Capitalizing the FLP: IRS & Property Tax Considerations PDF Print E-mail
Both the IRS and California State Board of Equalization (“SBE”) have certain exemptions amounts which impacts parent(s) making gifts to their children of real property interest.  Parents often want to make gifts to their children for many different reasons during their lifetime.  Naturally, parents want to do this transfer at the least cost to them.

Today both the IRS and SBE have a $1 million exemption for gift tax purposes and between parent and child for non residential property for avoiding a property tax increase.  This means for a couple, the combined exemptions is $2 million.  Gifting is often associated with transferring real property into either a limited partnership (“FLP”) or limited liability company (“LLC”) as part of the overall transaction.  For purposes of the transfer both exemptions are utilizing a fractional interest that will be subject to a discount by a qualified appraiser.  Discounting helps transfer the most value from the parent to the children at the least cost.  For example, an undivided interest value can normally be reduced by an appraiser between 20 to 30%.

Often the parent is willing to make a gift to a child but usually it is a small portion or fractional interest because the parent still wants to retain a certain amount of income from the property for themselves. However, they want the child more involved with the property as a business.  Asset protection is often another important factor when making gifts to children. This is when the FLP or LLC comes into picture as the business entity of choice.

Both the IRS and SBE have certain rules that need to be followed in order to not lose the favorable gifting and parent child exemptions.  The key is to understand how the FLP or LLC is going to be capitalized and when the transfer from the parent(s) to the child occurs.  Usually, the $1 million parent child property tax exemption is the controlling factor that determines the initial capitalization of the FLP and LLC.  I will explain this in more detail in my example below.

The IRS will attack the FLP or LLC as not correctly being formed for gift tax purposes if the parents transfer real property into the FLP or LLC and immediately make a transfer of a FLP or LLC interest to a child but fail to properly document the transfer in order to establish a valid gift.  Usually, this is easily overcome when working with professionals in documenting and establishing the FLP or LLC.

Both the SBE and county assessors may attach the transfer and more importantly the parents will lose the $1 million non residential exemption if the formation is not thought through from the time of formation until after the death of the parent.  This is where the interplay of shifting income to children and the two exemptions all impact the planning.

Let me give you an example.  A couple has a business property that is worth $2 million dollars.  They first transfer the property into a LLC and then make a gift to their child of a 50% interest.  The LLC is properly formed and documented for IRS purposes.  They also file a gift tax return and report the transaction.  It will be successful for IRS purposes.  The parents have shifted 50% of the income from the business to the child and no other gift tax impact will occur if they continue to respect the transfer and have shifted the appreciation out of their estate at a discounted value.

However, there will be an increase of property tax on the death of the parents when their interest will be transferred to their child.  The reason for this is that the transfer of the 50% interest was not a property interest transfer and since more than a 50% interest was transferred (50% on formation and 50% on death) the entire property will be reassessed for property tax purposes because of a change in ownership between business owners.

All of this could have been avoided at the outset by a two step process.  First, the parents transfer to the child a 50% undivided real property interest that will be exemption for property tax increase.  Second, after the transfer the parents and child transfer their 50% interest each into the LLC.  This will also be exempt from a property tax increase because both before and after the transfer the interests in the property were the same. After the death of the parents, there still will be no increase in property tax.  This is because not more than a 50% interest was transferred between the business owners after formation!

Sometimes when dealing with multiple properties the parents have to make a choice regarding whether or not there will be a need to have more than one LP or LLC when making a gift to a child and the limits imposed by the $1 million non residential parent child exemption.

Planning real estate transfers to children requires a good understanding of how various different taxes actually work, including preserving a low base property value for property tax purposes.  It is important to learn about interplay of theses different taxes based upon the desire of the parent.
 

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