Form a Family Limited Partnership
The University of Connecticut
by B. Patrick O’Donnell Jr., J.D., L.L.M., C.L.U.
For owners of family businesses, the issue of succession invariably becomes a terrible dilemma: How to transfer assets to the next generation while simultaneously maintaining controlover major decisions and avoiding crippling estate tax liabilities.
Growing numbers of owners are discovering a suitable answer in an estate and financialplanning technique known as a Family Limited Partnership (FLP). In an FLP, control lies withthe general partners, who can have a tiny equity ownership (as little as 1%, although 5% is morethe norm) while still retaining control and deciding how much partnership income goes to thelimited partners. The general partners are the decision makers and the limited partners hold mostof the equity.
Loss of control, of course, is the main failing of many estate plans and successionstrategies, in the view of business owners. So, it is easy to understand why FLPs are a hotcommodity. But family business owners must carefully monitor the issue of control if they areto achieve the intended goals of an FLP.
For all their positive attributes, FLPs can be complicated. And they are not necessarilythe answer for every business owner confronting succession and estate plan problems. But in theright circumstances, they are an extremely valuable tool.
In general, the bigger the company, the better the chances that an FLP is a good fit.Companies with a lot of assets are the best candidates for FLPs. Also, owners who havepersonal assets that they can be certain will produce a substantial income each year would dowell to consider an FLP. Business real estate is the classic, and marketable investment portfoliosare also strong candidates.
Remember, we are talking about assets of the business being placed inside the familylimited partnership–not necessarily the business itself. And when assets are transferred from thebusiness to the FLP, these transactions have their own income tax consequences which must beconsidered.
The advantages of a Family Limited Partnership
An FLP is much like any other kind of partnership. It is formed by an agreement thatsets out which assets are to be put into the partnership, with the assets divided among generalpartners and limited partners. It is essential that the partnership be based on an accuratevaluation of the assets involved, and it behooves the founding partners to commission anaccurate and fair valuation.
An FLP allows a family to consolidate the management of all of its assets in one placeto help the family organize its collective business and investment goals. By so doing, it providesa number of advantages:
- Involves younger family members By naming younger family members as limited partners, the partnership can serve toinvolve them more fully in the financial affairs of the family. It also gives these younger familymembers a greater financial stake in the success of the partnership itself.
- Avoids death by estate taxes Through an FLP, the older generation shifts income and assets to the younger generation in a way that creates enormous estate tax savings. Instead of having the entire value of the assetsresting in the estate of the older generation at the time of an owner’s death, an FLP allows the younger generation to hold a lion’s share of the equity of these assets.
Estate tax levels are at 55% and are due nine months from the time of death. The needto pay this tax often causes the surviving generation either to sell the business or other estateassets to pay the taxes, or it saddles the business and heirs with crushing debt. The FLP hasenormous potential to create estate tax savings and avoid this scenario.
- Creates other tax savings A partnership is what is known as a “pass through” entity. While the partnership isnontaxable, all items of income, loss, or gain must be taken into account individually by eachpartner. The partnership must divide profits and losses strictly according to the percentage ofthe interest in the partnership.
Because of their greater responsibilities, the general partners must be compensated priorto the determination of profit or loss. Any profit or loss after these disbursements is then divided among all partners. If the limited partners have 95% of the stock, they get 95% of the net profitsor share 95% of the net loss.
A profitable partnership can thus shift income tax burden to the limited partners, who areoften the owner’s children and will presumably be in a much lower income bracket than theirparents. In addition, as the value of the partnership increases, the owners are effectively shiftingthe growth of the partnership assets to the next generation while the owners are still alive. Sincethe current difference between the highest estate tax rate (55%) and the highest income tax rate(39.6%) is more than 15%, there are significant tax savings to be gained.
- Operates under fewer restrictions than S Corporations Family business ventures often are established as S Corporations to avoid the doubletaxation on dividends. Many of the restrictions placed on S Corps–limits on the number ofshareholders, the status of owners, etc.–do not apply to FLPs. A family business can either bean S Corp or an FLP; it can’t be both.
- Achieves greater flexibility than trusts One common planning technique to ease the crushing burden of estate taxes is for afamily business owner to establish an irrevocable trust. Assets placed into such a trust will notgenerally be included in the owners’ estate at the time of death for tax purposes. Furthermore,the trust’s terms for disposition of its assets can help owners implement their wishes forsuccession planning.
A problem with these irrevocable trusts is the fact that they are, indeed, irrevocable.Unforeseen changes in family and/or business fortunes may not be adequately addressed by the somewhat inflexible language contained in most trust documents. Since trusts are creatures ofstate law, they normally require a judge’s approval for modification. This can translate intoadded legal costs.
FLPs, by comparison, are flexible. They can be more readily amended should either thefamily or business situation radically change.
- Facilitates an orderly transition to the next generation Because the partnership interests in an FLP can be divided into units of relatively modestvalue, they can be transferred more easily in annual exclusion gifts. Also, these gifts will havemore clearly defined values than undivided interests in real estate or other difficult-to-divideassets.
Be sure to satisfy the IRS
As noted earlier, the big trap to avoid with FLPs is the problem of owners who retain too much control. If the donor/parent retains too much control over the recipient/child’s interest, the donor’s transfer will not be recognized by the IRS and the desired tax savings will not beachieved.
Donors can retain too much control by substantially limiting recipients’ rights to transfer,liquidate, or sell partnership interests. Donors also should be careful about retaining managementpowers that could be seen as “inconsistent” with normal business relationships among partners,and also with retaining control over the timing and/or amount of any partnership distributions.
Relevant FLP issues will vary from family to family. But generally the following issuesshould be watched:
- There should be a written agreement and it should clearly spell out the rights andobligations of the various partners.
- The FLP must be established for a “legitimate business purpose.” Otherwise, the IRSmight conclude that tax avoidance was the sole purpose for creation of the familypartnership, and treat it as a “sham.” Fortunately, something as basic as the desire tokeep the assets in the family will pass muster as legitimate business purpose.
- The limited partners must be recognized by the partnership as legitimate partners onincome tax returns, insurance policies, business contracts, leases and the like. Local lawrequirements for partners and partnerships must also be satisfied.
- All partnership income must be distributed on an annual basis, except for money thatmust be retained for reasonable business needs.
The Family Limited Partnership is popular these days for good reasons. It is a strategythat can reduce the burden of estate taxes and other forms of taxation, and help keep assetswithin the family unit.
B. Patrick O’Donnell, is Director of Advanced Sales at MassMutual.He is a member of the Bar in Connecticut andIndiana and has been admitted to practice before the United States Tax Court.His articles on tax law haveappeared in Trust and Estates, Estate Planning, and the CLU Journal. Pat and his wife, Liz, reside in Vernon,Connecticut.