Family Limited Partnerships

A family limited partnerships (or “FLP”) is a planning technique that is frequently used for both estate, gift and generation-skipping transfer tax purposes as well as asset protection purposes.  Frequently, individuals who engage in planning with an FLP do so to move wealth from one generation to the next. 

An FLP is a limited partnership formed under state law.  Limited partnerships are a special kind of partnership that have two types of partners or owners – a general partner or partners (the “GP”) and a limited partner or partners (the “LP”).  In an FLP, the GP is responsible for managing the FLP and its assets. The LP has an economic interest in the FLP, but typically lacks two noteworthy rights: control and marketability. That is, LP’s have no ability to control, direct, or otherwise influence the operations of the FLP. They can neither buy additional assets, nor sell existing assets, and they cannot act on behalf of the FLP. They also substantially lack the ability to sell or otherwise transfer their interest.  In effect, LP’s are silent partners and the GP runs the entire operation.

FLPs are typically formed as a holding company that owns assets such as a business, real estate investments, publicly or privately held securities, and the like.  The assets that are owned by the FLP are contributed by the partners (the GP(s) and LP(s)).

FLPs offer several non-tax benefits.  For example, an FLP allows family members with aligned interests to pool resources, thus lowering legal, accounting, and investing costs. An FLP also allows one family member, typically the GP, to move assets to other family members (often children who are LPs), while still retaining control over the assets. This is because LP’s, by definition, have no right to manage or otherwise control the FLP. The timing and amounts of any distributions from an FLP is the sole and exclusive prerogative of the GP (although distributions must be made to all partners according to their percentage interests).

FLPs can also generate favorable tax treatment relating to the transfer of the assets.  For estate and gift tax purposes, taxes are paid based on the fair market value of transferred assets.  Fair market value is the value that would be received or paid to sell or buy an asset between a hypothetical willing buyer and hypothetical willing seller, both acting in their own best interest and with reasonable knowledge of the relevant facts when neither is acting under compulsion.  Because of the way an FLP is established, LP interests traditionally are “worth less” than the equivalent pro rata interest of the underlying assets because the LP interest is not a controlling or marketable interest.

Consider this extremely oversimplified example. A father wishes to transfer $1,000,000 to his child. If the father gives the child $1,000.000 in cash, the father will have to pay gift tax on that full amount, as that is the fair market value of the property given. One million dollars is worth exactly one million dollars. If, however, father creates an FLP and contributes the $1,000,000 to the FLP and takes back both a 1% GP interest and a 98% LP interest (assume the other 1% interest is owned by another family member), the father can now gift LP interests to his son as opposed to the cash itself.  The fair market value of a 98% LP interest would be worth less than $980,000 although at first it might seem this is not the case. This is because a hypothetical willing buyer of the 98% LP interest would not be willing to pay $980,000. This is due to the lack of control and lack of marketability. Someone getting $980,000 cash can do with it as they please. Someone with a partnership interest worth $980,000, but that can't be collected until the GP declares a distribution (which may be many years away) is not as desirable, and a hypothetical buyer would factor this into their calculation of what they are willing to pay. Similarly, this asset cannot be sold or converted, and as a result, is less desirable than an equivalent amount of cash or marketable assets.

If an appraisal firm is engaged and values the 98% LP interest at $400,000, reflecting appropriate discounts for lack of control and lack of marketability in compliance with IRS regulations, the grantor (the father) has only to pay gift tax on $400,000 as opposed to the $1,000,000 in our example.

It is important to note that while FLPs are often used in estate planning, the IRS has recently challenged FLP’s on a number of grounds.  FLP’s need to be structured appropriately in order to obtain the planned for benefits.

It is also important to note that at least as of 2010, there is no estate tax.  This obviously needs to be considered before anyone engages in planning involving an FLP.

FLP’s are also used as an asset protection tool.  This is because an FLP allows an individual to maintain full control and enjoyment of property while divesting himself or herself of legal ownership. The law generally provides that a creditor of a partner cannot reach the assets of the partnership to satisfy an obligation of the partner since it is the partnership as an entity, not the partner, that now owns the asset. Instead, the creditor receives a charging order which in essence causes the creditor to be taxed for income never received which can be very discouraging to potential lawsuits.