All in the Family
The family limited partnership is one tool every
physician must have
to protect assets, save on taxes, and establish
a quality estate plan.
“Is there one tool that is most important in
asset protection, tax savings, and estate planning?” As an
attorney and a financial planner specializing in working with
physicians, we are often asked this question. While the answer
inevitably depends on the client’s goals, the one tool which we
most often employ for our clients is the family limited partnership
(FLP)—the “F” in FLP simply meaning an LP used within
a family context.
Protecting assets
The leading reason physicians create that LP is
that they want to shield their personal assets from potential medical
malpractice claims. They may look at other asset protection tools, such
as trusts and offshore structures, but these tools have a number of
drawbacks,
specifically:
• The doctor may lose all control and
ownership of the asset
• There may be more tax filings and taxes due
because of the structure
• It may be difficult or impossible to
dissolve
The FLP has none of these
drawbacks. Because the client is typically the general partner as well
as holding many of the limited partner interests, he maintains 100
percent control of the FLP and assets within it. Further, because the
FLP is merely a “pass through” tax entity, there is no more
tax due when an asset is owned by an FLP than when it is owned by the
physician personally. While a tax return will be needed for the FLP,
this is usually not expensive. Finally, because the physician and his
family will own 100 percent of the FLP interests, the FLP can be
dissolved by family vote at any time in the future. For these reasons,
the FLP is typically an attractive asset protection option.
How does an FLP protect
assets? It does so because state statutes regarding limited
partnerships provide a level of protection for FLP ownership interests.
More specifically, each state has what are called “charging
law” protections for LP interests. These laws are mostly uniform
among the states, but certain states, (Nevada, Oklahoma, and Arizona)
have particularly strong protections in the statues. Essentially, this
means that if a physician is sued as a member of his medical practice,
the plaintiff cannot take assets that are owned by the doctor’s
FLP.
The plaintiff cannot become a
partner in the FLP, nor can he force the physician out of the FLP. Most
importantly, he cannot take the assets in the FLP nor force the FLP to
transfer the assets out to him. All he can do is wait for any assets to
come out of the FLP to the physician, then the plaintiff can take them.
This is quite a strong protection and is very frustrating for
creditors. As you can imagine, it puts the physician in a position of
strength in negotiating a favorable settlement. This is what asset
protection is all about.
Because the protections given
FLP assets are significant, the costs are relatively low, and the
physician maintains control of the FLP and its assets, the FLP is often
a central part of any physician’s asset protection plan.
Saving income taxes
In addition to being an excellent asset protection
tool, the FLP may also be an income-tax reducing tool. The FLP can save
a physician income taxes by having an income-producing asset owned by
the FLP where the FLP interests are gifted to children or other
beneficiaries in lower income tax brackets. To see how this works,
let’s examine a case study:
Case Study: Doug’s
FLP Reduces Taxes
Doug and his wife Sally had taxable income of
$100,000 from his investments—stocks worth about $500,000. In a
39-percent combined federal and state income tax bracket, their income
tax on this income came to $39,000. To reduce their taxes, they
set up an FLP.
The FLP was funded with the
stocks. Doug and Sally were the general partners, initially with 84
percent of the ownership, and their four children were gifted 4-percent
limited partner interests (16 percent total). Because each
child’s interest would be valued at less than $22,000 (4 percent
x $500,000, less the minority valuation discount), no gift tax applied
to the transfers to the children. Because Doug and Sally were the
general partners, they controlled the stocks and mutual funds. Doug and
Sally made these 16 percent transfers to their children annually for
five years.
Under the FLP agreement, the
children were taxed on their share of the FLP’s income, which,
after five years, became 80 percent. Thus, in year five, 80 percent of
the FLP’s taxable income was taxed at the children’s lower
tax rate. Thus, when the FLP assets earned $100,000 in income, 80
percent of that income was taxed at the children’s rate—15
percent. Thus, the income tax bill with the FLP was
$7,800—39 percent on $20,000 (the parents’ share), plus
$12,000—15 percent on $80,000 (the children’s share). Doug
and Sally’s tax savings were as follows:
Total tax with the FLP, year five: $19,800
Total tax without the FLP, year five:
39,000
Year five family income savings
with the FLP: $19,200
Plus, there were savings in
years one through four as well, and all the years after that! Also
under the FLP agreement, the general partners did not have to
distribute any FLP income to the members. This was totally within the
discretion of Doug and Sally, the general partners. Thus, Doug and
Sally could pay all FLP taxes with the income and re-invest the
remaining proceeds.
Saving estate taxes
Along with the income tax and asset protection
benefits, FLPs provide estate planning benefits. In fact, they have
been used in the estate planning context for over 30 years. FLPs
allow you to save your loved ones estate taxes when you die while still
allowing you control over FLP assets while you are alive. As the FLP
manager, you control the FLP assets and can gradually move FLP
interests out of your estate, using tax-free gifts of $11,000 per donee
per year. Let’s see how this works:
Case Study: Robert’s
Mutual Funds
Robert Jones is a 63-year-old anesthesiologist
with almost $1 million in mutual funds and real estate. He sets up an
FLP to own the mutual funds, making himself the sole general partner.
He initially owns 92.5 percent of the general and limited partnership
interests, and gives 1.5 percent each to his five grandchildren. While
this 1.5 percent was, on paper, worth approximately $15,000, his
interests were discounted close to 30 percent because of the two IRS
discounts—lack of marketability and the lack of control
attributable to the minority interests. This brings the value of his
transferred interests within the $11,000 tax-free gift limit.
Robert can gift each
grandchild $15,000 worth of FLP interests each year, completely tax
free, as long as these discounts are applied. If Robert lives to 73, he
can gift a total of $750,000 worth of mutual fund FLP interests to his
grandchildren ($150,000 each), tax free. This $750,000 is no longer in
his estate, nor subject to estate tax. Because Robert’s other
assets put him in the 50 percent estate tax bracket, the FLP will save
estate taxes of $375,000 (50 percent x $750,000). And, as the
FLP’s sole general partner, Robert completely controls the mutual
funds while he is alive, and he can distribute income to himself or
sell funds for his expenses, pay less estate tax, and provide more for
each grandchild.
For its ability to protect a
physician’s assets from lawsuits, because it can save both income
and estate taxes, and because control remains with the client, we use
FLPs in almost every physician’s financial or legal plan. It is
certainly an important tool to consider in your planning. n
