A family limited partnership (FLP) is a limited partnership in which all the partners are family members or entities created by or owned by family members. A limited partnership is a common business entity that consists of at least one general partner and at least one limited partner. A general partner, who can own as little as one percent of the partnership interests, has the entire right to manage the business and can be held personally liable for partnership debts. A limited partner has no right to participate in managing the partnership business and has limited liability for partnership debts.
The general partners are almost always parents or grandparents, or corporations, limited liability companies, or management trusts controlled by those individuals.
By law, a limited partnership dissolves upon the death or disability of its general partner. Using these entities provides continuity within the partnership if such an event occurs. They are also used to create an additional layer of protection from the claims of aggressive judgment creditors.
Using a corporation as a general partner also provides income tax planning options. The corporation may charge fees and receive income for management of and duties performed for the FLP. This shifts some of the income from the limited partnership to the corporate general partner. The corporation can then use the income to pay salaries or set up retirement and other tax-advantaged plans such as welfare benefit trusts, defined-benefit plans, and medical reimbursement plans. As a result, the family is able to shift income from higher to lower income tax brackets and, at the same time, set up retirement pension plans for family members who are employees of the corporate general partner.
The limited partners are often children and grandchildren of the general partners, irrevocable trusts created by the senior family members for the benefit of junior family members, or revocable living trusts created by senior family members as part of their own estate planning.
Typically, you, the parent, will be the general partner, and you will also be the initial limited partner. You will then make gifts of limited partnership interests to your children. There are several advantages to making gifts of limited partnership interests:
It does not matter if the principle reason for establishing an FLP is to reduce tax liability, as long as there exists a business, investment, or financial reason for using that type of entity. Courts have made a determination that the IRS cannot disregard the existence of a partnership if the partnership is formed for business, investment, or financial reasons.
Your partnership will need to have a purpose such as:
Managing and/or developing real estate and other assets
Protecting partnership assets from the claims of creditors
Providing a reasonable and smooth economic arrangement among the members of your family to maintain the partnership assets in the family
Ensuring family harmony by providing that any dispute will be resolved by arbitration rather than going through the court system
Preventing assets of the family from being taken through the probate court system on the death of a family member
Providing for smooth succession and control of your family’s assets
Consolidating family assets which are held in fractional interests
Creating an orderly and consolidated management system for all assets held by the partnership
A qualified appraiser must appraise the value of the partnership assets and then the value of the limited partnership interests in terms of restrictions under state law and in the partnership agreement. These appraisals, while related, are not the same. The former involves the value of the assets held in the FLP, and the latter involves the value of the ownership interests in the FLP as an entity.
The IRS does not like family limited partnerships when used to obtain large discounts in the value of an estate, thereby saving estate and gift taxes that would otherwise be due. The IRS admits that valuation discounts of FLPs are legitimate, but it still challenges them in many situations. A challenge is most likely if the FLP is created just before death. Forming an FLP two days before death or when the parent is incapacitated invites the IRS to attack the partnership as solely a scheme for avoiding tax.
Since the IRS does not like the substantial estate and gift tax savings realized through the use of FLPs, it is possible that legislation in the future could limit the estate tax savings. However, you must remember that there are many advantages to the FLP, and it is unlikely that all the advantages will be taken away in one fell swoop. For instance, the creditor protection afforded by FLPs is created by state law and cannot be easily affected by federal law changes. Also, the ability to give shares of the partnership to children and relatives without giving up control of the assets within would survive any change in the law on valuation of partnerships for gift tax purposes.
Other than personal-use assets, such as a personal residence, most investments assets can be put into an FLP. Even family businesses can be contributed to an FLP. Closely held corporate stock of a family corporation can also be put into the partnership.
The following types of assets generally should not be used to fund FLPs:
IRC section 1244 stock
Professional corporation or association stock
Potential liability-producing assets
Assets with debt in excess of adjusted basis
IRAs and other qualified retirement plan assets, as well as S corporation stock, should never be contributed to a partnership of any kind.