The Family Limited Partnership: The What, The Why, and The How
By Scott A. Bishop, MBA, CPA/PFS, CFP® and Stephen Kirby, JD
WHAT IS A FAMILY LIMITED PARTNERSHIP?
A Family Limited Partnership (FLP) is created and governed by state law and is generally governed by state law and generally is comprises two or more family member partners. FLPs provide an excellent vehicle to centralize the management of assets, protect against creditors, reduce administration expenses of investment and expose younger family members to the investment and management of assets.
Top Ten Reasons to Use a Family Limited Partnership
10) Limitation of Payroll Taxes.
9) Accumulation of Wealth.
8) Family Training in Management and Growth of Assets.
7) State Taxes/Income Tax Flexibility.
6) Valuation Discount.
5) Consolidation of Assets.
4) Asset Protection-Inside & Outside of FLP.
3) Separate Property Maintenance/Pre-Martial Planning.
2) Continuity of Management.
1) Control, Control, Control.
WHAT ARE THE MECHANICS OF AN FLP?
An FLP has a general partner (GP), typically a parent, who controls the management of the partnership and is liable for all partnership debts. Although the GP ownership can be owned by the parent directly or in a trust, many have it owned in a corporation or limited liability company (LLC) that is owned by the parent to shield the underlying owners from unlimited liability. The limited partners (LPs) are typically children or trusts for children that have no control over management of the partnership assets, receive their pro-rata share of partnership income and are liable only to the extent of their investment in the partnership.
WHY USE AN FLP?
An FLP can be a powerful estate planning tool that may (1) help reduce income and transfer taxes, (2) allow you to transfer an ownership interest to other family members while letting you keep control of the business, (3) help ensure continued family ownership of the business, and (4) provide liability protection for the limited partner(s).
An FLP is often formed by a member(s) of the senior generation who transfers existing business and income-producing assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner(s) need not own a majority of the partnership interests. In fact, the general partner(s) can own only 1 or 2 percent of the partnership, with the remaining interests owned by the limited partner(s).
There are several advantages to organizing your business as an FLP:
- Limited partnership interests that are gifted to other family members are generally valued at less than the full fair market value of the underlying assets. That is, reasonable discounts to the value of the limited partnership interests are permitted for lack of marketability and lack of control. This means that by gifting the assets via a limited partnership interest instead of an outright transfer of the business assets themselves, you may be saving gift and estate taxes.
- At death, only the value of your ownership interest in the partnership will be included in your gross estate.
- The use of the partnership entity allows you to shift some of the business income and future appreciation of the business assets to other members of your family.
- You maintain management control of the business while transferring limited ownership of the business to family members.
VALUATION DISCOUNTS (LACK OF CONTROL AND LACK OF MARKETABILITY)
Because the limited partnership interest carries no ability to control, the value of the interest is not equal to the value of the underlying assets. The theory is that if someone offered you a $10,000 piece of property, but you had no control over its use, you would not pay $10,000 for it. This is referred to as a minority interest discount. Likewise, the ownership and transfer of partnership interests may have restrictions attached. This is referred to as marketability discount and also may cause the value of the partnership interest to be less than the underlying value. Valuation discounts are very useful for wealthy taxpayers because they provide gift tax leverage; that is, more assets may be gifted under the annual exclusion or exemption equivalent than otherwise would be possible.
HOW ARE FAMILY LIMITED PARTNERSHIPS USED?
The FLP is an excellent tool used by estate planners for the purpose of asset protection. It can be used to lower or eliminate estate taxes, to reduce income taxes, and to provide a smooth succession of the business. A family limited partnership is not a legally recognized entity; rather, it is a type of limited partnership restricted to family members. A limited partnership is a legal entity recognized in one form or another in every state. The limited partnership consists of two classes of partners: the general partner and the limited partner. General partners have the same rights, duties and obligations as general partners in a general partnership. They manage and control the family limited partnership and make all the decisions for the partnership. Consequently, they are exposed to all of the operational risks of the business and are responsible for any liability created by the partnership. The limited partners have no right to control or manage the business. They have no right to vote or a right to income; therefore, they are normally not responsible for any liability created by the business. Limited partners are investors who normally stand to lose only what they have invested in the business.
