Family Limited Partnerships:
FLP terms are very flexible, and can be changed or terminated by the general partners, as opposed to irrevocable trusts which require heavy litigation to amend.
In a family business, the company’s financial challenges can also become the family’s financial challenges.When a business owner dies, the family inherits all his/her assets, including the highly valued (hence heavily taxed) company. All too frequently we hear of a family that has sold off the company to pay crippling estate taxes.
Fortunately, financial estate planners have come up with an effective strategy to counter this problem: the Family Limited Partnership (“FLP”).Although this structure has some technical complexities, the concept is very simple.This article illustrates some of the benefits of this strategy so that you can make informed decisions about the future of your business and your family’s financial well-being.
A Family Limited Partnership is a business entity formed through a partnership agreement, which allows for business and other family assets to be distributed to limited partners (i.e. family members) in the form of limited partnership interests.These interests, or “units,”are held and owned by designated family members, while the controlling or general partnership interest is retained by the business owner.The FLP can be structured around many types of holdings. The business itself, as well as assets such as real property, life insurance, stocks, and cash are eligible. The advantages of FLPs, in addition to the reduction of income and estate taxes, are:
- Development of an equitable gifting program
- Transfer of future asset appreciation
- Retention by principals of the control of their assets
- Protection of assets through diversification
A typical scenario might be as follows: two brothers, Tom and Fred, own a successful baseball franchise and are seeking the best way to maximize financial benefits for themselves, as well as their children.They decide that the optimum method to address their current income tax concerns as well as their future estate planning considerations is to form an FLP.
First, Tom and Fred draw up an agreement whereby each brother acquires an equal percentage of the general partnership and limited partnership interests.The contract also specifies a termination date for the partnership, designates the future recipients of limited partnership units, and provides for control to be maintained by Tom and Fred, the general partners. After they create the FLP, Tom and Fred transfer their business holdings into the partnership.
The primary advantage of their FLP is that Tom and Fred can distribute their business interests (not necessarily all at once) to their children in the form of limited partnership stakes.In doing so, they may be able to shift part of their business income to a lower tax bracket (transferred income taxed at the children’s tax bracket). In this way, FLPs can be more tax efficient than irrevocable trusts, in that the latter’s tax rates are linked to the trustee’s tax bracket, and therefore may be higher.
Tom and Fred can also give away their partnership interests.Hence they and their wives can take advantage of the one-timeexclusion as well as the annual gift tax exclusion for each child (the exclusions vary from year to year; check with your accountant).Still more asset value can be transferred if the units have limited marketability; i.e., their full value is discounted when (1) the limited partner is prohibited from selling his or her interest, (2) the limited partner must wait until the partnership agreement terminates to collect on his or her stake, or (3) the limited partner has little or no voting power.Last year, the IRS officially recognized this discounting technique in the case of family business interests transferred between family members.
Tom and Fred find that their FLP actually helps them set up a more equitable gifting program for their children.For example, one of their largest joint holdings is a baseball stadium.They cannot directly transfer the stadium to a single family member while adequately compensating the others.Nor do they wish to leave that member out in the cold if the stadium becomes less profitable in the future.Through the FLP, each limited partner can have an equal share in the stadium, as well as Tom and Fred’s other business assets. Thus, the children enjoy not only fair distributions but also a certain degree of asset protection and share future appreciation through diversification.
Perhaps most importantly, Tomand Fred benefit by reducing their estate and transfer the potential future tax burden on their children, while maintaining asset control.Assuming that estate taxes would consume 50% of the brothers’ total assets, their children may have to sell all or part of the business in order to satisfy their tax bill.With the FLP in place, the children pay a much smaller amount of estate tax because the entire business is no longer tied up in the brothers’ estate.The business is more likely to remain intact, providing financial comfort, and perhaps employment, for many years to come.
Tom and Fred can reduce administrative costs by maintaining one consolidated FLP portfolio which can be cost-effectively managed by a financial counselor. They can also include a buy/sell provision in their agreement to keep all partnership interests family-owned.Finally, the limited partners are protected from creditors, through the control mechanisms that could be implemented by the general partners as well as the lack of marketability of the limited partnership interests, thereby shielding them from liabilities involving Tom, Fred or the FLP’s external business matters.
There are other benefits of FLPs that illustrate their advantages over trusts or corporate forms.For example, FLP terms are very flexible, and can be changed or terminated by the general partners, as opposed to irrevocable trusts which require heavy litigation to amend.A portfolio manager for an FLP can utilize a modern uniform portfolio strategy, while the manager of a trust must cope with the conflicting objectives of income and remainderman beneficiaries.
Now that the many benefits of FLPs have been explained, is there a hitch?Only that they may not be around forever in their present incarnation.Due to the overwhelming attractiveness of the FLP concept, many financial planners have taken advantage of it.Unfortunately, some of these professionals have been somewhat liberal in their discount-seeking techniques, resulting in increased scrutiny by the IRS.
Many professionals such as estate planners, financial managers, trust company administrators, accountants and attorneys can assist the family business owner in establishing his or her own FLP.However, a family business consultant may do the best job of coordinating these professionals and deciding which plan will suit the business owner’s needs.