Families who operate a business or jointly own real estate or other assets may take advantage of a family limited partnership (FLP) or a limited liability company (LLC) to protect their family’s assets, reduce estate taxes, and transfer wealth between generations while maintaining control of the business or other assets.
What is a family limited partnership?
A family limited partnership is a business entity owned by two or more family members to hold a family’s business interest, real estate, and other assets.
There are two types of partners in an FLP:
- General partners: Managing partners who handle day-to-day management tasks and own the largest share of the business. The managing partners are typically the business-owning parents or a limited liability company owned by the parents. General partners are liable for the partnership’s debts and liabilities. This is the reason many will choose to form an LLC to shield them from the FLP’s unlimited liability.
- Limited partners: Limited partners have an economic interest in the FLP but do not have management responsibilities, and their liability is limited to their investment in the FLP. Limited partners are typically children and grandchildren who buy shares in the business in exchange for dividends, interests, and profits generated by the business and other assets.
How are family limited partnerships used?
The structure of an FLP allows family members to transfer a share of their ownership of the FLP assets to other family members who are also partners. Parents and grandparents frequently donate assets to the FLP in exchange for shares as a small general partnership interest and a large limited partnership interest.
They can then donate all or a share of their limited partner’s interest to their children or grandchildren, either directly or by establishing a trust. Parents can manage the partnership’s assets and control the making and withholding of distributions by keeping the general partnership interest. When the parents die, the FLP is commonly dissolved, and the assets are divided among the children.
Using an FLP makes it possible to make lifetime gifts and transfers at death and obtain a discount on the value of these transfers. This discount is because the limited partners do not participate in management decisions and cannot compel distributions. The partners in the FLP report their income and deductions on their personal tax returns.
What are the advantages of an FLP?
There are many potential benefits to an FLP, including the following:
- Reduces the taxable income for parents and grandparents.
- Allows families to gift FLP interests tax-free up to the annual gift tax exclusion threshold. The gift exclusion in 2023 is $17,000 for individuals and $32,000 for married couples.
- Allows families to transfer property and businesses to their children at a discount because these assets are not liquid due to their lack of control and marketability.
- If these assets increase in value after the transfer, the increased value does not incur estate and inheritance taxes.
- Allows general partners to retain management control over the family assets.
- May help protect assets from creditor claims and former spouses. Charging order laws limit creditor rights to any economic benefit the debtor partner has, protecting the other partners in the FLP.
- Provides an avenue to mandate the transfer of assets from a former spouse to the family for fair market value.
- Shares in the FLP can be transferred to minors using a Uniform Transfers to Minors Act (UTMA) account.
- As general partners, parents can set stipulations in the partnership agreement on when shares in the FLP can be transferred or sold.
- FLPs are flexible because the partnership agreement can be revised as the family circumstances change.
- FLPs can be helpful for people who own real estate or tangible personal property in another state and may be subject to a separate probate proceeding.
What are the potential drawbacks of an FLP?
The major disadvantage of family limited partnerships is that they can be expensive and complicated to set up and maintain. It has the following potential drawbacks:
- It must be established and managed as a business.
- An FLP can only be used to transfer non-personal assets.
- General partners must not be given too much control, or the gifts could be considered to be future interest gifts and, therefore, not eligible for the annual gift exclusion.
- An FLP can potentially expose family members to unwanted liability, including capital gains liability.
- It’s difficult to transfer shares in an FLP to minors.
Establishing an FLP is complicated, and it must have a purpose beyond asset protection. An FLP must be managed like a business, with regular meetings, formal minutes, and reasonable compensation paid to the general partners in recompense for their management duties. Combining family businesses, properties, and other assets into an FLP can reduce a family’s investment and management fees.