Designed to preserve family businesses for future generations, Family Limited Partnerships (FLPs) can help shelter your assets and reduce overall estate and gift taxes. FLPs are commonly used as part of business succession planning, business continuity plans, and often serve as an integral component of an estate plan for high net worth individuals.
A Family Limited Partnership is typically established by married couples who place assets in the FLP and serve as its general partners. They may then grant limited-partnership interests to the children, of up to 99% of the value of the FLP’s assets. When this occurs, the assets are removed from the general partners’ estates, thus saving on future estate taxes. The general partners keep control of the FLP and its assets, even though they may own as little as just 1% of the asset value.
Limited partners may receive distributions from the FLP, and enjoy certain tax benefits. Asset protection is another attractive feature of the FLP. The partnership’s assets are shielded from the limited partners’ creditors. The interests in an FLP can be easily divided among family members, who may each own different amounts. The FLP enables ownership of a business to transfer to the younger generation, while allowing the senior generation to continue conducting operations and mentoring and grooming the young owners.
One of the significant benefits of a properly established and maintained FLP is that it can reduce the value of gifts to your children and grandchildren. The value of each limited partnership interest which you give away decreases the value of your taxable estate and, consequently, any tax which your heirs would have to pay upon your death. The gifts are made using the annual gift tax exclusion, so you may not have to pay any gift tax on the transfer.
Since limited partners do not have the ability to direct or control the day-to-day operation of the partnership, a minority discount can be applied to reduce the value of the limited partnership interests which you are gifting. Therefore, the value of the partnership interests transferred to your beneficiaries may be far less than the corresponding value of the assets in the partnership. Furthermore, because the partnership is a closely-held entity and not publicly-traded, a discount can be applied based upon the lack of marketability of the limited partnership interest. This allows you to leverage the FLP as a vehicle to transfer more wealth to your beneficiaries, while retaining control of the underlying assets.
With these significant tax benefits, it’s no surprise that many FLPs have attracted scrutiny from the IRS. Others have run into various problems due to mistakes or outright abuse. Care must be taken to ensure your FLP is properly established and operated. Specifically, the IRS may look at the following issues when assessing the viability of the FLP:
It’s not all about taxes. You stand a better chance of avoiding – or surviving – a challenge from the IRS if you can show a significant, legitimate non-tax-related reason the FLP was created. Tax savings are an important consideration, but you must be able to demonstrate that there are other reasons, as well.
Keep your personal assets out of the FLP. You can reasonably expect to transfer closely held stock or interests in commercial real estate into a Family Limited Partnership. However, personal property such as cars or residences will not fare well against an IRS challenge. Similarly, the FLP’s assets should not be used to pay for any personal expenses. The FLP must be a legitimate business entity operated to fulfill business purposes.
Have your FLP’s assets professionally appraised. Partners or family members should not determine the valuations or discounts for any assets transferred into the FLP. A qualified appraiser has a much better chance of withstanding IRS scrutiny.
Don’t push it. Many are tempted to put as many assets into the FLP as possible, to maximize the asset protection and tax savings benefits. Unfortunately, if the FLP is successfully challenged, a significant portion of a partner’s net worth could be vulnerable to taxes or lawsuits.