Family Limited Partnership

What is a Family Limited Partnership?

At heart, the main goal of an FLP is to protect family assets from creditors, reduce the tax burden of transferring family holdings, and retain wealth for future generations in the event of the death of a parent. All of the partners must be family members as defined by the IRS. Like an LP, an FLP has two types of partners:

General Partners
General partners manage and control the FLP and make all the decisions for the partnership. General partners retain full control of the business’s assets. This means that general partners are are exposed to all of the operational risks and potential liability of the business.

Limited Partners
Limited partners have no personal liability. The limited partner stands to lose only the amount which they have contributed. Limited partners in an FLP are similar to “silent” partners or passive investors, although they can vote on certain issues, such as the sale of assets or remove a general partner.

How Does a Family Limited Partnership Work?

FLPs put the “family” in family limited partnership and operate in much the same way a limited partnership operates, just with the added wrinkle of having to deal with, you know, family. FLPs are mainly used by families looking to transfer wealth at reduced rates. The general partners typically slowly transfer the partnership over to the limited partners over time.

For our purposes, we’ll imagine that a family owns a successful grocery business. The parents currently run the business and want to somedaygive the company to their two children. To set up the partnership, the parents transfer the grocery business and its assets into the FLP. The parents give themselves general and limited shares in the partnership. Over time, the parents transfer limited partnership interests to their children, while retaining control as general partners. Over a number of years, the parents can gift more and more shares to their heirs by utilizing the gift tax exclusion.

For 2022, the parents in this scenario can each gift $16,000 to each one of their children, for a total of $32,000 per child. This means that $32,000 in limited shares can be given to each child, without the children having to pay taxes as they would if it were counted as income. In this way, the parents as general partners maintain control of the assets while using the FLP as a vehicle to slowly transfer family wealth—and the business—in the form of partnership shares.

Advantages of a Family Limited Partnership

FLPs are excellent entities for transferring wealth from one generation to the next, but they have other advantages as well. Let’s take a look.

Asset Protection
FLPs provide some protection from lawsuits and other liabilities. The limited partners have limited liability, so their liability is typically limited to their investment. General partners, however, are personally liable for the debts and assets of the business.

Pass-through Taxation
One of the major tax benefits of utilizing an FLP is pass-through status. Rather than the FLP paying taxes, each member of the FLP simply pays taxes at the rate based on their individual tax bracket. This also allows lower income limited partners to pay reduced taxes on any assets or partnership shares gifted to them by general partners.

Flexibility
There are a lot of family wealth transfer options out there, but FLPs offer families some flexibility when it comes to managing their assets. For instance, FLPs allows partners go their own way by selling their interests back to the partnership. If disagreements arise, the partnership agreement can be altered to better meet the needs of the partners. What’s more the FLP can be changed, or ended, by a vote of the partners. In short, an FLP isn’t written in stone, and can be altered should family members get divorced, run afoul of the law, or have major disagreements.

Reduced Transfer Taxes
An FLP allows general partners to pass on limited interest shares at a lower tax burden. Because the FLP is a closely-held entity and not publicly-traded, the IRS allows for a discount to be applied based upon the lack of marketability of the limited partnership shares. In simple terms, most people don’t want to buy shares that offer no real control over how the partnership is run. Therefore, the value of the partnership interests held by the children are worth less than when they are held by the parent. This allows families to leverage the FLP as a vehicle to transfer the estate at reduced rates because assets usually increase in value, but the current value of the gifts aren’t considered as valuable as they will be in the future, thus reducing the tax burden at present day value versus twenty years on.

Disadvantages of Family Limited Partnership

FLPs have some truly awesome advantages, but that doesn’t mean there aren’t some some drawbacks. Let’s take a look at a few.

Cost Prohibitive
Make no mistake, FLPs are for transferring great wealth, not for deciding who gets the keys to the KIA when dad dies. Because FLPs can be complex and deal with major family assets, they greatly benefit from competent and professional legal and tax professionals to help administer the partnership in a legal way. A professionally organized FLP can cost upwards of five to ten thousand dollars to set up and maintain.

