The parents, therefore, create a CFLP to which they transfer $1 million in securities. Then the parents take back a 2% general partnership (GP) interest and a 98% limited partnership (LP) interest.
Now the parents gift a 4% LP interest to their son, and a 94% LP interest to charity, retaining the 2% GP interest. Assuming the partnership interests are subject to a 30% valuation discount for gift and income tax purposes, the gift to the children's trust has a value of $28,000 ($1 million - 30% discount x 4%), resulting in a gift tax of $14,000 (assuming a maximum 50% gift tax rate in the year 2002). The gift to charity has a value of $658,000 ($1 million - the 30% discount x 94% percent), resulting in a charitable deduction equal to that amount for both income and gift tax purposes. Assuming that the parents have an adjusted gross income of $350,000, the charitable deduction could be used over 6 years (30% of their adjusted gross income is the maximum deduction per year).
The partnership grants the limited partners (including the charity) a "put right" that allows them to sell their respective LP interests to the partnership in five years for their fair market value at that time, as adjusted for applicable marketability the minority interest discounts. This was the 30% discount figure used when the initial transfers to the son and charity were made.
The partnership now sells the $1 million of marketable securities. The partnership is a "pass-through" entity, which means that all income and capital gains realized by the partnership are allocated to the partners in proportion to their respective interests. Thus, 94% percent of the capital gain triggered by the sale ($940,000) is allocated to charity, which as a tax-exempt entity does not pay any capital gains tax. The remaining 6% of the capital gain ($60,000) is allocated between parents and son. The parents' aggregate income tax liability resulting from the sale is $4,000 ($20,000 x 20%) and the son's income tax liability is $8,000 ($40,000 x 20%). The charity dutifully exercises its put right at the end of five years and sells its 94% percent LP interest back to the partnership. Assuming the value of the partnership property has increased at a rate of 10% per year and no distributions were made to the partners, the partnership property would be worth $1.6 million at the time of such sale. Accordingly, charity receives $1.053 million for its 94% LP interest ($1.6 million - 30% discount x 94%), leaving $547,000 inside the partnership. After charity's interest is redeemed, parents' 2% GP interests will represent one-third of the remaining outstanding partnership interests, and the son's 4% LP interest will represent two-thirds of such interest. I recognize that a 10% return in today's markets without hedging to get there may be an unrealistic assumption, but some assumption has to be made and the 10% figure was achievable three or four years ago, and may one day be so again. We have seen through certain hedging strategies 9% to 10% returns in the most recent markets, so maybe such a return is even possible in the current investment climate.
If the charity invests its $1.053 million proceeds, again at the 10% rate of return, it would have $4.4 million after 15 or more years. Let's assume that the charity simply adds the $1.053 million to its endowment.
After 15 years, the partnership will be liquidated. Assuming the $547,000 of partnership property continues to grow at the same 10% rate, it would be worth approximately $2.3 million after 15 additional years. If the partnership is then liquidated, the son will receive $1.53 million ($2.3 million x two-thirds), and the parents will receive $767,000 ($2.3 million multiplied by one-third). Additionally, the parents' combined estates will be augmented by the income tax savings from their charitable contribution deduction (and the growth thereon), less the income taxes the parents paid on the partnership income and gains allocated to them.
Much more could be said about this concept and although it is challenging to understand, I hope it is obvious that "the game is worth the candle." All "i"s must be dotted and "t"s crossed-meaning that the discount rate used when the property is contributed to the son and charity is reasonable (that is why I picked 30%). Also, the parents cannot take large fees as general partners to manage the partnership, thereby hurting the interests of the limited partners by reducing the value of their assets. If those conditions are met, this is a sound way to diversify one's portfolio of marketable securities or other assets in a way that leads to charitable benefits as well as personal benefits for the family. The CFLP is quite superior to some other techniques because its "guts" are the ability to use hundreds of thousands of dollars of the government's income tax money in a partnership to benefit a charity and family.
The CFLP, perhaps more than any other principle, requires an investment advisor to play a key role in projecting realistic returns, working with appraisers to arrive at realistic valuations and working with the estate planner on realistic estate planning objectives. Through combined talents of the estate planner and investment advisor, much can be achieved by using this device. The technique has not been without its criticism, but that has been based generally on the abusive use of the concept and not the technique as outlined in this article.
Roy M. Adams is a partner in the law firm Sonnenschein Nath & Rosenthal in New York City.