As many of you know, Family Limited Partnerships (FLP) have long been considered an estate planning tool for transferring wealth at discounted values and ultimately reducing estate tax transfer costs. With the possible repeal of the federal estate tax (maybe, maybe not), is there still a need for these Family Limited Partnerships? The answer remains a strong YES. Here I share with you a number of reasons to have a FLP as well as some of the practices that should be followed so that your FLP will be recognized as a business entity and not considered a sham.
Family Limited Partnership
What is a partnership? A partnership is a joint venture between at least two investors or owners to manage and operate a business or investments. Generally, there is a written plan (operating agreement) that lays out various terms of the agreement such as (but not limited to) who and how will the partnership be managed, who are eligible partners, if and when earnings and profits will be paid and how to end the relationship. A partnership is a flow-through entity for income tax purposes. This means that the individual partner will be responsible for payment of the taxes rather than the partnership.
A limited partnership is a similar entity but will have two classes of investors, general partners and limited partners. As the name implies, the limited partners have limited powers in the management of the partnership. This can be good and bad. You may not have a say in the management but you also have a limited liability based on those decisions (your loss is limited to the investments into the partnership). Family Limited Partnerships will usually be formed as a limited partnership. The managing partner determines in accordance with the operating agreement if and when distributions will be made and when to terminate the partnership thus controlling the management of the assets.
How it works. The family limited partnership is formed by the senior generation. Often times, a second generation family member will manage the partnership (general partner). Assets of the senior generation will be transferred into the FLP in exchange for limited partner interests. These limited partner interest are then gifted to family members either at one time or through systematic annual gifting program. The managing partner can then determine the level of distributions from the partnership. Should limited distributions be made to cover income taxes of the partners since this is a pass-through tax entity? Or, should the distributions be higher to help pay for college educations of the younger generation? The options are numerous but at the discretion of the manager.
Purpose of the FLP
Although the primary reason for using a FLP might be the possible reduction of the estate and gift transfer tax due the IRS (through the use of valuation discounts), there continues to be other non-tax purposes to validate the formation of the Family Limited Partnership. Additionally, there is a requirement that one or more of these “other purposes” be met so that the partnership is recognized as a business entity for legal reasons. These purposes/benefits include one or more of the following:
- Transfer of the family business or investments for succession planning (ease of transferring FLP interest).
- Centralized management of investments or other family assets such as a second home or other assets that you would rather not have to liquidate.
- Diversification of investments.
- Management during senior generation’s life-time and thereafter.
- Credit protection / Spendthrift protection.
Planning Tip – When forming the FLP think” Long-Term”. What will our situation be in 10 years? 15 years?
Do’s and Don’ts of an FLP
Operation of the FLP is key (in addition to the business purpose of the entity) in order to withstand a challenge to the entity recognition. Here are some of the do’s and don’ts to formation and operation of the FLP.
- Provide for a succession plan from senior generation.
- Limited partners should contribute assets to the partnership at start-up. Consider using prior gifts from senior generation.
- Senior generation should retain other liquid assets in their name to cover living costs. Don’t transfer all of senior generation assets nor the primary residence.
- Do not commingle personal assets and FLP assets.
- Ensure that distributions follow the operating agreement and are in proportion to ownership.
- Prepare management reports on a regular basis and distribute to all partners.
- Do not terminate FLP shortly after the passing of senior members.
As we all wait to see how the debate regarding the federal Estate Tax Law plays out in Congress, recognize that the are other non-estate tax reasons for having your own family limited partnership. But the most important point is that once your set up your FLP, it is of the utmost importance to follow good business practices in managing your FLP. You want your state and the federal government to recognize your FLP as a separate entity so that you will be able to achieve your goals that were set out when the FLP was formed. Always consult with your accountant and attorney when setting up these entities.
This article was written by Kevin E. Hines, CPA, MST, CVA, CSEP, partner with Meyers Brothers Kalicka, P.C., with specialties in Business Valuations, Estate Planning and Taxes. You can reach Mr. Hines at (413) 536-8510.
