How a family limited partnership is used in estate planning
Families with significant or fast-growing assets are often concerned about minimizing estate taxes, protecting assets against creditors, and succession planning. One estate planning tool used by many families to address these concerns is a family limited partnership ("FLP").
This article will help explain how an FLP works and why so many families use this tool in their estate planning.
How does a family limited partnership work?
An FLP is a holding company owned by two or more family members and can be used to retain a family's business interest, real estate, securities, and other assets that its members contribute.
A partnership agreement must be created that sets forth the rights and duties of the partners. The partnership agreement must also specify how the partnership will be managed and how profits and losses will be distributed among the partners.
The partnership agreement must establish two classes of owners - general partners and limited partners.
General partners (GPs) are responsible for the FLP and its assets. They have control over the FLP and can make decisions about its operations. GPs are also entitled to reasonable compensation for managing the partnership.
Limited partners (LPs) have an economic interest in the partnership but are not able to control, direct, or influence the FLP. LPs usually cannot sell their interest in the FLP unless it is to an immediate family member. However, the LP does have a right to a pro-rata share of the partnership income. Also, LPs are liable only to the extent of their investment in the partnership.
Thus, GPs are the operators, and LPs are passive owners in the FLP.
While this may seem like an unfair arrangement, it is often required to protect the limited partners' interests. Without this delineation of roles, limited partners could be held liable for the debts and obligations of the FLP, which they have no control over. By establishing clear boundaries between the two types of ownership, an FLP can help to shield its LPs from financial liability.
Once an FLP is created, the partners may contribute assets to it in exchange for a partnership interest. Typically, the parents or grandparents transfer assets into the partnership in exchange for GP and LP interests and take the role of GP. Their children then join the partnership as LPs either by contributing assets or by receiving LP interests as gifts.
What are the benefits of a family limited partnership?
One of the key advantages of an FLP is that it allows families to transfer ownership interests to other family members at a discount to the unencumbered fair market value of those interests.
For example, Bill and Jennifer transfer $1 million of real estate to a new FLP in exchange for a 1% GP and 99% LP interests and serve as GPs. Their two children, Donnie and Charlie, join the FLP as LPs. Bill and Jennifer decide to transfer 50% of their LP interests to their children, Donnie and Charlie. Unencumbered, the value of the partnership interest may be $500,000. However, since Donnie and Charlie have limited control over the assets and limited ability to sell their partnership interests, the taxable value of the partnership interest transferred to them may be significantly discounted.
The above example demonstrates how partnership interests may be discounted and transferred to family members. The transfer in the example would count against Bill and Jennifer's lifetime gift exclusion but would be at the discounted value instead of the original unencumbered value. Let's say it's discounted to $350,000. In this case, the parent's taxable estate is reduced by $150,000.
Let's say Bill and Jennifer want to transfer partnership interest to their children without using their lifetime gift tax exclusion. They can achieve this by structuring the partnership agreement so that Donnie and Charlie receive interests up to the annual gift tax exclusion, which is $16,000 for an individual or $32,000 for a couple (who are both partners in the FLP). While this may take longer than a lump-sum transfer, the transfers are free of estate tax.
Once assets are transferred to an FLP, gifted future returns related to those units are excluded from the original asset owner's estate. Upon the death of the original asset owner, their estate will only include the value of their remaining interest in the FLP based on the value of assets at their date of death.
The lifetime gift tax exclusion is relatively high at $12.06 million per individual for 2022. Under current law, this exclusion amount will revert to $5 million (adjusted for inflation) after 2025. The value of estates exceeding the lifetime exclusion is taxed at a rate up to 40%. Many states also impose additional estate and inheritance taxes. Thus, an FLP can be an important tool in reducing the taxable value of estates that may exceed the owner's lifetime exclusion.
General partner control over assets
Another advantage of an FLP is that it enables the general partners, often the senior generation in a family, to retain full control over the underlying assets in the FLP. This is often beneficial for family businesses where the senior generation has yet to select a successor.
And, when the senior generation is no longer in a position to manage the FLP, they can choose who will receive their general partner interests - which could be a family or a trusted third-party advisor. You should discuss with your advisor the risks related to retaining this control up through your date of death.
An FLP can also be an effective asset protection tool. A well-drafted partnership agreement can include restrictions on the distribution of assets, limiting the exposure of the FLP's assets to creditors, particularly for LPs. Specifically, laws limit a creditor's right to only the economic benefit a limited partner receives from the FLP. An LP's creditor can generally not access the FLP assets or force a sale of those assets.
An LP's creditor must wait until the GP decides to distribute funds from the FLP, which may be delayed for an extended time. This situation not only puts the LP in a strong bargaining position with the creditor but enables the GP to protect the FLP's assets from the LP's debt.
General requirements of a family limited partnership
A family limited partnership is a real business arrangement that must meet standards set by the Internal Revenue Code. For an FLP to be valid, regular meetings must be held, formal minutes must be taken, and reasonable compensation must be paid to the general partner.
Additionally, limited partners are responsible for paying taxes on their share of income from the FLP. However, partnership agreements can typically be structured to make annual distributions to limited partners to cover their tax liabilities.
Contact our office for more information
Individuals or couples with estates approaching or exceeding their lifetime exclusion should take steps to reduce the taxable portion of their estate. It's especially important to address estate planning now while the lifetime exclusion is at an all-time high but scheduled to revert to a much lower level in 2026. With careful planning, an FLP can be a valuable tool for reducing, if not eliminating, estate taxes while also providing control over the assets and creditor protection.
Of course, there are many factors to take into consideration. This article is intended to provide a brief introduction to family limited partnerships and is not a substitute for speaking with one of our expert advisors. If you'd like to learn more about FLPs and whether one is right for your family, please contact our office.