A Family Limited Partnership (FLP) is an ideal vehicle in which to hold ownership interests in family business(es) and assets. The primary reason to establish a FLP is for non-tax purposes, so that it passes the IRS tests; once that is done, then the tax benefits of an FLP can be outstanding.
Here are only several of the reasons to form a FLP for its non-tax advantages.
(1) The FLP can be the vehicle that ties together the family’s overall estate plan;
(2) Fragmented interests held by family members or their respective trusts can be consolidated into a FLP that allows centralized control, enables investment at more optimum rates of return, and reduces bookkeeping and operational costs;
(3) These interests can be placed in one entity for ease of administration and to minimize probate costs;
(4) Creditor protection is enhanced with the establishment of a FLP;
(5) A FLP is more flexible than a corporation;
(6) A FLP can be amended or revoked, unlike irrevocable trusts; and,
(7) A FLP provides more flexibility in making investments than a trust; because the FLP is subject to the business judgment rule whereas a trust is subject to the more restrictive prudent man rule in evaluating investment risks.
A FLP is composed of the General Partner(s) [who own an interest in, exclusively control and make all management decisions of the partnership] and Limited Partner(s) [who own an interest in the partnership, but do not participate in the management or operation of the partnership]. The general partner is liable for all partnership debts, judgments, etc. The limited partner’s liability for partnership debts is limited to the extent of their interest; the interest gifted to them and/or the money they have invested in the partnership.
A FLP agreement is executed, typically by the parent(s) as both general partners and as limited partners. Assets (usually family businesses or other property) are assigned and deeded over to the partnership by the parent(s). The parent(s) then assign their partnership interests to the family living trust and the trust can thereafter assign [ie, gift] portions of the partnership interests to children or other heirs, if desired.
There are several reasons why a FLP is a superior entity for estate planning purposes and to hold family assets . The two major ones are:
Asset Protection
(1) A major reason for parent(s) to transfer assets to a family limited partnership would be to provide asset protection, while maintaining control over those assets as the general partner. Our society is very litigious and people are not hesitant to sue, especially if they think there is any money to be won. Limited partners are not liable for the obligations of the limited partnership; beyond their ownership interests in the partnership.
Judgment creditors of limited partners [insofar as it pertains to assets held by the partnership] are entitled only to a charging order on the distributions from the partnership to any judgement debtor limited partner. This means that a judgment creditor of a limited partner, “may charge the partnership interest of the partner with payment of the unsatisfied judgment …” and this is the judgment creditor’s only remedy. However, the partnership agreement will be drafted so that the general partner can decide to withhold distributions to all partners and retain the profits for partnership purposes. The judgment creditor can not force distributions of income or principal from the partnership to the judgment debtor limited partner. The partnership agreement provides that the assignee or creditor of any limited partner has no rights in the partnership.
Further, a judgment creditor who obtains a charging order against a limited partner’s income interest in the partnership becomes liable for the income tax on the distribution that would have otherwise been originally paid to the judgment debtor limited partner, but for the general partner deciding not to make a distribution. Revenue Ruling 77-137, 1977-1, CB 178. Limited partners receive an annual K-1 IRS form, indicating their portion of income or loss from a partnership that is taxable to the partner, whether or not the partner actually receives the income from the partnership. This would mean a judgment creditor would instead receive the K-1 (because they have a charging order from a court ordering the partnership to distribute the judgment debtor limited partner’s interest to the judgment creditor) and become liable to pay taxes on income never received, because of the charging order.
Authors in the field cite this as the “KO’d by K-1” principal; that will probably result in a swift settlement on favorable terms once the creditor realizes the situation. This is a powerful asset protection tool!
Valuation Discounts of Assets Held by Partnership
(2) A FLP (or a family living trust that owns limited partnership interests or units) can easily transfer and gift portions of the FLP to children/heirs at a significant reduction from fair market value (referred to as valuation discounts).
One could embark on a gifting program of transferring limited partnership interests to one’s children or other heirs at less than fair market value, due to the valuation discounts available to interests in a family limited partnership as a result of: (1) minority interests discount; and (2) limited partnership interest with lack of control discount; (3) Lack of marketability discount; Northern Trust Co. Transferee vs Comm’r, 87 T.C. 349 (1986); Estate of Andrews v Comm’r, 79 T.C. 938 (1982). Estate of Harrison vs Comm’r, 52 T.C. 1306. Discounts of generally 25% to 50% have been allowed, some even higher. Rev. Rul. 93-12. [Note, more conservative appraisers today are limiting the upper range of valuation discounts to approximately 40% to lessen the validity of any IRS challenge to the amount of discount calculated.]
The use of an FLP can depress the value of family assets for transfer taxes, because of the discounts available. This depressed value can be used to minimize estate and gift tax liability, yet at the same time the true market value of the assets held by the FLP are unaffected. The IRS’s own manuals indicate that lack of marketability discounts are valid as well as minority interest discounts when valuing FLP’s. These are two separate discounts and both can be utilized at the same time.
Assets that have a percentage depletion allowance attached to them are not allowed the discount reduction in value for such assets.
Normally, the General Partner [i.e. the parent(s)] would own 1-2% of the assets of the FLP and the parent(s) would own the remaining 99-98% interest (sometimes called units) as Limited Partners. The parent(s) then assign their general and limited partnership interests to the living trust, just as they did other assets so as to avoid probate on the limited partnership interests. [Note: the Partnership itself would still own the partnership assets; it is the limited partner’s ownership interest in the Partnership that is transferred to the Living Trust].
The Parent(s) individually can act as General Partner(s). A general partner has unlimited liability for all partnership debts, judgments, etc. Because of this fact, some estates are better served to have a corporation or a separate management trust be the general partner; in order to limit individual liability of the parent(s). The parent can be the president of the corporation or the trustee of the management trust and control the partnership. This is not normally an issue unless there is an ongoing family business that can generate liability. In any event, it is a great idea to carry at least 100/300K auto liability policies with an umbrella policy over that to really protect one’s assets from excess judgments; as a car wreck is the most common form of serious liability a person generally faces.
Gifts out of the living trust can be made of the FLP interests (or units) to heirs or children at a significant reduction from market value as shown above. This makes it quite convenient to gift parts of a business, property or other asset owned by the partnership; as it is percentage interests in the partnership that is being gifted. Of course, only those items assigned over or deeded to the partnership in the first place are subject to the partnership agreement.
If a regular gifting program of $10,000 per year is utilized [so as to avoid any gift tax] when the partnership interests are being gifted, at say 30% to 40% reduction in value; one can see that you are really gifting $13,000 to $14,000 in value per year-free of gift tax. Even if a gift tax is paid, it is immediately apparent that you can save a significant percentage of the tax that may be due, because of a sizable reduction in value of the interests being gifted. One can then understand why holding family assets in the form of a FLP and then gifting to heirs can be very worthwhile.
Moreover, these valuation discounts are available to the estate of the deceased parent(s) who are general/limited partner(s). In other words, the discounts can be utilized in gifting to children as well as at the death of a parent in valuing the estate.
The idea thereafter is to gift discounted interests of the FLP to the heirs in the maximum amount each year to further reduce the taxable estate.