Family and Limited Partnerships

Family Limited Partnerships (FLPs) are partnerships where family members own the general and limited interests. The main purpose of this type of entity is to reduce the value of assets subject to the federal estate or gift tax. A FLP can also serve to pass a family business on to the next generation, spread income to a larger number of participants who may be in lower tax brackets, provide some protection against creditors, and consolidate control of a number of assets into one single entity. Before one can understand these features, it is necessary to know what a limited partnership is and how it works.

Basic Aspects Of Limited Partnerships

There are two main types of partnerships: general and limited. In a general partnership, each member is a general partner with a right to participate in the affairs of the business. Each partner has joint and several liability for all obligations of the entity once creditors deplete the partnership assets. In a limited partnership, there are two types of partners: general and limited. The general partner has sole control of the management of the business and full liability for the entity’s debts once the assets are gone. Limited partners, though, have no right to control the company’s affairs. As long as they obey this restriction, limited partners have no liability for the company’s obligations. Moreover, the limited partners have fewer rights to retrieve their investment than do owners of other businesses. In general and limited partnerships, the entity pays no tax. Instead, the income or losses pass through to the partners in proportion to their percentage of ownership.

How A Family Limited Partnership Works

Upon formation, members of the family contribute some of their assets to the FLP. They choose one or more general partners to run the company. The general partner takes responsibility for liabilities the business cannot pay. The limited partners have no vote in the operations and no liability for debts beyond their capital contributions. Each year, the partners receive a share of the entity’s profits or losses.

Passing On The Torch

A FLP can gradually pass along management and ownership of a family business. The parents who hold the general partnership shares control the company and continue to run the show. Likewise, they retain sole responsibility for its failure. As time goes by, they give limited partnership shares to the children. This divests ownership of the company to the next generation of the family and removes assets from the parents’ estate. This also sprays income to younger persons who may pay income taxes at lower rates. With enough time, and increasing confidence, the parents may give a majority of the ownership… and eventually the leadership… to the children.

Enhancing The Reduction Of The Parents’ Estate

The size of the parents’ estate goes down in two ways. First, gifting the limited partnership shares chips away at the number of assets the parents own. Second, splitting the ownership amongst more persons reduces the value of each unit. Because there is a lack of marketability and decreasing concentration of ownership, the collective value of the individual units is less than the value of the underlying assets. This process is known as “Valuation Discounting.” If the parents give away enough of the limited partnership shares so that they no longer hold a majority interest, then their shares also receive a “Minority Discount.” The IRS recognizes discounts in these cases of anywhere from 20% to 40%.

Consolidation Of Different Types Of Assets

The parents can coordinate the management of many items that have little in common by placing them in the FLP. Many types of assets, such as real estate, life insurance, stocks in publicly traded corporations, closely held shares, bonds, mutual funds, and farms can all fit into the FLP under the right circumstances. Some unique assets, like artwork, do not qualify. The common denominator is there must be a legitimate business purpose for the FLP. Centralizing the control of diverse interests and streamlining operations, as well as providing continuity of management, are valid business reasons for FLPs.

Disadvantages

The asset owners must carefully choose the items that fund the FLP. They must select suitable assets and avoid traps that cause a realization of income upon the company’s formation. Once this is done, all the assets must be retitled in the name of the FLP. Quite frequently the addresses for payments and notices need revision. All of this is time consuming. In addition, the FLP requires books and tax returns separate from its participants. The entity’s profits or losses appear on each member’s K-1, and a person needs their K-1 to prepare their own tax returns. It is commonplace for members of FLPs to ask for extensions of their tax filing deadlines. Not only is the maintenance of a FLP costly, but the fees to establish it are greater than many other types of estate planning. Fees for annual bookkeeping and accounting can exceed $1000, and the initial investment to appraise the items, draft the FLP, make the necessary state and local filings, and retitle the assets is usually more than $3000. There are also legal fees each time the parents make gifts of partnership units.

Advantages

For persons with sizeable assets and trusted family members, the FLP is a valuable tool to reduce federal estate or gift taxes. It carries out other purposes too, such as business continuation planning. However, it is a complicated and expensive device. Before committing to this approach, a person should look at simpler, less expensive alternatives with experienced counsel to make certain the FLP is an appropriate choice for their circumstances.