Piggy Bank

Family Limited Partnerships: What You Need To Know

Piggy Bank

Wealth transfer strategies are an extremely important topic when it comes to financial planning. Establishing the proper legal conduits to ensure the maximum amount assets transferred to beneficiaries according to a client’s best wishes is essential. The risk to clients is having wealth lost in the process to legal fees (probate) or taxes, which can be substantial.

One of the more advanced estate planning topics are family limited partnerships (FLPs). An FLP is a limited liability business entity composed of 2 or more family members. It is an excellent estate-planning tool for those who have successful business enterprises that they would like to keep within the family. One of the family members, usually a senior, acts as the general partner while the remaining family members, usually juniors, act as the limited partners. Once the FLP is formed, the family transfers property to the partnership in return for ownership interest in the capital and profits of the FLP. Here is an example:

Josh Herwin owns a successful chain of sandwich shops in the Midwest. He has three children: Josh Jr., Sam, and Courtney who are all involved in the business. Josh would like to someday allow his children to take over the family business and is looking for ways to minimize his potential tax and liability exposure. He contacts his family attorney to draw up the agreement. Upon formation, Josh transfers the ownership interest of his family business to the FLP, designating himself as the general partner and his 3 children as the limited partners. Josh retains 1% interest in the FLP while the children each receive 33% interest. He reports and pays the gift taxes involved in the transfer, less the annual gift tax exclusion.

Josh runs the business for 15 more years before retiring. Each year he files annual reports with the state and distributes the FLP income each year- 1% to himself and 33% to each of his children. Collectively, the family saves in income taxes since each of the children are in a lower income tax bracket than Josh. When Josh Sr. retirees, everyone votes Josh Jr. as the new managing partner of the family business and general partner of the FLP and Josh Sr. becomes a limited partner. 10 years later, Josh Sr. passes away. The value of business has increased dramatically over the 25 years, but only 1% of that value is included in Josh Sr. estate for estate tax purposes.

To understand the full benefit of having the FLP in place, imagine the alternative. If Josh Sr. was the only owner of the family business, 100% of the value of the business would be included in the estate when determining estate taxes at the time of his death. Not only would there be a tremendous amount of wealth lost, it could potentially leave a huge tax bill for beneficiaries who might not have enough cash on hand to pay the bill.

The benefits of establishing a FLP include:

  • Retain ownership interest in the business
  • Help avoid transfer taxes
    • Removes future appreciation of business assets
    • Takes advantage of annual gift tax exclusion (currently $14,000 per donee)
    • May be entitled to valuation discounts for limited partners (as much as 35%)
      • Inability to transfer interest
      • Inability to withdraw from FLP
      • Inability to participate in management
      • Keeps business within the family
      • Provides for children who may not be engaged in the business
      • Protects assets
        • General partner provides liability protection
        • Puts assets beyond the reach of creditors
        • Flexibility
          • FLPs can be amended by vote based on the agreement.
          • Avoids Probate
          • Maintains Privacy
          • Ensures Continuity of Business Operations

The main tradeoffs involved in FLPs include:

  • Expensive
    • This can include attorney’s fees, title fees, appraiser’s fees, state and local filing fees, tax accountant fees
    • Complex
      • It is vital that you work with an experienced estate planning attorney to make sure the FLP is set up properly and fully reflects the wishes of the family

In order to have a qualified Family Limited Partnership (FLP), the following conditions must be met:

  • Distributions from FLP must be to family members only
  • Reasonable compensation must be paid to each partner
  • FLP income distributed to a partner cannot be proportionally greater than the capital contributed by each partner
  • Partners must receive partnership interest through a bona fide transaction (i.e. gift or sale)
  • FLP must own income-producing capital (inventories, plants, machinery, and equipment)
  • All formalities must be observed

For those who already have a Family Limited Partnership setup, here are a few tips to keep the FLP in good order:

  • Have one or more substantial nontax purposes for creating the FLP, such as asset protection
  • Keep good records
  • Create the FLP while you're still in good health
  • Observe all legal formalities when creating the FLP and while operating the business
  • Hire an independent appraiser to value assets going into the FLP
  • Transfer legal title of assets going into the FLP
  • Put only business assets into the FLP--don't put any personal assets into the FLP
  • If you do put personal assets into the FLP, such as your home, pay fair market rent for their use
  • Don't commingle FLP assets and personal assets--keep them separate
  • Never use FLP assets for personal purposes
  • Keep enough assets outside the FLP to pay for personal expenses
  • Distribute income to partners pro rata 

If you are interested in learning how a Family Limited Partnership (FLP) may be an effective estate-planning tool in their overall financial plan, please contact your personal attorney. Your IFA Wealth Advisor will assist in anyway that we can.