With the outcome of the estate tax laws up in the air, it leaves tax planning a little unsettling. With the federal estate tax exemption now at $2 million per person, we don’t know if Congress will increase it, decrease it, or eliminate it. The chances are, in my opinion, that there will be some downward movement due, in part, to the consequences of a run-away national debt. (See article: "It’s What We Don’t Know that We Don’t Know that Hurts.")

Suppose Henry and Ruth Johnson have a $5 million estate. They can currently pass $4 million of it onto their children without being taxed. That leaves $1 million. With the lifetime gift tax exemption of $1 million, they are in great shape. But suppose the estate tax exemption is reduced to $1 million per person. They now have a $2 million tax liability. With the gift tax rates ranging from 41% to 45%, giving the money away may not be the answer. What should they do?

One solution is to donate a portion of their estate to a CRT or Charitable Remainder Trust. This process will get the assets out of their estate and free of taxation upon their death. Henry and Ruth have a nice stream of income while they are alive but the asset is now in the hands of their favorite charity. While the Johnsons are socially minded people, they know their real estate assets are going to continue to appreciate and they want to pass on that increased value to their kids and still maintain a solid stream of income for their retirement.

Another solution that is growing in popularity is the Preferred Family Limited Partnership. It works like this:

Henry and Ruth transfer all or part of their assets into a partnership in exchange for a preferred partnership interest with an interest rate determined by the partnership, say 6%. This rate is established by comparing the distributions to similar investments with comparable levels of risk. Setting the rate too high, like 12%, could be considered

excessive and a gift tax could be levied, unless treated as increases in value of the common interests. Therefore, it is important to seek professional counsel to determine a realistic interest rate.

These distributions are cumulative, accruing at a fixed rate interest until paid. They are entitled to $120,000 a year ($2m x 6% = $120,000). With their preferred status, they receive preference over the other partners when the returns fall short. The preferred partners are paid first before the other partners are paid their shares. These preferred distributions can be paid monthly, quarterly, or annually from the partnership as long as they are alive. Upon their death, the yearly payouts will be included in their estate and a value will be determined based on current interest rates at that time. If the rates have not changed drastically, say 7%, the value of their interest will now be $1,714,285 ($120,000 / 7% = $1,714,285) for estate tax purposes.

However, there is a small catch with the Preferred Family Limited Partnership. The nonpreferred or common interests must make contributions to the partnership that is equal or greater than 10% of the original contributions by the preferred partners. This can really throw a wrench in the deal, unless you plan ahead. If you know your intention is to create a Preferred Family Limited Partnership then the preferred partners may want to make gifts to the nonpreferred partners (children) in advance in the amount necessary to capitalize the partnership. Suppose in Henry and Ruth’s case, they know they want to contribute $2 million to the partnership to be safe with those assets that may be subject to tax. Consequently, their four married children would have to collectively contribute at least $222,500 to have a valid Preferred Limited Family Partnership. This is determined by calculating what 10% would be of all the original contributions ($2,000,000 + $222,500 = $2,222,500 x 10% = $222,500). Given that Ruth and Henry can gift $24,000 per year to each child and their respective spouses (4 x 2 = 8), they can gift $192,000 per year. Therefore, it would take Henry and Ruth at least two years of gifting to their children (without a gift tax) to establish a fund large enough for the nonpreferred partners to capitalize the Preferred Family Limited Partnership.

Now here is where it gets exciting. Similar in concept to the growth in value of common stock of a corporation, the partnership should have an objective to earn more than the 6% preferred distribution rate. If the partnership can achieve excess earnings of 5% or higher (achieving a 10% return or better), the Preferred Family Limited Partnership will be worth over $4 million in 14 years. The net result is that the nonpreferred partners will benefit from an appreciation of their contribution of $222,500 to an appreciated value of nearly $2.5 million. Isn’t that what the Johnsons wanted in the beginning? While the estate is still subject to the $1,714,285, nearly $2.5 million dollars of real estate has been removed from Henry and Ruth’s estate, free of gift or estate tax. The children are in a much better place, too, when, and if, an estate tax imposes a tax on the $1,714,285.

For those that have appreciated real estate and they believe it will only go up further in value, the Preferred Family Limited Partnership makes obvious sense. However, like all intricately designed estate planning tools, the IRS loves to challenge those that could be considered as tax avoidance strategies. Therefore, it is extremely important that you seek competent legal counsel when you consider using this win-win exit strategy. Can I be your kid?

Mark C. Hughes is President and CEO of Virtuosity Unlimited, LLC which operates with a team of advisors to help those with highly appreciated assets or lucrative businesses to downsize or transition their equity into viable options without paying unnecessary taxes in the process. Mark can be reached at This e-mail address is being protected from spam bots, you need JavaScript enabled to view it or visit www.virtuositypro.com. Mr. Hughes and Virtuosity Unlimited, LLC publishes the VirtuosityPro eNewsletter as a service to its clients and their advisors. While we make every effort to ensure the accuracy and reliability of the information published, we do not warrant or guarantee the accuracy of the information or its fitness of purpose.