Though all families are different, there may be one common thread woven through each one: the ability to make sound financial decisions is not a trait all family members are blessed with.
Because of this phenomenon, many of today's family patriarchs and matriarchs are interested in estate planning options that balance two often contradictory goals: maintaining tight control of assets during their lifetimes while minimizing estate and income tax consequences.
A Family Limited Partnership (FLP) allows you to accomplish both.
What Is a Family Limited Partnership?
An FLP is a legal entity. Instead of 'shares,' members own 'interest' in the partnership.
If you're already familiar with limited partnerships, then you're up to speed on the structure of the family limited partnership. A family limited partnership is simply a limited partnership with members who are all part of one family.
If you're not familiar with limited partnerships, here's a brief overview.
A limited partnership is an entity controlled by a general partner (GP). The GP is responsible for all decision-making, from minor clerical work and accounting duties to major decisions like asset sales/purchases and partnership distributions.
The GP typically only holds 1% to 5% of the total ownership in the limited partnership; nonetheless, they wield complete control over the underlying assets. Most of interest in a limited partnership, up to 99%, is owned by the limited partners (LPs). LPs are 'limited' in that they don't get to make any decisions. They are completely passive members.
Why would a partner give up decision-making power? The answer is liability. In a limited partnership, the limited partners are shielded from liability if the partnership is sued.
How Do You Set Up an FLP?
Typically, the senior generation creates an FLP and becomes its general partner. The FLP then becomes the owner of whatever assets the general partner places in it. In exchange for contributing these assets to the FLP, the general partner receives 100% of the interest in the FLP. FLPs can hold stocks, bonds, bank accounts, mutual funds, real estate (in the form of REITs), and life insurance policies as well as other family heirlooms and assets like gold, silver, fine art, and other collectibles.
Now, since the whole point of this exercise is to provide for the next generation of family members, the GP gives away portions of its interest in the FLP to the members of the next generation. If there are 19 heirs, perhaps the GP will decide that each LP will ultimately receive 5% ownership of the FLP, with the GP retaining 5%. The general partner distributes the ownership interest to the LPs over time according to annual and lifetime gift tax exclusions. LPs can be children, grandchildren and even great-grandchildren.
What Else Can An FLP Do?
The primary goal of an FLP is to reduce income and estate taxes.
Using an FLP allows money above estate tax thresholds to be transferred to the next generation, free of estate taxes. The FLP also confers income tax advantages. Income distributions can be spread among family members who may be in a lower income tax bracket. Income distributions are an effective way of further transferring value to the next generation, over and above the allowed annual and lifetime gift tax exclusions.
Moreover, all future asset appreciation within the FLP occurs in the estates of the younger generation and will not be subject to estate taxes until their deaths, which barring unforeseen tragedy is far in the future. There will be no tax due on that appreciation when the GP dies.
But there are several other advantages to consider.
- An FLP allows you to transfer the ownership of your assets to your heirs without relinquishing control of the assets.
- Assets held in an FLP are largely protected from lawsuits, creditors and divorces.
- By consolidating all family-related assets into one legal entity, the transfer of assets is simpler both during your lifetime and upon your death.
- Continuous family ownership of assets is assured.
Because the GP can retain control of the assets being transferred, this is an ideal approach to use when the senior generation is not ready to transfer control to the younger generation. Even with ownership as small as 1%, the GP has total control over management decisions, investment of assets, and distribution of income.
If the family specifies it in the wording of the FLP, control can be transferred gradually to a new GP over time. This is an especially useful feature because control can be transferred to a new GP while ownership percentages stay the same.
FLPs also provide asset protection. Because the partners do not personally own the assets placed in the partnership, creditors can have a very difficult time getting their hands on those assets. That’s because the asset actually owned by the partner is the partnership interest. A court order is required for relinquishing partnership interests, and even then, the creditor only gets paid with the income from the FLP. Under the law, creditors can't demand distribution from the FLP or become a partner.
The consolidation of family assets simplifies the ongoing management and the eventual transfer of assets. Instead of gifting specific assets on an annual basis, interests in the FLP are transferred, resulting in a simplified, transparent and consistent approach to gifting.
When putting together an FLP, seek the help of experienced legal counsel, who can answer your questions and make sure your FLP is structured properly. Death may be unavoidable, but with an FLP, taxes certainly aren’t.