When a family business passes from one generation to the next, estate taxes often inflict a crushing burden. One succession strategy that eliminates the problem is to give your children shares of the company while you're still alive using a family limited partnership (FLP).

With this estate planning tool, you not only keep the business in the family, you retain control and collect breaks on gift and estate taxes. Here's a three-step guide:

Step 1. Get a professional valuation of the assets to be transferred to the partnership. The IRS often challenges these deals and its main argument is the value put on the assets at the time they were transferred to the partnership. Contact your tax adviser for assistance on how to get your business independently appraised. 
Step 2. Create an FLP and transfer your business, rental real estate or other valuable assets to it in exchange for the ownership interest in the partnership. Start by being both the general partner and the initial limited partner. Legal title must be changed to reflect the transfer.
Step 3. Make gifts of all or most of the limited partnership interests to your children or other heirs. You retain the general partnership interest, which is usually 1 percent of the total value. By doing this, you retain control over the business or property. Under partnership law, limited partners have little or no say in how assets are managed. As the general partner, you can receive "guaranteed payments." Yet you aren't considered the owner so only the value of the partnership interests you still own when you die will be included in your estate.

But here's the main advantage of an FLP: When you make gifts to your children, you can often claim valuation discounts of 20 percent and sometimes more. In effect, you're saying that each piece of the family business that you give away via a limited partnership interest is worth less because the recipient has limited power and liquidity.

By using the valuation discounts and the annual gift tax exclusion, an FLP can become the foundation of a family gifting program. In 2012, you're allowed to give $13,000 a year, or $26,000 for married couples, to as many recipients as you want without any gift tax consequences.

With a series of gifts, you can transfer all or most of your company out of your taxable estate.

For example, let's say you and your spouse own a $8 million family business that you want to pass on to your two children. You transfer the company to an FLP. You retain a 1 percent general partnership interest and give the remaining limited partnership interests to your children.

A professional appraiser values the partnership interests at $6 million -- a 25 percent discount - because an independent buyer wouldn't pay the full price for a minority share in a family company.

You can eliminate even more from your estate by giving each of your children annual gifts of limited partnership interests. You and your spouse can give $26,000 jointly to each child tax-free so you can cut your estate by $52,000, or $26,000 times two children. 

Let's say you do the same thing again next year and give $104,000 amount to your two kids. What have you accomplished? Since the amount you can shield from estate taxes in 2012 is $5.12 million, you may have eliminated any federal estate tax on the value of your business. (The estate tax exemption may change in future years.) In addition, FLP assets often have protection from lawsuit damage awards.

Warning: For a family limited partnership to pass muster with the IRS, there must be a business purpose. IRS auditors crack down on valuations they consider too aggressive. Consult with your tax adviser to see whether this estate planning tool meets your needs.

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