What You Should Know About Family Limited Partnerships

The family limited partnership (FLP) is a favorite tool of many estate planners. But it isn’t appropriate for every estate, and precautions are in order when it is appropriate.

FLPs became a popular tool when the lifetime estate and gift tax exemption was much lower, and many more people had to worry about estate taxes.

When the rules were followed carefully, an FLP could reduce an estate’s value and transfer future appreciation of assets out of the estate. The estate owner also could retain significant control over the assets.

The IRS aggressively challenged FLPs that were used to reduce estate and gift taxes. It won some court cases and lost others.

For those worried about estate and gift taxes, the FLP still is a tool worth considering. But you must work closely with an estate planner and manage the FLP according to the guidelines established by the estate planner.

The FLP can deliver significant estate planning benefits even when estate and gift taxes aren’t a major issue.

Additional benefits of the FLP include management continuity of a business or investment portfolio, asset protection, income tax shifting among family members, and simplified wealth transfers within the family.

Some estate planners prefer a limited liability company (LLC) to a limited partnership. The two are very similar with differences depending on nuances of state law. I’ll focus on the FLP in this discussion.

An FLP is a type of business entity formed under state law. It is owned by multiple family members or a trust that benefits the family.

There are two classes of FLP owners: general partners (GPs) and limited partners (LPs).

Typically, a married couple who are the parents and grandparents of the rest of the family form the FLP and are the GPs. The GPs control and manage the FLP and have an economic interest in the entity.

GPs don’t have liability protection for their GP interests. That’s why the GP often is an LLC or S corporation that is owned and controlled by the parents and grandparents.

The LPs are the rest of the family, and the GPs also can have LP interests. While LPs have little control over how the FLP and its assets are managed, they receive most of the economic benefit.

LPs receive significant asset protection from creditors as well as divorcing spouses. The outsiders can’t take control of the LP interests or force distributions from the FLP to satisfy their claims. A creditor must wait for the FLP to distribute assets to an LP.

The asset protection can be enhanced when the LP interests are owned by trusts.

FLPs are very flexible and can be organized and structured in different ways.

In a standard FLP, the parents/ grandparents form the FLP as part of their estate plan. They receive GP interests that are 1% of the economic interests of the FLP.

They also contribute assets to the FLP in return for LP interests that are 99% of the economic interests of the FLP. Then, they distribute the LP interests to their children and grandchildren. There are many ways to do this. Gifts of all the interests can be made at one time or in installments over a period of years. There might be taxable gifts when the FLP interests are transferred. Sometimes the children and grandchildren contribute cash or assets to the FLP in return for some of their interests.

While under the law, the GPs determine how the FLPs assets are managed and distributed, some GPs use the FLP to introduce younger generations to managing assets.

They hold periodic meetings at which the FLP’s assets are explained. After alternatives are discussed, the views of the LPs are solicited.

The degree of control the GPs have over distributions can be a touchy legal issue when the GPs want asset protection or estate tax reduction. When those are the goals, the GPs shouldn’t retain control over distributions or the liquidation of the FLP. Your estate planner can suggest alternatives such as allowing votes by the limited partners or having rules set in the operating agreement.

There are some common mistakes to avoid.

When there are different businesses or real estate properties in the family, they shouldn’t be in the same FLP. Each business or property should have its own FLP to maximize asset protection.

Some GPs operate the FLP as though the assets are their personal property or checkbook. That’s a mistake. Don’t pay personal expenses from FLP assets. That is likely to terminate the asset protection and tax benefits.

Likewise, any real estate held by the FLP should have separate insurance coverage that isn’t personal homeowner’s insurance. Otherwise, a court will find the assets are personal property of the GPs or LPs.

Don’t wait too long to form the FLP, especially if you’re looking for tax benefits. Courts are likely to ignore an FLP when the people forming it passed away not long after the formation. Likewise, it might be too late to obtain asset protection benefits when the FLP is formed after problems with creditors arose.

Consider not having the LP interests owned directly by the children and grandchildren. Having the LP interests held in trust for them provides better asset protection, reduces mismanagement and poor spending decisions and can shield the interests from a divorce.

The FLP makes distributions to the trust. The trustee determines whether it is safe to distribute assets to a particular child or grandchild after considering factors such as creditor risks, reckless spending and mismanagement.