FLP Questions Answers

First of all, a limited partnership is a type of business organization recognized in most states where management rights and responsibilities are vested in one or more general partners while the ownership interests are vested in limited partners. A limited partnership is a flow-through entity for income tax purposes, which means that the partners pay income taxes or enjoy tax benefits individually, based upon their ownership interest in the partnership.

A family limited partnership is not a different type of business organization. Instead, it is used to describe a limited partnership where most or all of the general partners and limited partners are related to each other.

Usually families with business assets which they desire to own in common, including assets which some family members wish to pass on to other family members, benefit from an FLP. For example, parents owning all or most of the interest in a store who want to involve their children in the ownership and management of the business may benefit from setting up an FLP. What the FLP does is to allow the family to have flexibility in dividing the store’s ownership and control in ways which will work for its members. Inasmuch as the organizational costs can be substantial, families having business assets which total less than $1.5 million rarely find it to their advantage to establish an FLP.

Any kind of business or investment assets work in an FLP. Assets connected with an operating business, such as a store or ranch, usually work particularly well, but some families establish FLPs solely with investment-type assets. Personal assets, such as homes and furniture, should not be placed in an FLP. Retirement accounts, such as IRAs and 401k plans, usually don’t work in an FLP.

Among the benefits are:

Centralization of Management – An FLP fractionalizes ownership while management remains centralized.

Facilitating Intra-Family Transfers – FLPs ease the transfer of interests in family business assets from one family member to another. For example, a parent would be able to transfer a specified percentage of a collection of business assets (in other words, an interest in the FLP) to each child, rather than multiple transfers of specific assets.

Discounts – In most cases, the FLP interests owned or transferred by a family member are valued at less than the underlying assets would be valued if the partnership did not exist, possibly saving transfers taxes.

Avoiding and resolving family disputes – FLPS provide a means to resolve existing or future family disputes, thereby making it more likely to avoid these disputes entirely.

Among the drawbacks are:

Organizational costs — Setting up an FLP costs $5,000 or more, so the potential advantages need to outweigh this up front cost.

Operating requirements – The FLP has to be operated as a separate business, with separate bank and investment accounts and separate tax returns. The FLP form must be respected, which means changes from prior family practices. Personal and partnership finances must be kept separate. Most people aren’t willing to make these changes, and FLPs are not for these people.

Tax scrutiny – The IRS scrutinizes FLPs for estate and gift tax purposes because the agency does not like the discounts many FLPs receive. Therefore, families should be prepared for this type of scrutiny when gift and estate tax returns are filed.

In order to establish a Family Limited Partnership, the senior family members (i.e., the parents) transfer property to the partnership in exchange for a small general partnership interest (such as 1%) and a very large limited partnership interest (about 97%). The children make a contribution in exchange for a 1% general partnership interest.

Typically, the parents would hold both the general and the limited partnership interests as Trustee of their Revocable Trust, although that isn’t always the case. The parents would be the managing general partners having sole management control over the partnership. Their retained general partnership interest allows them to have complete control over day-to-day investment and management decisions which relate to the partnership property. The limited partners and other general partners haven’t any voice in the management of the partnership.

The Family Limited Partnership can be drafted to provide that the limited partners will not be allowed to transfer their partnership interests during their lifetime without the other partner’s consent. Restriction of transferring the partnership interests will reduce the value of the gifted partnership interest for gift tax purposes by reducing its marketability (“marketability discount”). Because the limited partners have no voice in the partnership’s management, the value of the gifted limited partnership interest will be discounted to reflect this lack of control (“control discount”). Collectively, these two discounts usually reduce the value of the transferred interest for gift tax purposes by 20%-60% (and the taxes by 10-25%), depending on what kind of assets are being held by the partnership.

Typically, the parents would hold both the general and the limited partnership interests as Trustee of their Revocable Trust, although that isn’t always the case. The parents would be the managing general partners having sole management control over the partnership. Their retained general partnership interest allows them to have complete control over day-to-day investment and management decisions which relate to the partnership property. The limited partners and other general partners haven’t any voice in the management of the partnership.

Yes. Control over partnership property can be maintained for as long as you want it to. A plan can be prepared making you the managing general partner with sole management control over the partnership. Your children can have as much or as little control as you require them to. You could even go so far as to allow them only the right to stop you from independently dissolving the partnership. You could retain all other powers.

Yes. The Family Limited Partnership is the perfect medium for transferring control of the family business and/or property to your children either quickly or gradually as you wish. Frequently, the first step in developing children’s responsibility is to provide them with a small share of the family business that will attract and develop their interest. The Family Limited Partnership is flexible enough to allow you to transfer control and responsibility for the business as you see fit.

