What Is an FLP – Family Limited Partnership?
A Family Limited Partnership (FLP) is a type of business organization in which family members pool their money to manage a company enterprise. According to the specific partnership operating agreement, each family member purchases units or shares of the firm. As a result, each can benefit in proportion to the number of shares they possess.
An FLP can also be formed as a type of trust or holding company. Its purpose is to preserve a family’s commercial interests, real estate, publicly traded and privately held stocks, or other assets pooled by its members. The goal of forming such an entity is to achieve creditor protection and decrease gift and estate taxes while preserving control over the partnership’s assets management and distribution.
There are two kinds of partners in a Family Limited Partnership. General partners often hold the majority of the company. In turn, they are in charge of day-to-day management activities such as reviewing all cash deposits and investment transactions. If specified in the partnership agreement, the general partner may additionally deduct a management fee from earnings. Limited partners are not in charge of anything. Instead, they purchase stock in the company in return for dividends, interest, and profits generated by the FLP.
FLP – Family Limited Partnership Example
The nature of the business determines the type of FLP. Assume a person wants to establish a luxury apartment business. They anticipate that the project will cost $1 million, including working capital. The venture is projected to generate around $200,000 in cash each year before interest on mortgage payments and taxes. To start the project, a 50% down payment of $500,000 will be required. So a group of family members gathers and agrees to form an FLP. The FLP will issue 5,000 limited partnership shares at $100 each for a total of $500,000. According to the limited partnership agreement, shares cannot be sold for at least seven years. Also, the FLP will payout 70% of cash earnings in dividends.
The original individual who made the proposal buys 500 shares as the general partner by putting up $50,000. The remaining shares are purchased by other family members. Each family shareholder now has an interest in an FLP worth an initial $500,000. The general partner may then proceed to secure a first mortgage loan for the remaining $500,000 to begin the $1 million venture. The FLP quickly leases these units to renters and starts collecting rent. Profits and dividends are divided when the mortgage is paid off. Each family member benefits proportionately based on the initial shares purchased.
Regular Meetings, Taxes, and Distributions
FLPs are legitimate business agreements. As such, they must exhibit the characteristics of a business partnership. Otherwise, they risk being categorized as a gift to the children by the IRS. In compliance with the Internal Revenue Code, regular meetings must be conducted, written minutes must be made, and adequate remuneration must be provided to the general partner for their services to the partnership. A partnership is a pass-through entity, which means that LPs must pay taxes on their portion of the FLP’s revenue.
FLP – Advantages of a Family Limited Partnership
There are a number of advantages to using an FLP as an estate planning tool:
- Taxation – In addition to the yearly gift tax exception, any future profits earned by an asset placed in an FLP remain in the FLP. This is as opposed to being included in the parent’s estate. This implies that when the parent dies, the estate only includes the asset’s value at the moment it was put into the FLP. For example, an investment property valued at $1,000,000 at the time it was put into the FLP is included in the parent’s inheritance at that $1,000,000 valuation. Even if its value has doubled and climbed to $2,000,000 by the time the parent dies. Those who own a stake in the FLP will benefit from the remaining growth in value.
- Agreement – Because of the FLP structure, parents retain influence over the operation of the FLPs in their position as general partners. Further, they can construct the FLP agreement to contain any limits on the transfer of FLP interests. For example, regulating what happens if a child’s spouse also has limited partnership shares). Also, the agreement is susceptible to future revision or alteration. This means those general partners can amend the terms of the agreement on an ongoing basis. This allows them to respond to changes in the personal circumstances of family members.
- Limited partners and creditors – Children, spouses, and grandkids can own limited partnership interests in the FLP. As a result, creditors cannot seize these interests unless the general partners agree. These creditors are likewise not able to compel the FLP to pay any financial distributions. This means that, to some extent, asset protection can be granted to limited partners inside the family limited partnership. (Source: legalzoom.com)
FLP – Disadvantages of a Family Limited Partnership
However, in addition to the benefits, there are also a number of drawbacks to consider when using the FLP as an estate planning tool:
- General partner liability – The FLP must be conducted like a company. Therefore, general partners are exposed to any possible responsibility arising from the partnership. Furthermore, unlike those who have limited partnership shares, the FLP is nonetheless vulnerable to claims by the creditors of its general partners. Ultimately, an FLP (family limited partnership) is a company at its heart. Therefore, the general partners must be capable of running it as such.
- Complexity – Properly establishing an FLP is not an insignificant undertaking. The structure should be reviewed by a variety of specialists both during the setup process and on an ongoing basis. This should involve an estate planning attorney or a tax specialist. If real estate is involved, a property valuation expert can determine the worth of the property put into the FLP.
- Restriction on the types of assets – At its core, an FLP is a company and ongoing business. Personal assets transferred into an FLP can jeopardize the ability to use the yearly gift tax exception to transmit limited partnership shares to your heirs. As a result, an FLP is most useful if there are enough nonpersonal assets to transfer to the FLP, such as investment properties and securities. (Source: ibid)
Frequently Asked Questions
What is the benefit of an FLP family-limited partnership?
How is an FLP taxed?
FLPs, like other partnerships, are exempt from federal income tax. Instead, the income from an FLP is “passed through” to its partners, who pay tax at their individual rates. Enterprising families will frequently choose to leave large blocks of their fortune to their heirs while they are still living. They can do this by using an FLP. Further, by transferring property at a discount to its fair market value, they can avoid state estate and inheritance taxes totally while also extending their potential federal estate tax exemption.
To put that in perspective, as a result of the Tax Cuts and Jobs Act of 2018, an individual can pass along $11.18 million to their heirs and a married couple can pass along $22.36 million free and clear of federal estate taxes. Assets above those exemption limitations are subject to a 40% federal estate tax rate. Many states will impose an additional estate or inheritance tax as well. (Source: bnymellonwealth.com)
When would you use a family-limited partnership?
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