Is a Family Limited Partnership Right for You and Your Family?
A Family Limited Partnership (“FLP”) is an entity known as a limited partnership created as an asset ownership vehicle between family members. FLPs can be formed with business or investment assets. An FLP has two types of partners who together, own all of the partnership interests. The two partners are general partners and limited partners. The general partners have all control over the operations of the FLP. The limited partners have limited or no control and are not at risk for the operations of the entity.
Typically, parents establish the FLP and transfer capital assets into the partnership. Within the partnership structure, the parents often create a limited liability company to serve as the general partner, while the children (or grandchildren) serve as the limited partners. The general partners often own only a small portion (i.e. 1%) of the partnership, while the limited partners own a majority interest. The general partners have complete responsibility and control over the partnership activities, and liability for the partnership debts and losses. The limited partners have no control or management rights. Their liability is limited to their ownership interest in the FLP.
The primary reasons for establishing an FLP:
1. Income Tax Benefits
The traditional purpose of an FLP has been to divide investment income among children in lower tax brackets, increasing the family’s net spendable income. Income generated by an FLP is often allocated according to the ownership of the FLP. Frequently, children as limited partners own a majority interest. Most of the partnership income will be taxed to them at the children’s lower marginal tax rates. The income tax laws have changed over the years to require income earned by minors and dependents taxed to the parents. Consult your tax advisor to see if this reason justifies the expense of creating and maintaining a FLP.
2. Estate Planning Benefits
FLPs have also been used for long-range estate planning. Closely held businesses, with other assets, are subject to federal estate and generation-skipping transfer taxes. When they apply, these taxes can prevent the transfer of a family business from one generation to the next.
The FLP provides a valuable estate planning tool to lessen these tax burdens. By contributing assets to the FLP, the parents are transferring asset value out of their taxable estates and shifting asset growth from themselves to younger generations. The FLP interests retained by the parents remain part of their taxable estates, but are valued in a far more favorable manner than had the parents continued to own the assets outside of the FLP. The parents can maintain control of the assets in the FLP even though only a small percentage of their taxable estate.
3. Possible Protection of Assets from Lawsuits
FLPs may also provide the partners with asset protection. Most state’s limited partnership statutes prevent creditors of a limited partnership from attaching partnership assets. The most creditors can receive is a charging order, which in effect makes them an assignee. Appropriately drafted partnership agreements prohibit transfer of partnership interests to creditors and others. They cannot become partners, cannot vote, and cannot participate in partnership decisions. They can, however, receive partnership distributions, should the general partners make any. Creditors cannot force a distribution. The IRS may still attribute a share of the partnership income to creditors whether they receive a distribution or not, further enhancing the desirability of an FLP for asset protection purposes.
Some people have abused these provisions over the years, believing they can defraud creditors and victims by transferring interests to limited partnerships before committing fraud and other intentional conduct that injured third parties. These abusive circumstances caused courts and state legislators to change their laws related to protection of assets in a limited partnership from creditor claims. You must obtain advice and properly drafted agreements from an attorney experienced and knowledgeable about limited partnerships if you add this vehicle to your portfolio.
Often partners may transfer their FLP interests at a discounted value. But use caution if you intend to use a valuation discount for lack of control, marketability or other reason. The Internal Revenue Service will not recognize valuation discounts if they are attributable to restrictions more stringent than those found in the state law. Therefore, a qualified appraiser must accurately value the interests.
4. Teaching Family Members to Manage Assets
An FLP can also prove to be a useful tool for teaching children or grandchildren to manage the family business or other partnership assets. The partnership interests can then be transferred to those who take an active interest in the partnership.
5. Flexibility in Planning
One of the most attractive features of the FLP is its flexibility. Some estate planning strategies must be “irrevocable” to be effective. Once they are set up, these irrevocable trusts cannot be changed or undone, except for some technical reasons. The FLP document can be modified to respond to changes in the family or business structure.
FLPs are not for everyone, but when designed properly, can be a very effective estate planning tool. The documentation for a partnership must be carefully designed to avoid problems with both federal law and the laws of the state under which the limited partnership is being created. Contact a qualified estate planning attorney familiar with the creation of FLPs to see if an FLP is right for you.