Parent forms an FLP and transfers assets to it. Parent’s wholly owned limited liability company is the general partner and Parent is the sole limited partner. The following year Parent decides to give annual exclusion gifts of limited partnership interests to his children. The FLP is appraised and the appraiser informs Parent that the value of a limited partnership interest should be discounted by 35% due to lack of control and marketability. Accordingly, Parent may gift limited partnership worth $66,000 to his children that, due to the family context, may be worth $88,000 to them.
WHY USE A FAMILY LIMITED PARTNERSHIP?
- CONTROL RETAINED BY THE GENERAL PARTNERS
One of the most common purposes of the family limited partnership is to allow older family members, the general partners, to retain control of the business and its assets while the younger family members, the limited partners, learn the business so that they can eventually run it themselves. Parents always have the option to give away their estate while they are still alive; however, by doing so, they lose control of the assets and managing the business and they will not be able to protect the business or assets from unintended beneficiaries. The family limited partnership, through the creation of an effective partnership agreement, can state how the business is to be distributed to partners for purposes of a smooth transition. A partnership agreement can give all children a share of the business through their limited partnership interest, but the one child can receive a salary for her work and assume the role of a general partner upon the death or retirement of one or both parent. Additionally, the family limited partnership allows the family’s assets to be consolidated and centralized. Any changes that are needed concerning family control can simply be done by changing the general partners.
- ASSET PROTECTION
Another common purpose of the family limited partnership is to protect family assets. Assets owned by the limited partnership belong only to the limited partnership. Therefore, any personal liability created by individual decisions or actions of a partner will not affect the partnership’s assets. The partnership agreement can provide additional protection by defining what partners can and cannot do. The law also provides some protection for the partnership that is not at fault and for the partners that have done nothing wrong. This asset protection stops creditors from seizing the partnership, interfering with management of the partnership, demanding a partnership distribution of income or assets, or terminating the partnership. However, any liability created by the partnership will expose the partnership’s assets to creditors.
- REDUCING INCOME TAXES
Unlike a corporation, a partnership is not a tax-paying entity. The method of taxation that applies to a partnership is usually referred to as pass through taxation. The partnership must file an annual information tax return which states its income and expenses, but it does not have to pay tax on its income. The income or loss of the partnership is allocated to the partners per the partnership agreement. Each partner is required to include in their personal income tax return the amount of each allocated item. The partnership sends each partner a statement as to the amount of income, deduction or loss allocated to him or her for the year. The family limited partnership can provide tax savings to the partners by spreading income from the parents, who are probably in a higher income tax bracket, to the children, who are probably in a lower income tax bracket. Additionally, the partnership agreement can be written to state that all proceeds to the children will not be actually distributed; portions may be used to pay their income tax and some or all of the rest may be put aside for savings. Using our scenario, if the hardware store is making money, the parents do not have to pay taxes on all the income. They can pay out income to their children through their distributive shares and the children will pay their taxes, which should be at a lower tax rate than their parents.
- REDUCTION/ELIMINATION OF ESTATE TAXES
The federal estate tax can be reduced through various estate planning methods. The family limited partnership can drastically reduce or even eliminate estate taxes, especially for businesses where the estate assets are investment real estate used for family business purposes. Under a family limited partnership, the general partners can make a gift of the limited partnership interest to their children. This would allow parents to shift their assets out of their estate, but yet still have control. The IRS has provided an additional advantage for using a family limited partnership. The law allows transferred interests in limited partnerships to be discounted to reflect their true value in the market. These discounts can range from twenty percent to fifty percent. Why can limited partnerships be discounted? There are several reasons. First, even though limited partnerships are similar to stock in a corporation, they are not as valuable as stock because they are not traded and do not have any immediate value. They also cannot be easily sold. Second, the limited partner has no right to participate in management and therefore cannot control decisions that affect business income and profitability.
