With discussions about tax reform beginning to take shape, the media is beginning to focus on the types of deductions that might be eliminated. These include such widely used deductions as the mortgage deductions. However, some of the largest tax shelters are virtually ignored, as many people aren’t even aware of them. 

Tax Deductions Being Considered For Elimination 

Among the tax deductions widely uses that are being considered for elimination are the following: 

• Mortgage Interest Deduction 
• Health Insurance, Deductible By Corporations 
• State And Local Taxes 
• Charitable Deductions 
• Municipal Bond Interest 

All of the above have appeared as “on the table” in media reports about tax discussions currently under way. 

Nearly all of these deductions are used by any taxpayer that files an itemized return. 

However, there are other tax shelters that are used primarily by wealthy Americans, which should also be considered. 

The Real Tax Shelters – One Example: Family Limited Partnerships

One of the most commonly used tax shelters by wealthy persons is the Family Limited Partnership. 

This is a corporate entity that is used to avoid estate taxes, primarily, although it also allows for more easily distributed income to family members, if a business is placed into the partnership. 

Family partnerships are entities where parents, typically, transfer assets into the family partnership, where the parents are the general partners.  Being general partners, they retain essentially the same amount of control over the assets that they have when they have direct complete ownership.  

The other members of the family are limited partners, meaning they have no control over the assets. This gives the limited partners a significant tax advantage. However, as limited partners, they have some claim on the income generated by the assets in the partnership. 

Furthermore, the partnership can be constructed so that the limited partners eventually can have ownership of the assets, usually when the general partners die. 

Where is the tax advantage here? 

When assets are placed into the partnership, a gift or transfer tax usually applies. The gift tax is essentially the same as the estate tax, in terms of applicability and rates. 

However, because shares of a limited partnership generally can only be sold to other members of the partnership, the IRS allows a discounted value to be placed upon the assets transferred into a family limited partnership. 

The rationale behind the discount on the value of assets is that the assets are not liquid, and therefore a potential buyer is able to pay a substantially smaller sum for the asset.  Of course, the sale of shares of family limited partnerships likely never happens, except to other members of the partnership, meaning that the discount is "artificial" at best. 

A discount of 25% is frequently quoted by tax advisors as “safe,” meaning that the IRS will not likely challenge such a discount. Since there is no discount established by law, more aggressive users of family limited partnerships might claim discounts as high as 50%.  

The Discounted Transfer Value Is Worth Big Bucks In Lower Taxes 

Since every individual is allowed to transfer $5.12 million worth of assets during their life time free of gift tax or estate tax, the 25% discount can be worth as much as $1.25 million. 

For example, if a business owner transfers his business into a family limited partnership, he can, in conjunction with his wife, transfer a business worth nearly $14 million into a family limited partnership without any gift tax applied.  (Using this deduction does mean that the estate will not be able to claim the deduction.) 

If the business were transferred directly to the heirs, or were to enter the estate, only $10.4 million of the asset would be exempt from estate tax or allowed to be transferred. 

Because of the ability to apply a deduction to this transfer, valuing the $14 million dollar business at just $10.2 million, this means that nearly $4 million worth of assets were able to be transferred without tax.  

At the estate tax rate established by the fiscal cliff compromise in January, of 40%, this means that about $1.6 million in tax revenue is lost in the transfer of assets using  a family limited partnership. 

If the “fair market value” assessment, conducted by a third person, aggressively establishes the fair market value of the entire business low to begin with, before the 25% deduction  is applied, the lost tax revenue is even greater.

Lost Tax Revenue Increases With Higher Valued Assets 

The lost tax revenue is even greater with assets well above $10 million, the exemption limit. 

By using the discount for “illiquidity” that the limited partnership allows, substantial savings on very large estates can be gained. 

For example, transferring assets worth $110 million directly to heirs, either during the owners’ lifetimes or in an estate, a gift or estate tax of about $40 million.  (The first $10 million would be exempt, with the remaining $100 million taxed at 40%). 

If, however, these same assets were transferred to an family limited partnership, all at one time, the value of the assets could be deemed to be just $82.5 million (75% of $110 million.) 

The gift or estate tax in this case would then only be $33 million, a loss of $7 million in tax revenue. 

Obviously lawyers can charge significant sums for the creation of family limited partnerships, as the potential savings in taxes owed make them a bargain. 

But why do we even have family limited partnerships? 

The Social Purpose 

What social purpose is served by the Family Limited Partnership? 

It is simply a tax shelter for wealthy persons. It is hard to argue how the rest of society benefits from shelters like this. 

The mortgage interest deduction, for example, can be argued as serving a valid social purpose of encouraging broader household ownership among Americans.  

It could also be argued that the mortgage interest deduction unfairly targets renters, but since renters have no political lobbying representation, the argument rarely gets made. 

Charitable deductions can also be argued to have a social purpose that justifies them, as the assumption is generally made that a “charity” is a good social purpose just by definition. 

However, any social benefit of the family limited partnership is hard to conceive. At least, we find it difficult to construct. 

Conclusion 

The only reason that family limited partnerships exist is to find a cheaper way around the gift and estate tax rates, for the purpose of transferring assets to heirs. 

In many respects, it makes the “public” estate tax rate of 40% somewhat of a sham.  

How many wealthy families actually pay the full 40% estate tax on assets in their estate above $10 million?  

Since the IRS does not publicly reveal the number of family limited partnership returns, along with their income ranges, as they do for individual income taxes, we don’t really know how large this issue is. 

Nevertheless, we think that most wealthy families use tax avoidance techniques such as the family limited partnership to pay what amounts to much lower tax rates on estates and asset transfers. 

The family limited partnership is only one such tax avoidance technique used by the wealthy.  We have only picked it as the most easily explained. 

Frankly, we would prefer to see the estate tax lowered to a level that does not prompt elaborate tax avoidance schemes such as the family limited partnership. 

The existence of high estate tax rates sends the political message that great family wealth cannot be built up on America. However, the existence of tax avoidance schems such as the family limited partnership illustrate that the "stick it to the rich" message of high estate tax rates is really a false political action. 

Why aren’t these types of tax shelters being addressed by Washington, instead of the widespread deductions such as mortgage interest used by much of the middle class? 

Your guess is as good as ours, but it is useful to remember that most of the members of Congress – on both sides of the aisle – are wealthy persons themselves. 

Comments may be emailed to the author, Robert V. Green, at aheadofthecurve@briefing.com