A family limited partnership can offer numerous tangible benefits to business owners.
As a framework for business ownership, a family limited partnership (FLP) can help provide many tangible benefits. It may allow you to maintain substantial control over your company's day-to-day activities for as long as you wish. It may also give you influence over executive succession planning and the eventual disposition of the company, regardless of whether you are directly involved in the subsequent decision-making processes. At the same time, an FLP can give you significant opportunities for tax management, as it offers the potential to discount the value of shares in your company for estate and gift tax purposes.
What is an FLP?
An FLP is a form of corporate ownership for privately-held businesses in which one stockholder, or sometimes a small handful, serve as general partners who exercise management control over the business. The remaining stockholders—the limited partners—are restricted to passive roles in actual operations, and generally cannot sell their shares without general-partner approval. FLP ownership structures may be implemented for virtually any kind of business activity, including retail, wholesale, manufacturing or service organizations, commercial-scale farming, timber and mineral leasing, and investment real estate, among others.
The distinction between general partners and limited partners is critical to reducing the taxable value of your company in your estate. Here is how it might work.
Assume that you create equal shares in your firm—one for you as general partner, and one for each of your heirs as limited partners. If these partnership interests were like ordinary stock, they would all have equal value. In the FLP structure, however, general-partner interests have more direct power over corporate affairs than limited interests, even if both receive the same dividend. This imbalance makes the limited interests worth significantly less. As a result, limited interests can be substantially discounted in estate and gift tax calculations. In fact, the total discount may approach up to 50 percent of your business' net asset value. These discounts may effectively increase the amount of limited interest that can be conveyed to heirs without gift tax exposure under the applicable unified exclusion. One other point to keep in mind: individuals' FLP interests can be weighted in the proper circumstances to give each partner a different portion of any income and capital gains.
The person who creates the partnership generally sets the functional parameters of the partnership agreement. Typically included in that document are the rules for selling or cashing out of any partnership interest. Also included are the procedures for replacing the general partner if necessary and the preconditions needed to allow restructuring of the partnership.
An FLP structure may create a liability shield similar to a corporate ownership structure. In general, financial claims against the underlying business cannot be collected from the partners' personal assets. In addition, any liability claim against a partner personally cannot normally be extended to the business itself, although creditors can typically seize that partner's share of any distributions or dividends. In some states, assets in an FLP may be insulated from claims in divorce proceedings.
Considerations for Creating and Managing an FLP
The most effective FLPs tend to be those created with valid business reasons—that is, with reasons other than simple tax management in mind. Such reasons may include a desire to set a framework for corporate governance and unified administration of assets and a need to manage environmental, business and personal liability exposure. In addition, if you own significant property in another state, an FLP may eliminate the need for probate in that state, as well as your home state. More information in this regard should be sought from a legal and tax professional.
Experts often remind partners in FLPs that their partnership should operate just as any other business corporation would; otherwise, the partners could lose access to many of the tax and estate planning benefits that made the structure attractive in the first place. For example, the partners in an FLP should maintain a clear paper trail showing that they carried out all of the duties agreed to in the partnership's founding agreement, which is essentially the equivalent of a corporate charter and bylaws. Among useful records are detailed minutes of partnership meetings and receipts that might indicate when and where those meetings were held.
Putting appropriate financial management and control measures in place may prove to be vital to the viability of the FLP. For example, the FLP should have its own bank accounts to manage all income and expenditures related to its assets. And of course, while cash belonging to the partnership can be distributed, those distributions should be in the same proportions as the partnership interests. The IRS has challenged some FLPs and won by proving that their general partners received excessive distributions, arguing that the one-sidedness showed there had been no genuine transfer out of the estate. As with other business structures, an FLP should not be used to directly fund personal expenditures of any sort.
Implementing an FLP in the context of a business succession plan involves complex trade-offs and can incur substantial costs. The advantages of discounted giving and the potential for channeling effective control can yield value for both your family and your estate. iBi
Cathy S. Butler, CFP, CRPC is a financial advisor with the Butler/Luthy Group of Morgan Stanley. For more information, visit www.morganstanleyfa.com/thebutlerluthygroup.