Therefore, the value of the limited partnership interest transferred is lower, the size of the parent’s estates and the amount of estate tax liability is reduced. For example, if the client own a 50% limited partnership interest in a limited partnership worth $1 million, then at a 20% discount, it would actually be worth $400,000 instead $500,000. If their tax bracket is 55%, then their tax payout would be $220,000. The Client’s tax savings would be $55,000.
HOW DO YOU TAKE DISTRIBUTIONS FROM A FAMILY LIMITED PARTNERSHIP?
Both general and limited partners share in the profits of the Limited Partnership. The distribution of profits from the business is called a “distributive share”. In addition, general partners may receive compensation for their role as managers of the partnership. Income is distributed to the partners according to the amount of interests they own. The more interests you hold as a partner in the FLP, the greater your proportion of the FLP income. The extent to which such distributions can be made is stated in the partnership Agreement.
DISTRIBUTIONS FROM A FAMILY PARTNERSHIP
Distributions are made from profits of the FLP. Distributions from an FLP may be made after the Managing Partner establishes a prudent amount of cash reserves for the FLP. According to the I.R.S., this means enough cash to pay its expenses and liabilities, as well as enough for current operating capital, a reserve for future operating capital, enough for current investment opportunities, and for future investment opportunities. Once the amount of reserve is quantified, the managing partner may distribute cash to the managing partner and general partner, in proportion to their ownership interests. Furthermore, the managing partner may make additional distributions to the partners, but these additional distributions are treated as loans by the I.R.S. and if they are not paid back within 30 days from notice given at the end of the tax year, the Partner’s capital account must be decreased to offset the unpaid loan. (This should be outlined in the FLP document).
So, once the managing partner decides how much the FLP needs for the purposes listed above, they may distribute excess cash (profits) to herself and the management trust, in proportion to their ownership respective interests (pro-rata distributions). They may also make additional distributions, beyond profit, but these must be counted up at the end of the tax year and notice given to repay them within 30 days of that notice.
General Partner Management Fee
It is important that the general partner receive reasonable compensation for the services performed on behalf of the partnership. Section 704(e) of the Internal Revenue Code requires that partners providing services on behalf of the partnership be properly compensated for such services in order to avoid a shifting of income and benefit to the other partners. Additionally, compensating the general partner adequately for his/her services is consistent with the operation of a partnership among non-family members. The practitioner must be careful that the management fees paid to the general partner are reasonable based on third-party standards. Otherwise the partnership could lack the business attributes applicable to a business partnership, and the IRS may argue that a gift has been made to the children (if no or little management fee is charged) or that a partial gift has been made by the children (if a larger than reasonable management fee is charged to the partnership).
CAUTION – POSSIBLE REGULARTORY, LEGAL OR LEGISTLATIVE CHANGES
Ever since IRS ruled that minority and marketability interests might be appropriate in the family context FLPs have been touted as vehicles to transfer wealth to younger generations at substantially reduced federal gift and estate tax costs. Over the last decade, IRS presented largely unsuccessful challenges, based on sham, step transaction theories, the disregard of the entity itself or the restrictions in the agreement, to disallow the discounts taxpayers were taking on gift and estate tax returns. Beginning in the late 1990s, however, IRS has succeeded in including underlying assets in the taxpayer’s estate under Section 2036(a) of the Code based on an implied retention of the right to enjoy the income. How the IRS prevails on this issue may depend on what circuit court is considering it. The bottom line is that FLPs are intensely factual cases. FLPs that hold assets for a real business purpose and with respect to which the formalities (formation and administration) are followed have a much better chance at success. FLPs are complex financial tools that when designed too aggressively may attract the attention of the IRS. Clients considering a FLP must do so with extreme caution and with the consult of qualified legal counsel.
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