Background: What Is a Family Limited Partnership?
A family limited partnership (FLP) is an entity created under state law in which the only partners are family members or family trusts. Normally, entities controlled by parents are general partners, and children or grandchildren (or trusts) are limited partners. General partners, with as little as 1% interest, retain a certain level of control over family assets, yet the bulk of taxable value can be transferred to children or other family members. In addition, the non-controlling interest may also be eligible for discounts, which may allow for the limited partnership interest to be transferred at a smaller taxable value.
Family limited partnerships have become very popular in recent years because of certain advantages inherent to such entities, making an FLP a powerful vehicle. Read on to learn more about how an FLP works and if it may be beneficial for you and your loved ones as you consider your estate planning needs.
Asset Protection
- Layers of Protection: Individual family members no longer have legal title or equitable title to assets owned by the FLP. Transfers made for legitimate and estate planning purposes are typically perceived as lawful.
- Creditors Rights: Without consent of all partners and a provision in the certificate of limited partnership, a partner can transfer only their share in profits. Assignees don’t become limited partners and may not exercise any rights as partners.
- Charging Order: Generally, a “charging order” provides the only means by which a creditor of a partner can reach the partnership interest of the debtor-partner. The charging order entitles a creditor to receive a debtor-partner’s share of profits and distributions, but it doesn’t allow the creditor to reach the assets of the partnership nor become a partner. Even with a charging order in effect, the general partner remains in control of the FLP and continues to make decisions regarding management of the FLP’s assets. The creditor receives funds only from distributions and cannot demand such distributions. As a result, a creditor may have to pay income taxes on their share of partnership profits without actually receiving any cash distributions.
Taxation Considerations
- Taxed as a Partnership: An FLP is considered a pass-through entity for income tax purposes and doesn’t pay taxes on income. Instead, each partner reports their share of partnership income or loss. Generally, the partners who contribute property to an FLP recognize no gain or loss.
- No Gain on Appreciated Property: Generally, the FLP doesn’t recognize gain when it distributes appreciated assets to a partner.
- Cash Distributions Not Taxable: Cash distributions to a partner generally don’t create taxable income to the extent distributions don’t exceed basis in the partnership. Conversely, a partner must report their share of partnership net income, whether distributed or retained in the partnership.
Control Considerations
- Tailored Provisions: Partnerships as an entity structure, in general, have a high level of flexibility. Individualized, specially tailored provisions of an FLP agreement can:
- Limit a partner’s right to demand the return of any part of their contribution except upon dissolution or liquidation.
- Give the general partners the ability to retain the profits for reasonable needs.
- Require a high percentage of ownership interest for voting purposes.
- Provide that involuntary transfers (perhaps by a failed marriage) be subject to a buy-sell agreement.
- Restrict voluntary or involuntary assignment of a limited partner’s interest. Such provisions can help ensure that management and control of the FLP remains with the general partners and deters override of the partnership agreement or general partner decisions.
Valuation Discounts
- Determining Value: Recent tax court decisions support “lack of marketability” and “minority interest” discounts in determining the value of a partnership interest and suggest discounts of 30% to 35%.
- Lack of Marketability: Discounting exists because few buyers will pay full price for a non-controlling interest in an entity with many limitations and restrictions.
- Minority Discounting: Minority discounting arises when a minority owner cannot force a liquidation or dissolution and lacks control over business items.
- No Aggregation Necessary: The IRS agreed not to aggregate a family member’s interests when determining if a certain interest supports a minority or lack of marketability discount.
Gifting of Partnership Interests
- Reduction of Estate Taxes: The FLP allows the parents to reduce their taxable estate through a planned gifting program, by divesting themselves of limited partnership interests.
- Facilitates Gifting: The FLP makes it easier to gift indivisible family assets, such as real estate. The FLP also allows for gifting a combination of family assets in one gift.
- Retention of Control: The donor, acting as general partner, retains “effective control” over partnership assets.
- Tax-Free Growth: The FLP allows for appreciation of partnership assets to occur free of gift taxes. The value of the interests in the FLP does reflect such appreciation.
- Giving More for Less: Due to the discounting of the limited partnership interests, the FLP allows the donor to transfer assets of higher value at a lower gift tax cost.
Careful Planning
- Compliance & Implementation: Because general partners may retain a certain level of control, it’s important that family members work closely with their tax advisors and attorneys to help mitigate the risk of adverse tax consequences.
- Non-Tax Goals Matter, Too: While the numerable tax benefits that exist with this structure make it attractive to many, consider that the non-tax benefits such as asset protection, ease of administration of family assets, consolidation of family assets, and many others may be considered and well-documented, as the partnership is truly a family enterprise.
Consider Preparing Now
With estate and gift tax exemption sunsetting after 2025, consider staying a step ahead and start planning now. If you have any questions or need assistance, please reach out to a professional on our Forvis Mazars Private Client team.