In the previous post, Wealth Transfer Planning – Loans and GRATs, I discussed the current low interest rate environment and how loans and Grantor Retained Annuity Trusts (GRATs) may be used to transfer wealth efficiently and effectively. That begs another important question: once transferred, how is wealth protected from depletion, mismanagement, divorce, or creditors?
This post will briefly discuss two popular transfer techniques: family trusts and family limited partnerships.
Recall our hypothetical family: Mary and John and their two adult children (each married) and their four young grandchildren. Mary and John are in their mid-50s and in good health. They have built a successful company, acquired income generating multi-family real estate, raw land, and a diversified securities portfolio. Their current net worth exceeds $17MM. They expect their assets to appreciate at a combined rate of 6% for the foreseeable future. They expect their gross estate to exceed the estate and gift tax exemption, especially if the current exemption sunsets in 2025 back to the per person $5MM adjusted for inflation threshold. They are looking for a cost and tax-efficient means of transferring wealth to their heirs.
In addition to cost and tax efficiency, they want to ensure the assets they have accumulated will be protected from common killers of family wealth: waste, divorce, and creditors. The first risk, waste, is the most common and deleterious. The National Endowment for Financial Education estimates that 70% of wealthy families lose their wealth by the second generation, and a stunning 90% by the third. I will discuss this issue in future posts.
Placing assets in a family trust can help mitigate threats from waste, divorce, creditors, and estate tax. The reason is simple: the assets belong to the trust and not to the beneficiary. Since the assets are not the beneficiary’s, the assets are protected. The settlor or grantor of the trust designates a trustee to assume a fiduciary duty to prudently manage the assets and make distributions per standards laid out in the trust instrument. When establishing and funding the trust, the transfer to the trust may be a taxable event depending on the size or method of transfer. GRATs, discussed in the previous post, and a myriad of other techniques, can help to minimize the taxation of a transfer. Other techniques could simultaneously serve family wealth transfer goals while also achieving charitable goals. When designing a trust, carefully consider goals, asset base, who it is intended to serve, and for how long. It is important to know that trust capital gains and income tax rates hit the top bracket at approximately $13k. Trustee selection is paramount as well. You want to be sure the trustee and future trustees will adhere to the terms of the trust. Corporate trustees may be considered, but fee structure, bureaucracy, investment policies, and all ancillary fees (these can add up), and willingness to work with outside advisors must also be carefully considered. Trusts are a time-tested wealth transfer and wealth preservation tools.
Family Limited Partnerships
Family Limited Partnerships (FLPs) are limited partnership business entities duly filed with the state. Often, the general partners are parents, or an LLC or trust held by the parents, and limited partnership interests are distributed over time to children or other heirs. Some of the benefits of an FLP include wealth transfer, possible discounting of transfers, and importantly, control. By retaining the general partner interest, the general partners retain may retain control over investment decisions and distributions, which is something that is lost when assets are transferred to trust. Here is a brief example of how an FLP works.
Mary and John transfer a 100% interest in a successful sporting goods company valued at $2.02MM to their newly formed Smith Sporting and Investments, LP. In return for the exchange, Mary and John receive a 1% general partnership interest, and 100 limited partnership units, representing 99% of the new entity. Each unit is valued at $20k. A business valuation expert determines that a 25% discount for minority interest, among other factors, is reasonable for the LP units. Therefore, Mary and John can engage in a gifting strategy whereby they transfer two units valued at $15k per unit to each child and each grandchild per year over an eight-year period. In doing so, they maximize their annual gift exclusion of $15k each and transfer all of the LP units without incurring estate or gift tax nor using any of their lifetime exemption. In addition, as GPs, they maintain management control, protect the assets from LP creditors or divorce, and potentially remove assets from their estate.
Trusts and FLPs offer advantages but the costs must be weighed against the benefits. With trusts, irrevocability, loss of grantor control, taxation, and costs of administration are among considerations must be considered. With FLPs, they must be operated as any other limited partnership interest, and to withstand IRS scrutiny for estate and gift tax purposes, they need to serve a valid business purpose and transfers need to be bona fide and for a significant non-tax reason. In addition, there are liability and tax matters to consider.
In sum, family trusts and family limited partnerships can be effective wealth transfer vehicles but a careful cost benefit analysis should be conducted before pursuing one or both of these strategies.
In the next part of the Wealth Transfer Planning series, I discuss trust administration.
For questions or comments reach out to me by email.
Keith A. Pillers, JD, CFP®, CIMA®, CPWA®
Director of Wealth Management
Investment advisory services offered through Ackerman Capital Management, L.P., a registered investment adviser.
The content herein is general information and should not be considered a recommendation or personalized legal advice, tax advice, or investment advice. It is not personalized advice of any kind. Consult with you tax advisors and legal advisors before taking any action relating to any content hereinabove. Further, the content herein is not intended as a recommendation of any kind under any circumstances. Any assumptions, opinions, and estimates are provided for illustrative purposes only and not a guarantee of future performance. Forward-looking statements should not be relied upon as actual results may differ materially from those anticipated. The content herein (quantitative or qualitative) is subject to assumptions, risks, and uncertainties, which can change over time. Edits may be made without notice. Investing in the stock market involves gains and losses and may not be suitable for all investors. Neither Asset Allocation nor Diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk. Ackerman Capital Management assumes no duty to update the content and does not warrant the accuracy or completeness of the content. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Users of the Content herein agree as a condition precedent to usage of such information that (i) all Content is accepted on an “as is” basis; (ii) the user freely and knowingly assumes all risks of Content usage, (iii) the user fully releases and hold Ackerman Capital Management harmless, along with its affiliates and all of their employees, owners, managers, and agents from any damages or losses resulting from the use of such Content by the user along with indemnifying Ackerman Capital Management for any damages, costs or attorney’s fees incurred by Ackerman Capital Management as a result of any uses of such Content by the user. All content herein is protected under the copyright laws of the United States and/or other countries, and only permitted for personal, non-commercial use. All other uses, redistributions, reproductions, or republish, in any form, are strictly prohibited without the prior written consent of Ackerman Capital Management.