Liability Issues
If the business is liable for debt or bankruptcy, general partners are personally liable. While a charging order is generally the only remedy for a lawsuit against an FLP, general partners are still fully on the hook for any settlement that arises. It means that the general partners will be required to hand over personal assets to cover the business’ financial obligations. General partners are also liable for the actions of other general partners too. On the other hand, limited partners do not face the same problem because they enjoy limited liability. They are protected from the need to give up personal assets to help the company pay its debts.

Potential Risk
The IRS has its eyes on FLPs and how they operate. If the IRS thinks that the FLP was set up with the express purpose to avoid taxes, and not as a legitimate business entity, they can come after you and levy all sorts of penalties.

How to Form a Family Limited Partnership

An FLP is simply a limited partnership with family members thrown in the mix. This means that you form an FLP in the same way you form a limited partnership. Each state has its own rules with regards to forming an FLP, but in general an FLP will need to follow these steps:

1. Name your FLP. The name must be distinguishable from any other limited partnership name registered, or reserved in your state. Typically you’d name your FLP after the family, something like “The Jones Family Limited Partnership” for simplicity.
2. Hire or appoint a registered agent. The registered agent will receive all legal correspondence and official paperwork on behalf of the FLP.
3. File a Certificate of Limited Partnership with state, and pay all required state filing fees.
4. Get an appraisal of the FLP assets from a reputable estate appraiser. A qualified appraiser will be more impartial with regards to assigning value to the assets, which will give an FLP a much better chance of avoiding or withstanding IRS scrutiny.
5. Draw up a limited partnership agreement which spells out how the partnership will operate, and details the rights of the general and limited partners.
6. File annual reports and any state compliance documents for your FLP.

You can form an FLP on your own, but because you’re dealing with high dollar assets, it is probably best to hire a professional asset attorney. They’ll help you draft the FLP agreement, file all the necessary forms and required documentation with the appropriate state agencies, and most importantly, help you legally transfer assets into the FLP. Be prepared to spend a few thousand (or more) hashing out the particulars of your FLP.

One wrinkle to consider. General partners are fully liable for the debts of the FLP. If the original business that is being transferred into the FLP is registered as an LLC or corporation, the parents should consider naming the entity as the general partner of the FLP.

This will allow the LLC or corporation to accept liability for any debts or lawsuits against the FLP, while the other assets of the partnership, owned by the limited partners, remain safe from creditors.

Family Limited Partnership vs LLC

FLPs and LLCs are both useful entities for estate planning, as both enjoy “pass-through” taxation and avoid the “double taxation” that is associated with corporations.
Both qualify for the annual gift tax exclusion and lifetime gift tax exemption, and both allow you to transfer shares while retaining control of the way the entity is run. However, there are few important differences between FLPs and LLCs:

• Startup Costs
  LLCs are relatively easy and inexpensive to form. On the other hand, it can be expensive to set up an FLP. You’ll want to hire an attorney well versed in estate planning, and as we all know, attorneys cost money. There will also be state and local filing fees, costs to transfer titles to assets, appraiser’s fees, and more.
  
• Control
  LLCs allow all members to participate in managerial decision making. FLPs, by nature, only give general partners a say in how the FLP is managed. Limited partners have very little control over how things operate.
• Tax Deductions
  FLP limited partners, as passive investors, typically can’t deduct partnership losses for tax purposes. In contrast, LLCs usually allow all members to deduct their share of losses.
• Liability Protection
  Whereas LLCs protect every member from liability, FLPs only protect limited partners, and leave general partners exposed to lawsuits.

Conclusion

FLPs are generally a solid option if you are looking to protect, leverage, and control family wealth. They don’t take the place of LLCs when it comes to forming businesses, or insulating partners from bankruptcy or lawsuits, but FLPs are a solid option for wealth management, particularly if your family has assets to pass down.

To learn more about partnerships and LLCs, check out our page on LLCs vs Partnerships:

Partnerships vs LLCs