As a new investor, you already know it isn’t only about how much money you make, it’s about how much you keep in your pocket. In addition to watching out for frictional expenses such as brokerage commissions, it is important to learn how to lower taxes. Most new investors think only about capital gains taxes but for those approaching retirement, gift taxes and estate taxes are equally important considerations.

By pooling your investments in a special type of legal structure known as a family limited partnership, which I explained in detail in Family Limited Partnerships 101 – An Introduction to Family Limited Partnerships, you can transfer your assets such as stocks, bonds, real estate, art, collectibles, and more to heirs such as children and grandchildren by gifting partnership equity each year up to the gift tax limits. If you are married, you can give away even more each year because the gift tax exclusion levels effectively double! It is a great way to help you keep the investments you build up through decades of hard work in the family rather than having the government take them.

For example, imagine that you and your spouse have amassed $5,000,000 by saving and investing over a lifetime. (This only requires $358 a month at a 10% return for 50 years.) You have four children and sixteen grandchildren. As of 2010, the gift tax limit per recipient is $13,000. That means between you and your spouse, you can transfer up to $26,000 to each of your children and grandchildren without paying a penny in gift taxes.

You pool all of your assets into a family limited partnership and name yourself and spouse as the general partner, giving you control of the day-to-day management. Your stocks, bonds, real estate, art, collectibles; all of it gets contributed to the family limited partnership.

On January 1st of each year, you transfer $26,000 worth of the family limited partnership interests to your twenty beneficiaries (four children and sixteen grandchildren). You can even insert provisions in the partnership agreement to help ensure that your gift isn’t squandered; e.g., making it so that they cannot sell their shares or transfer them to anyone else (such as a spouse if they get married) until they reach their 35th birthday.

This means that each year, you can give away $520,000 worth of assets without paying a penny in gift taxes ($26,000 transferred to 20 different family members = $520,000)! Even better, going forward, your children and grandchildren now own equity in the family limited partnership so they will receive all of the dividends, interest, capital gains, and other profits from their ownership stake.

Over Time, The Tax Benefits of a Family Limited Partnership Can Be Huge

If the family limited partnership increases in value by 10% after taxes each year due to rental income, property appreciation, stock gains, cash dividends, bond interest, or other factors, at the end of the first year, you would still have almost exactly $5,000,000 in assets in your general partner account despite having transferred the $520,000 to your heirs. This is a huge advantage because, over time, you can avoid paying inheritance or gift taxes and yet enrich your family. In only ten years, with a comparable after-tax rate of return (10%), your share of the partnership may be exactly the same but your children and grandchildren would have $5,000,000 or more in family limited partnership shares!
Furthermore, not only will your family members receive the $520,000 you transfer to them each year, they will be earning a collective $500,000 on their $5,000,000 ownership stake (10% of their $5,000,000 would result in $500,000 each year). Over several decades, it would be possible to transfer massive sums of money and future earning power to your heirs completely intact, all while maintaining enough assets to permit you to live comfortably and maintain control of the family’s holdings. You could even encourage the younger generation to save and invest by using their paychecks to buy additional shares of the limited partnership.

Compared to compounding your money and leaving it in your will upon death, the result of a well-structured family limited partnership is millions upon millions of more dollars in the hands of your family and friends. When used with other investment tax strategies such as charitable remainder trusts, it can be a great tool in your wealth-building arsenal.

More Information About Limited Partnerships

For more information, read the New Investor's Guide to Limited Partnerships.