Keeping It All in the Family

When newlywed Albert Sakharoff and his French bride boarded a bus in New York City in 1946, they were bound for Southern California and his job as a sheet-metal worker, which paid 40 cents a hour.

Now, 47 years later and retired since 1984, Sakharoff and his wife, Micheline, have assets estimated at $9 million--much of it in real estate.

In an interview in their Ventura Keys home, the Sakharoffs, both 70, talked about the plans they have made to pass their wealth--as free from taxes as possible--to their only daughter.

The couple began estate planning several months ago after a discussion of annuities with their insurance agent. Micheline Sakharoff, now retired after 25 years of teaching French language and literature at Cal State Northridge, had accumulated the annuities through her job.

“When (the agent) saw our financial statement, he urged us to see an expert right away,” Sakharoff said. They contacted attorney Jon J. Gallo, an estate planning specialist, who advised them to create a family limited partnership.

A family limited partnership (FLIP) is one of the most complicated, sophisticated and expensive of tax-reducing techniques. It is particularly suitable for people who have much of their wealth in real estate.

A family limited partnership is a means of making gifts of property to children at highly discounted rates. As long as the gifts fall below the $600,000 lifetime exemption for each parent, they will avoid gift taxes. FLIP also serves to reduce the value of the estate when the parents die.

Another point in the FLIP’s favor: Transferring real estate to a family limited partnership does not trigger a property tax reassessment under Proposition 13. And once the property is in the FLIP, the parents can transfer up to 49% of the partnership to their children without reassessment.

The Sakharoff FLIP, which is filed with both the county and the state, consists of five pieces of income property they own in Ventura and Los Angeles counties. When appraised when the FLIP was created, the net value of the properties was $1.5 million.

The couple made their only child, Katherine, a limited partner in the FLIP, giving her a 30% interest with no control over the affairs of the partnership. Sakharoff and his wife are 70% general partners, making all decisions relating to the management of the properties.

Had the Sakharoffs simply given Katherine a 30% interest in the properties without their being part of the FLIP, the gift would have amounted to $434,000.

However, after applying certain discounts, which are a key element of a FLIP--Katherine’s 30% was worth only $222,000, a reduction in value of $212,000. This procedure, as mentioned earlier, has reduced the value of the gift and ultimately the value of their estate.

The value of Katherine’s interest is so much less under the FLIP because the partnerships operate on “discount theory,” the premise that investors will offer less for property interests if they are non-marketable and if they lack control. Both conditions describe the status of limited partners such as Katherine.

Here’s a simple explanation:

If you owned a duplex worth $400,000, do you think someone would pay you $100,000 for a 25% share, which gave that person absolutely no say in operating the duplex? Not likely. Any potential buyer would want a discount because that 25% minority share is definitely not worth 25% of the full value of the duplex.

“In the case of limited partnerships, the sum of the parts is less than the whole,” Gallo said.

The IRS no longer challenges the concept that the market discounts minority interests, the experts say, if you’re wondering about the legality of this technique.

But it’s up to the taxpayer to have credible evidence to support the claimed discount. And that evidence can only be provided by qualified real estate appraisers; in fact, two types of appraisers.

Here’s what they do:

Before the FLIP is created, the property that’s going into the partnership must be appraised. That’s the job of appraiser No. 1, whose fee can range from $1,000 to $10,000--if you happen to own a shopping center.

Once his or her work is complete, the appraisal goes to a second appraiser who specializes in fractional interest discounts. This specialist will provide one, or possibly two, vital figures: 1) an appraisal of the discounted value of the limited partnership interest being given to the children when the entire building is in the partnership, and/or 2) an appraisal of the value of the children’s minority interest when only a portion of the property is being transferred to the partnership. (This second appraisal is a double-discounting technique, and you may have some difficulty with the IRS if you try to take double discounts.)

These appraisals will cost between $1,500 and $3,500--or more--depending on the type and size of the property. The Sakharoffs, for example, are paying $10,000 for all their appraisals.

Besides appraisal fees, the attorney’s fee for creating the FLIP can range from $3,500 to $5,000.

For the Sakharoffs, it’s money well spent. Their FLIP will save their daughter at least $118,000 in estate taxes. (This is 55% of the $212,000 discount that was created by the transfer. The Sakharoffs are in the 55% tax bracket, as is anyone whose net worth is more than $3 million.)

With an estate as large as theirs, the Sakharoffs said they are also investigating the merits of a charitable remainder trust and a qualified personal residence trust. People with substantial wealth frequently utilize all three of these techniques, legal experts say.

How a FLIP Works

Here’s a hypothetical example of how a family limited partnership works: Tom and Charlotte Martin have two children and a highly appreciated duplex appraised at $400,000. The Martins create a FLIP and transfer the duplex to the partnership.

One of the FLIP conditions is that Tom is the general partner and owns a 2% interest. Tom manages the duplex.

Charlotte is a limited partner with a 98% interest. As a limited partner, Charlotte has no control over the duplex, but she can give away part of her interest in the partnership.

She gives 24% of her 98% interest to son Jim and 24% to daughter Carla. In dollars, that means that Jim’s limited share in the partnership ought to be worth $96,000 and Carla’s share ought to be worth $96,000. But they really aren’t, because who wants to buy a 24% minority, limited partnership interest in a partnership controlled by Jim and Carla’s parents?

Now, if someone did want to buy a minority interest, the buyer would expect a discount ranging from 25% to 40%, experts say. But even with such discounts, it would be hard to find a buyer.

However, the discount is still applicable for valuing the gift of the limited partnership interest for gift and tax purposes. In our example and using a 40% discount rate, the original $96,000 gift is reduced to $57,600.

The FLIP thus allowed the Martins to transfer roughly one-half of the property (worth $200,000) at a discounted value of $115,200.

Help With Estate Planning

The estate-planning strategies discussed in this series are too complicated to tackle on your own. You need an attorney specializing in this field. But how to find one?

A first step is to call the Los Angeles County Bar Assn.’s lawyer referral service, SmartLaw, which makes referrals to private attorneys in more than 30 areas of law, including estate planning, wills, probate, taxes and elder law. The lawyers are screened and have met a require level of professional experience.

Clients are asked to pay a $25 fee to help support the nonprofit service for their first half-hour consultation with a lawyer.

The SmartLaw number is (213) 243-1525.