Understanding Family Limited Partnerships

A family limited partnership (FLP) can be an effective means of protecting assets and transferring wealth between generations while minimizing taxable consequences. FLPs have also played an important role in family estate planning, because of the many non-tax advantages they offer. Let’s take a closer look at the ins and outs of FLPs.

How It Works

Formed under state law, an FLP is a legal entity in which the partners are family members. An FLP requires at least two partners, who each contribute assets (hence the term “donor”). At least one of the partners (either one of the donors or a corporation owned by the donor) must be a general partner. An important requirement is that an FLP must generally operate as a trade,business, investment or income-producing venture. The partnership cannot be an S corporation shareholder, and problems are associated with the partnership owning voting shares of stock of a corporation controlled by the general partner.

General and limited partnership interests are exchanged for a transfer of assets. Usually, each general partner receives a 1% general interest, and issues the remaining interests as limited partnership units. General partners transfer these units to recipients by using the unified gift- and estate-tax credit and the annual gift-tax exclusion.

The general partners control the FLP’s assets by making all investment, business, and management decisions, while transferring up to 98% of the value of the partnership to children, grandchildren, or other family members. The general partners determine the cash distributions to limited partners. They also have fiduciary responsibility to the partnership and must handle all transactions at arm’s length. In payment for these services, the general partners should receive a reasonable management fee.

The limited partners have no control over investment, business, and management decisions. Generally, the partnership agreement prohibits them from unilaterally removing assets from the partnership (via distributions or otherwise) and from forcing its liquidation. The limited partners can be taxed on up to 98% of the partnership income at their appropriate (often lower) tax rate.

Common Nontax Reasons For Establishing an FLP

Most of those who establish an FLP do so because they wish to:

• Retain control over transferred assets. The most common reason for establishing an FLP is to give children or other beneficiaries an interest in valuable property without surrendering control over that property. By making beneficiaries limited partners and assuming the role of general partner, those establishing the partnership maintain control over its income and assets.
• Protect assets from creditors. A partner’s creditors are only entitled to a claim against his or her partnership interest, not the underlying assets. These interests are often unattractive to the creditors and difficult for them to access. Also, the partners can be insulated from exposure to the partnership’s creditors.
• Protect assets from marital claims. An FLP arrangement can help partners avoid these same difficulties in the event of marital claims against them.
• Increase the size and scope of assets. The partnership can allow family members to create a larger pool of assets, reducing management and administration costs and increasing diversity.
• Maintain continuity of business interest and investment philosophy. The head of a family can establish an FLP to allow a smooth transition of assets to successors. This can provide a longer time horizon for investments.

FLPs Can Be Powerful Financial Planning Tools

To set up an FLP, you may need an appraisal of the value of the underlying assets, such as real estate, and an appraisal of the appropriate minority and lack of marketability adjustments. These adjustments result from the restrictions on the limited partners’ control of the assets. Expert advice is important to avoid later problems with the Internal Revenue Service or when case disputes arise.

Genuine benefits are usually accompanied by time and money requirements. The FLP requires some effort, but also offers powerful potential as a way to transfer wealth while enabling the older generation to retain adequate control over the management and growth of these assets.

These powerful financial planning tools will help you preserve your assets.

Tim McNamara is the co-founder of New England Divorce Solutions, a firm dedicated exclusively to matrimonial finance issues. He is among the country’s leading experts in wealth management and divorce finance. His company work with individuals and their attorneys throughout North America to help families protect and grow their assets before, during, and after divorce.