What is a Family Limited Partnership
A Family Limited Partnership is simply a formal partnership where the partners are family members. Like other partnerships, a Family Limited Partnership (FLP) is a real business selling products, services, or renting property to real customers. The difference here is that family members are involved, and the partnership is structured to provide a number of significant tax and legal benefits for the family. The three most powerful benefits are:
- Reduction in estate taxes
- Preventing future growth in asset values from being estate taxed
- Protection from lawsuits or divorce actions.
If constructed and managed correctly, the Family Limited Partnership can be a powerful tool for high-net-worth families. Interested in learning more? Schedule a meeting with one of our advisors to see if FLPs are right for your situation.
When we say there is a “real” business involved, we don’t mean that you have to start a new business. In fact, most FLPs are created to take ownership of an existing business or investment real estate. Whether you already own a manufacturing, distribution, or services company or own several real estate investments, you can transfer ownership into the FLP to take advantage of its key benefits.
Understanding the Family Limited Partnership
Here’s how it typically works. On day one, you have an attorney create a Family Limited Partnership agreement. There needs to be at least one general partner and one limited partner, but typically, there are several limited partners. To activate the partnership, you would transfer your ownership of your business or investment real estate into the partnership in exchange for all the general and limited partnership shares. On day two, you would own 100% of the partnership, which now owns 100% of your business or investment real estate.
Here’s where the fun begins. To take advantage of the key benefits we’ve mentioned, you need to gift some or all of the limited partnership shares to other family members. This isn’t just a series of random gifts; you’re gifting shares to each family member whom you eventually want to own your assets after you’ve passed away.
You’re fast-tracking your estate plan. Instead of waiting until you’ve passed away when your heirs would receive your assets, you’re giving them away now in a manner that reduces gift and estate taxes while providing some creditor protection. To understand why you need to understand more about the difference between general and limited partners.
General vs. Limited Partnership Interests
General Partners – General partners in a Family Limited Partnership are responsible for the management of the partnerships and its assets. They control management of the partnership very similarly to how a business owner controls his or her company. The general partners have unlimited liability for debts incurred by the partnership agreement, but there are ways for general partners to protect themselves against liability. The general partners can be paid a salary just as a business owner is paid a salary.
Limited Partners – Limited partners in a Family Limited Partnership are only responsible for management duties that the general manager assigns them. They also can be paid a salary. The limited partner is not responsible for the partnership’s liabilities, and the limited partners do not have any control over the partnership. All that control stays with the general partners. These limited partners are generally the youngest family members – typically children or grandchildren.
Percentage Ownership – The responsibility and control described above is NOT affected by the percentage each partner owns. In other words, if the general partner(s) own 2% of the partnership, they still control 100% of the partnership and, therefore, 100% of the business or investment real estate in the partnership.
The limited partners could own 98% of the partnership, but they still would NOT control the partnership, nor any of the business or investment real estate in the partnership.
Sharing Profits and Cashflow – The profits of the Family Limited Partnership (after salaries and other expenses) must be shared with all the partners in the same percentage as their ownership. In our example above, the general partner(s) would control 100% but would own 2% and therefore only be entitled to 2% of the profits; the limited partners would not control anything but would own 98% and therefore be entitled to 98% of the profits.
Remember, the general partner controls who fills different management roles and which family member is paid a salary. The general partner can take a substantial salary in keeping with his/her management role.
Cashflow distributions are discretionary. The general manager determines whether a distribution will be made. This is important – and goes to the heart of the benefits we mentioned – because the limited partners are entitled to a share of profits (and have to pay income taxes on them), but the limited partners are not entitled to cash if the general partner decides he or she isn’t going to make a distribution that year.
The partnership agreement allows the general partner to keep management control over the business or real estate and to keep control over cash flow.
Advantages of Family Limited Partnership
The unique ownership structure of Family Limited Partnerships is what allows this estate planning tool to provide such powerful benefits.
In this video, Greg Welborn gives a review of some of the complexities and benefits to Family Limited Partnerships.
Tax Reduction
The FLP reduces estate and gift taxes because partnership shares are not worth the same amount. In a general corporation, one share of stock has the same fair market value as another share of stock. In a Family Limited Partnership, the general partner shares are uniquely different than the limited partner shares. The general partner shares (even just 2% ownership) are more valuable than the limited partner shares.
Think about this logically. If I told you I own a company worth $1,000,000 and want to sell 98% of it to you, you’d be willing to pay me $980,000 (98% of one million dollars). But if I told you that those 98% shares do NOT let you vote for the board of directors, do not let you fire/hire the managers of the company, and do not entitle you to any dividends or distributions, you would not pay me $980,000. You might still want to own part of this company, but you’d pay me a lot less for those shares.
A good general rule of thumb is that you’d pay roughly 60%. In other words, there would be a 40% discount in value for those shares which do not give you any control. That discount can vary, but it is a good rule of thumb.
The IRS acknowledges this economic fact. That means if you gift your kids/grandkids 98% of the Family Limited Partnership in limited partner shares, the IRS will acknowledge that you’ve made a monetary gift of roughly $588,000 (a 40% discount on $980K).
Tax laws only allow you to give away a certain amount of your net worth before estate taxes are due. If you use a FLP, you can give away almost all of a $1 million business or investment property but only use up a small amount of your lifetime estate tax exemption.
This is known as valuation discounting, and it is very powerful. If used on larger businesses or real estate, the tax savings are huge.
Preventing Future Growth From Being Taxed
This is a pretty simple concept. Once you’ve gifted the limited partner shares, they are out of your estate. No matter how large the underlying business or real estate grows, it won’t be subject to estate tax or gift tax as long as it stays within the Family Limited Partnership. This benefit can be continued for future generations if the limited partner shares are gifted to trusts for your kids instead of to the kids directly, but that’s a topic for a different article.
To understand the power of this technique, let’s assume the business or real estate grows by 6% per year. In 24 years, the $1 million value will have grown to $4 million, but there will not be any estate or gift tax on that $3 million in growth.
Creditor and Divorce Protection
The sad reality is that many civil lawsuits and divorces are not settled on their merits but instead are settled on whose lawyer is the best poker player. It’s mostly a negotiating game. If your kids are seen as “deep-pockets” with lots of cash flow coming their way, the attorney suing them is going to go for the jugular and not be motivated to settle.
On the other hand, if your child’s attorney points out that a substantial portion of your child’s net worth is limited partnership shares offering no control, no rights to liquidate, no cashflow, but potentially a substantial tax liability, well, that other attorney is more motivated to settle quickly and for less money. In fact, if structured properly, FLP shares couldn’t even be included in your child’s or grandchild’s divorce case; they would be off-limits.
The Right Structure and Right Asset Are Critical
Family Limited Partnerships are powerful tools for high-net-worth families, but not all FLPs are created equal. The key is choosing the right asset or investment real estate to be owned by the partnership. You need to balance cash flow, earnings, future growth, potential future asset sales, and a number of other factors before deciding which assets to place into a FLP. You need to carefully consider what restrictions you want to place on the limited partners to maximize the tax and creditor protections.
It all starts with a well-crafted and personally tailored wealth and estate plan. Understanding where you are now, what you want retirement to look like, and how best to achieve that are all precursors to establishing a Family Limited Partnership. We highly recommend you engage the services of a 100% objective wealth advisor – someone who qualifies as a fiduciary and is legally bound to act in your best interests – to design your family’s plan and help you implement it.
