The Family Limited Partnership Made Easy
By: Dr. Bart A. Basi & Marcus S. Renwick
Many people want to enrich their children and grandchildren with the wealth, possessions, and business interests that they own. The problems in the past have been the inability to control the assets once they are given and the potential of facing estate tax issues when assets are substantially appreciated. The device known as The Family Limited Partnership or FLP has been developed through case law and has survived scrutiny from the IRS to become a legitimate estate and business planning vehicle.
What is an FLP?
An FLP is an estate planning device that allows the general partner to fund the device, transfer value to heirs, keep general control over the assets, and utilize various other strategies to reduce gift and estate taxes. In practice, an FLP is similar to a trust in so far as assets are transferred for the current and future benefit of another while allowing the grantor/general partner to keep control over the assets.
The FLP differs from a trust in that it provides for additional tax and nontax advantages while offering potential unlimited life and can keep operating after the grantor’s/general partner’s death. While the trust still has a well-established place in estate planning, the FLP’s niche in estate planning is a little less established, but not devoid of advantages.
The Limited Partnership (the LP portion of FLP) is a legitimate business entity set up under state statute. Legally, the General Partner is potentially liable for all the debts and claims against the entity to the extent of the business assets in the LP and personally held assets. The Limited Partners, on the other hand, are not subject to personal liability and are only liable for debts and claims to the extent of their investment in the FLP. The General Partner’s liability can be largely absolved by having the general partner shares owned through an S Corporation or a Limited Liability Company.
While the tax benefits of the FLP are substantial, the nontax benefits cannot be overlooked. Not only are the nontax benefits important for the family business, but making an effort to achieve the nontax benefits is important to gain the tax benefit advantages as well. Consolidation of management is a benefit of the FLP structure. Instead of setting up separate trusts, separate bank accounts, and separate brokerage accounts, the FLP can use one central account. The consolidation also has the effect of reducing investment expenses and unifying the investment as well. Unifying the investment, in the manner of an FLP, also provides longevity to the investment insofar as the FLP can be operated post-death by a family member to provide the greatest return.
The FLP also provides the benefit of creditor protection. Assets involved in businesses, especially a closely-held business owned by a minority non-voting shareholder, are often not attractive to creditors or potential ex-spouses.
THE TAX BENEFITS
A professional business appraiser is required to be retained when valuing an FLP. An FLP, like most businesses, is not a simple asset to value. Houses, cars, antiques, and items for donation must be valued by a qualified appraiser. Closely-held businesses, including FLPs, are often so intangible in nature and often so different from one another that a simple valuation by a nonprofessional is not sufficient. Because of the complexity, differences, and unique nature of each business, an appraisal by a professional appraiser is needed. The appraiser will appraise the business using a variety of methods; methods that may be advantageous to your estate tax position.
Along with an appraisal, the professional appraiser can assign discounts for lack of marketability and lack of control. For an FLP, combined discounts for lack of control and marketability can total from 20-40%.
HOW TO FORM
In form, an FLP is simply a Limited Partnership formed under state statute and owned by family members. One person (the parent) retains a 1 or 2% interest as the General Partner. The children are then granted up to a 98% interest, over time, as Limited Partners.
The importance of the details of the formation of the Limited Partnership can not be overlooked. While a typical partnership can be formed with no written agreement, the Limited Partnership REQUIRES that it be formed according to state statute. Beyond the formal creation requirements, case law has developed guiding particularities in both the creation of the entity and the operation of the entity. If the particularities are overlooked, the IRS is free to scrutinize the FLP as a tax avoidance device; and given the fierce history the IRS has had against FLPs, it is imperative that these particularities not be overlooked or disregarded.
As mentioned, forming and operating an FLP requires strict adherence to various rules that have come about through case law and practice. The guidelines are as follows:
a) When creating the FLP, list a legitimate business purpose such as consolidation of family asset management, lowering administrative costs of family assets, avoidance of family asset fractionalization, etcetera. Not listing a business purpose or listing a patently offensive purpose such as “to take advantage of valuation discounts” is an improper reason for creating an FLP and should be avoided.
b) Do not transfer the donor’s home into the FLP, unless the home is vacated and treated as a rental property. If personal items are placed in the FLP, the person benefitting from the usage of the item should pay rent back into the FLP at fair market value. The home, in contrast, should not be rented by the donor at all.
c) Do not make personal loans from the FLP.
d) Operate the FLP in accordance and within legal requirements such as annual company meetings, minutes, and record books. Properly funding, insuring, and not treating the FLP as a pocketbook company is recommended as well. This rule is universal in any company that is formed and operated. To form and operate a business otherwise invites scrutiny not only from the IRS but also during potential civil suits. At some point, if proper legal requirements are not followed, this scrutiny can lead to the corporate existence and therefore benefit, to be disregarded completely.
e) Do not commingle assets between the partnership and personal assets. This is another rule that is universally useful whenever anyone operates a business. First, bank accounts should be in the name of the FLP. Business records, financial (bank statements), and nonfinancial (minutes, corporate record book, court proceedings, insurance documents, car titles, deeds, etcetera) should be kept and kept separately from personal assets.
f) Generally, the transfers should conform to a business plan over some time. Transferring assets as part of a “death bed” transfer or in contemplation of death will draw IRS scrutiny and could eliminate some of the benefits associated with the FLP.
g) Make sure the donor has sufficient personal assets to make a living separate from the assets transferred into the FLP. If the donor does not have sufficient assets, the destitution of the donor is prime evidence that the FLP is a sham created to take advantage of certain tax benefits.
h) Of prime importance – the FLP must be valued using a professional business appraiser. Simply using a multiple to estimate the worth of assets or using a real estate appraiser is insufficient under IRS rules for business valuation. The appraiser will have an understanding of the methodology and discounts that can be taken to use an FLP to its full advantage. Taking overly aggressive discounts will draw IRS scrutiny, invite expensive litigation and ultimately result in less discount than what could legitimately be used.
The FLP will require that a professional business appraiser value the entity from time to time. As discussed above, some discounts can potentially be taken when the FLP is appraised. The first potential discount is the control discount. Since the limited partners have largely abbreviated rights, to begin with, AND lack any control, their interest in the FLP is discounted to reflect the lack of control that they do not possess. The second discount that can be taken is one for lack of marketability. The simple fact is that interests in small, non publically traded businesses lack overall marketability. An interest in a family-owned limited partnership is equally as unmarketable. While discounts for lack of control and lack of marketability can be justified; extending and taking discounts without justification can be fatal to an otherwise well-crafted valuation.
FLP is one device/strategy of many that can be taken to plan for tax and business issues your estate will face. The FLP is an extremely useful and tested device that can be applied in your estate and business planning. If you are interested in forming an FLP or would like more information, feel free to contact the professionals at The Center at (618) 997-3436.