
to withdraw the property that was gifted to the trust,
then the gift can qualify for the annual exclusion.
The trust would grant the beneficiaries of the trust
the right to withdraw a portion of each gift to the
trust, up to their annual exclusion amount (or twice
the annual exclusion amount for gifts made by a married
person who elects to split gifts with his or her spouse).
A grantor can
make significant gifts to a trust without paying gift
tax or using any of his or her applicable exclusion
amount. For example, a married individual who has
three children and five grandchildren can create a
trust for his or her descendants and may make annual
exclusion gifts of up to $160,000 ($20,000 x 8 descendants)
per year to the trust. Typically, in addition to the
withdrawal rights, the Family Trust would benefit
all of the grantor’s descendants. The trustee could
distribute income and principal to any of these descendants.
The trust would terminate and pass free from estate
tax at the date of death of either the grantor or
the survivor of the grantor and his or her spouse.
The remaining trust assets would be divided equally
among the grantor’s children, and each share created
for a child could also be held in trust – either until
the beneficiary reaches a certain age or for the beneficiary’s
life time. Thus, even though the grantor is taking
advantage of his or her grandchildren’s annual exclusions,
the children receive the most benefits. Furthermore,
each child receives an equal share of the Family Trust
upon termination, even if that child has fewer children
of his or her own than do his or her siblings.
Valuation
Discount
The amount
of a gift for gift tax purposes is the "fair
market value" of the gifted property. If an individual
simply gifts cash or marketable securities to the
trust, then the fair market value of the gift equals
the amount of the cash or the value of the marketable
securities on the date of the gift. However, when
a donor makes gifts of percentage interests in an
LP or LLC, the amount of the gift is not equal to
the corresponding fraction of the underlying assets
of the entity. Well established valuation and legal
principles demonstrate that these percentage interests
must be discounted for their lack of marketability
as well as for lack of control.
These valuation
principles offer real property owners significant
opportunities to leverage their gifting. For example,
Owner and his or her spouse transfer their interest
in real property worth $2,000,000 to an LP in exchange
for each receiving a 1% general partnership interest
and a 49% limited partnership interest in the LP.
Owner then creates a Family Trust for the benefit
of his three children and five grandchildren. Absent
valuation discounts, Owner and his or her spouse could
transfer an 8% interest in the LP to the trust each
year without using any of their applicable exclusion
amounts or paying gift tax. However, an appraisal
of a fractional minority interest in the LP would
support discounts for lack of marketability and lack
of control of anywhere between 25-50%. Assuming a
33 1/3% discount, Owner and his or her spouse can
gift a 12% interest in the LP without them using their
applicable exclusion amounts or paying gift tax. Thus,
by making fractional gifts of the LP, Owner and his
or her spouse can move an additional $80,000 in assets
(in addition to $160,000 before valuation discounts)
to their descendants and out of their estates for
estate tax purposes. Over five years, Owner and his
or her spouse can transfer $1,200,000 in underlying
assets to the Family Trust, including an additional
$400,000 of assets using valuation discounts.
One additional
benefit to using this gifting strategy is that descendants
who might otherwise attempt to withdraw the annual
gifts from the trust would be discouraged from doing
so. Since the trust would only own interests in the
LP that the grantor (and his or her spouse) would
control, the trustee would distribute limited partnership
interests instead of cash. If the LP does not make
distributions, a beneficiary who exercises his or
her withdrawal rights would be taxed on his or her
distributive share of the LP’s income but would not
have the cash to pay the taxes on that income.
For this strategy
to be successful, it is critical that the legal formalities
of the LLC or LP are respected at all times. This
means, among other things, that members or partners
must follow all requirements imposed by the operating
agreement (for an LLC) or partnership agreement (for
the LP). Moreover, LLC or LP assets should always
be held in separate accounts for the LP or LLC, and
the members or partners should never treat these accounts
as their own personal assets. The IRS will respect
these entities only if the members or partners have
respected the formalities themselves. Finally, taxation
of partnerships is a highly complex area, and members
or partners must obtain specialized tax advice concerning
the income taxation of these entities.
Conclusion
Real estate
owners can achieve significant transfer tax savings
by transferring ownership of their real property into
LLCs or LPs and then making gifts of fractional interests
in those entities to Family Trusts. Additionally,
these entities provide necessary asset protection
that all real property owners should have.
To
return to this issue's table of contents, click below
E-Dirt
Table of Contents