After establishing the Family Limited Partnership, you could use your Family Limited Partnership as part of your estate plan to make “discounted” lifetime gifts to your children. The other alternative is to hold the interest in your Family Limited Partnership until one of you dies, after which time the survivor could start making gifts of the limited partnership interests to the children. This second use of a Family Limited Partnership has a double benefit; the survivor receives a full step-up in basis of the underlying partnership assets for income tax purposes after the first death, and following the death of the survivor the limited partnership interests could be discounted for estate tax purposes.

If you establish a Family Limited Partnership and later make lifetime gifts of the limited partnership interests to your children, the limited partnership interests would entitle your children to all economic benefits from their gifted partnership interest, but without any management authority in relation to the partnership property. Because of the restriction discussed above, the limited partnership interest has a reduced value. T

he value of any limited partnership interest given to your children during your lifetime will be removed from your estate for estate tax purposes. After your death, only the value of your general partnership interest and any remaining limited partnership interest you still own will be able to be included in your estate for estate tax purposes.

Restrictions on transfers as referred to above, has an added benefit when the limited partnership interests are gifted to your children, since the restriction provides some protection from a child’s judgment creditor (such as a divorced spouse). A child’s creditor will not be allowed to reach the underlying partnership assets in order to satisfy a judgment, but more exactly will only be entitled to the child’s economic interest in the partnership, i.e., the right to partnership distributions.

Should you or another family member become unable to satisfy a future creditor, that future creditor’s only remedy against the partnership is the right to receive a “charging order” against that member’s interest in the partnership? Assuming there is no fraudulent conveyance, the creditor may not be able to reach partnership assets. While the charging order allows the creditor to reach income, the assets are safe.

In addition, the Family Limited Partnership can be planned to provide that an involuntary transfer to a creditor is not permissible and that the transferred interest is to be purchased by the partnership at its fair market value (frequently much less than the underlying asset value). An ex-spouse or a divorcing spouse receives the same treatment provided that the partnership interest is the separate property of the family member.

The restrictions on transfer also could deter an irresponsible family member from wasting family assets.

In comparison with an irrevocable trust, which may not be amended, a Family Limited Partnership is a flexible document. If all the partners in the partnership agreement concur (typically, all are family members) the partnership agreement may be amended or terminated. Also the partnership may be ended without adverse income tax consequences.

The major disadvantage of a Family Limited Partnership is the ongoing cost. After the initial start up cost, there are annual franchise taxes and tax returns such as those for corporations. And, there is the obvious: reducing in value for estate tax purposes is due to the very real affect of the lack of control and length of marketability discounts. This is not a trick being done with re-characterization of your property. At the same time, these aspects are what give the family limited partnership its significant chance of success in accomplishing your estate planning goals.

While Family Limited Partnerships are being implemented by estate planners throughout the U.S., it must be remembered that they are a comparatively new tool, dependent on several recent developments in the law. There is no assurance that the law will not be changed in the future or that Family Limited Partnerships will not in the future come under serious attack by the IRS. However, based on the current state of the law these tecniques have a significant possibility of achieving all or part of their goals and that the potential savings exceed the costs.

When done correctly, there will be no property tax reassessment. A change in ownership does not include a transfer between any person and a partnership in which the proportionate share of that person’s ownership in the subject real estate remains the same.

In establishing your partnership with your children, a small percentage of the interest in the underlying real estate will be transferred first to the children. Together, both you and your children transfer the real estate to the Family Limited Partnership and, in return, will receive partnership shares in the same proportion to your ownership in the real estate. How will placing my real property in an FLP affect the risk of liability for other assets?

Placing real property into a Family Limited Partnership should reduce the risk that liability originating in assets in one Family Limited Partnership would reach to other assets. Generally, a creditor of a Family Limited Partnership will be limited to the assets of that limited partnership to satisfy partnership liability. In order to reach other assets, the creditor has to prove personal liability of either yourself or another general partner or some liability existing prior to the creation of the Family Limited Partnership in order to reach your personal assets or those of another general partner.

Your children will experience no liability as limited partners, other than the investment they have in the limited partnership. As general partners, they would have some potential liability, just as the operator of any business would. However, the children are unlikely to be a managing general partner and, therefore, are unlikely to have such additional liability until after you have either passed on or resigned as managing general partner.

This liability could be protected further by having a trust or limited liability company, wholly-owned by your children, act as the successor general partner.

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Family Limited Partnerships

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