Impact of Estate Tax Repeal - FLP

Impact of Estate Tax Repeal on FLPs

   EGTRRA repeals the estate and generation-skipping transfer taxes effective for decedents dying after December 31, 2009. Prior to repeal, EGTRRA provides for a gradual increase in the applicable exclusion amount for estate tax purposes from $675,000 in 2001 to a maximum of $3.5 million. The exclusion for 2003 is $1 million; it rises to $1.5 million for 2004 and 2005. (The GST exemption remains at $1,000,000, adjusted for inflation, until 2004 when it becomes the same as the estate tax applicable exclusion amount.)

Although estate and GST taxes are repealed beginning in 2010, the gift tax remains. EGTRRA increases the applicable exclusion for gift tax purposes to $1 million for 2002 and beyond. Unlike the estate and GST tax applicable exclusion amount, which gradually increases to $3.5 million, the amount for gift tax purposes remains at $1 million.

The scheduled repeal of the estate tax, combined with the continued $1 million exclusion amount for gift tax purposes, complicates estate and gift tax planning with FLPs. The following are a few guidelines to consider before recommending an FLP to a business owner.

Estate Tax Considerations. From an estate tax perspective, using an FLP to create valuation discounts that reduce the value of an owner’s estate is probably not warranted if the owner is likely to live until 2010 when the estate tax repeal becomes effective (assuming the owner believes it will be permanently extended and not allowed to sunset). In fact, using an FLP to reduce the value of the owner’s estate may be counterproductive when (if) the estate tax is repealed and replaced with a modified carryover basis system. With a carryover basis system, the valuation discounts would actually reduce the owner’s ability to step up basis, thus subjecting the owner’s heirs to potentially higher income taxes when the assets are sold or the partnership is liquidated.

Uncertainty regarding the estate tax repeal/reinstatement may make some clients hesitate to implement strategies to reduce their estate tax. If the estate tax is permanently repealed, there will no longer be any need to establish FLPs solely to avoid the federal estate tax. However, if permanent repeal does not occur, FLPs will continue to be viable estate-tax-avoidance vehicles for wealthy individuals. Practitioners should also point out the reasons for forming an FLP other than avoiding estate tax, including asset protection, ability to transfer ownership in assets without relinquishing control, and potential valuation discounts for gift tax.

Gift Tax Considerations. The discounts applicable to limited partner interests continue to make FLPs an attractive vehicle to reduce the value of lifetime gifts. Since these gifts also remove value and appreciation from the donor’s estate, they still provide estate planning benefits to owners who are likely to die prior to the estate tax repeal in 2010.

Lifetime gifts of FLP interests can also be used as a hedge to reduce estate taxes in the event the owner dies unexpectedly before 2010 (or if the estate tax repeal is not reinstated in 2011). In either of these instances, the owner will be subject to estate taxes. Thus, gifting FLP interests will remove value and appreciation from the owner’s estate and reduce potential estate taxes. When gifts of FLP interests are used as a hedge against potential estate taxes, they should be limited to amounts that do not generate any payable gift tax (e.g., annual exclusion gifts or gifts that do not exceed the owner’s applicable exclusion amount). Otherwise, the owner may pay gift tax that would not have been incurred if he or she is never subject to estate tax.

Warning: A principal use of FLPs is to obtain valuation discounts for transfer (estate and gift) tax purposes.  These discounts continue to be closely scrutinized by the IRS. Any gifts where valuation discounts are claimed must be disclosed.

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