All in the Family The uncertainty surrounding the estate tax has made family partnerships hot.
By Leslie Haggin Geary

(MONEY Magazine) – Only a few years ago, estate planning boiled down to one question: How can I make sure that the wealth I've amassed through hard work and savvy investing won't be decimated by taxes when I die?

Last year's gradual repeal of the federal estate tax--coupled with three years of stock market losses--has turned around that way of thinking and made a mess of traditional planning. For starters, unless you know what year you'll die, you can't be sure your heirs will even face an estate tax. This year and next, estates worth more than $1 million are subject to taxes of up to 50%. The exemption rises to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009. In 2010 the tax is repealed, but it returns in 2011 for estates over $1 million. In June the Senate narrowly rejected a permanent repeal, but the issue could re-emerge in Congress in the coming years.

Faced with such uncertainty, why spend thousands on a restrictive trust you might not need? Why shed sizable assets today and incur a gift tax if your heirs might never owe estate taxes? (Under current law, you can distribute up to $1 million over your lifetime before triggering the gift tax. Plus, you can give up to $11,000 a year to any number of people tax-free.)

Complicating matters is the bear market. With a smaller portfolio, it's even harder to tell whether you'll be rich enough to qualify for the tax. More important, stock losses may make you reluctant to give away what's left. "Clients understand that it makes sense to gift, but emotionally they're no longer comfortable with it," says Don Weigandt, vice president for wealth advisory at J.P. Morgan Private Bank. "They say, 'If I give it away, will it affect my lifestyle?'"

Enter a new buzzword in estate planning: flexibility. Consult an adviser and you're more likely than ever to hear about flexible techniques that let you trim the value of your estate without giving up full control of assets that you may need later. Two that are particularly hot are the family limited partnership (FLP) and its close cousin, the limited-liability company (LLC). Both strategies have helped families pass on farms and small businesses. Now advisers are pushing them as valuable tools to protect stocks, bonds and real estate as well.

If you own a small business or have well over $2 million in assets--the total estate-tax exemption that a married couple can currently claim--and you're fairly certain that you want to leave those assets to your heirs but are not quite ready to give them up entirely, you should consider an FLP or LLC. Those with smaller estates can stick with simpler flexible techniques such as bypass trusts and life insurance (see the box on page 138).

THE BENEFITS OF PARTNERING. The big appeal of FLPs and LLCs is that they let you give assets to your heirs at a discount, thus maximizing the tax-free portion of your estate. Here's how that works.

The key is the partnership structure. With both vehicles, ownership of the assets can be spread among an unlimited number of partners, including general partners who call the shots (that can be you and your spouse) and minority or passive partners with no control over the assets (often your kids or other heirs). When you set up an LLC or FLP, you transfer assets to the partnership and then divvy up shares among your heirs. Assuming that your heirs are minority partners, their shares are considered to be worth less than the value of the underlying assets--usually 20% to 40% less.

That discount is important because putting shares in your heirs' names can be deemed a taxable gift. But a 20% discount would mean that $14,000 in shares would be worth $11,000 for tax purposes and therefore be tax-free under the annual gift-tax exclusion. A married couple can give each child and grandchild up to $22,000 in shares every year tax-free and continue to do so indefinitely. Another option is for a couple to make a one-time gift of up to $2 million--the lifetime gift-tax exclusion for both spouses--and make subsequent $22,000 annual gifts.

The second benefit of an FLP or LLC is that you can continue to control the assets--buying and selling stocks, for example--and collect a steady stream of income from them. All the partners must collect income proportionate to their stakes, and that income is taxable. In most cases, the general partners decide when the partnership will distribute money and how much. So if you later find that you need more income from the FLP or LLC, you can increase the distributions.

However, you must be careful when you do this. Because all partners collect income based on their stakes, your heirs will also have to take larger distributions when you do. That's why experts caution against treating an FLP or LLC as a savings account. "It's a business, not a personal pocketbook," says Martin Shenkman, a New York estate lawyer and author of Estate Planning After the 2001 Tax Act. "You should have enough assets outside the partnership so that you don't have to tap it for everyday expenses."

When you and your spouse die, your remaining shares in the FLP or LLC are considered part of your estate. (If you were the general partner and died before naming a successor, the remaining partners generally pick one.) In most cases, those assets qualify for a discount for tax purposes because they're harder to market than they would have been if they were not held in a partnership, says Jere Doyle, manager of estate planning at Mellon Private Wealth Management in Boston: "Nobody wants to buy an asset that they have no control over and they can't liquidate easily."

THE CASE FOR A CORPORATION. Whether you should use an LLC or FLP will depend on several factors, including state laws, the kind of assets you're putting in the trust and your risk of being the target of a lawsuit. If you're the general partner in an FLP, you are personally liable for unlimited claims against the partnership, says Kevin Meuse, a partner with the law firm Kirkpatrick & Lockhart in Boston. In an LLC, it's harder for successful plaintiffs to get at your property. So a doctor who's concerned with protecting assets from a malpractice suit may want an LLC. On the other hand, an FLP may be cheaper to maintain than an LLC in some states.

WHAT TO WATCH FOR. Of course, FLPs and LLCs aren't for everyone. They're complicated to set up and must be administered carefully--help from a pro familiar with these techniques is a must. To create one, you'll have to pay a lawyer at least $1,000 to $7,500, depending on the partnership's complexity. You'll also have to hire an expert to value your assets, which generally costs another $2,000 to $10,000.

Finally, the IRS has long been on the lookout for artificial FLP and LLC discounts, so having one increases the chances that your estate will be audited, warns Kalman Barson of the Barson Group, an accounting firm in Somerville, N.J. that specializes in valuing businesses. If the IRS decides that you overdiscounted assets, it can assess penalties. Generally, says Barson, penalties will kick in if your discounts differ from the IRS-approved discounts by more than 10%.