What Is a Family Limited Partnership?
A family limited partnership (FLP) is a specialized type of limited partnership designed for managing and transferring family wealth, falling primarily under the umbrella of Estate Planning. In an FLP, family members act as partners, typically with older generations serving as general partners who retain control over the assets and operations, while younger generations or other family members are limited partners with ownership interests but no management authority. This structure allows families to consolidate assets such as real estate, marketable securities, or businesses, aiming to achieve various financial and non-financial goals, including wealth preservation, asset protection, and tax efficiency. The formation of a family limited partnership involves a formal partnership agreement that outlines the rights and responsibilities of each partner and the operational guidelines of the entity.
History and Origin
The concept of the limited partnership, from which the family limited partnership evolved, has roots in 19th-century English law, designed to encourage investment by offering a way for individuals to put capital into a business without assuming the full personal liability of a general partner. In the United States, limited partnerships gained legal recognition and became a staple for certain business structures. The emergence of the family limited partnership as a prominent estate planning tool, however, is a more modern development, largely driven by strategies to mitigate estate and gift tax liabilities. Practitioners began leveraging the inherent characteristics of limited partnership interests—specifically their lack of control and marketability—to justify significant valuation discounts for gift and estate tax purposes. These strategies became increasingly popular by the early 1990s, prompting increased scrutiny and challenges from the Internal Revenue Service (IRS).
##6 Key Takeaways
- A family limited partnership is an estate planning vehicle used to manage and transfer family assets across generations.
- It typically involves general partners (often older generations) who maintain control, and limited partners (often younger generations) who hold ownership interests.
- Key benefits can include asset protection, centralized management, and potential for valuation discounts for gift and estate tax purposes.
- The IRS often scrutinizes family limited partnerships, particularly concerning the legitimacy of valuation discounts and the primary purpose of the entity.
- Proper formation and ongoing adherence to legal and operational formalities are critical for an FLP to withstand challenges.
Interpreting the Family Limited Partnership
The effectiveness and interpretation of a family limited partnership hinge on its underlying purposes and strict adherence to legal formalities. Beyond potential tax benefits, an FLP is viewed as a mechanism for centralized asset management and facilitating succession planning within a family. For the entity to be recognized as legitimate by tax authorities and courts, it should ideally have substantial non-tax purposes, such as consolidating fragmented family assets, providing a framework for family governance over investments, or protecting assets from future creditors. The structure offers continuity of management, as the general partner retains decision-making authority, potentially safeguarding assets from the inexperience of younger generations or adverse personal situations affecting limited partners.
Hypothetical Example
Consider the Lopez family, with parents Maria and Javier, who own a successful real estate portfolio valued at $10 million. They have three children who are interested in inheriting the family wealth. Concerned about potential estate taxes and ensuring their children maintain a unified approach to the properties, Maria and Javier decide to establish a family limited partnership, "Lopez Family Holdings, LP."
Maria and Javier contribute their entire real estate portfolio to the FLP. In exchange, they receive a 1% general partnership interest and a 99% limited partnership interest. The general partnership interest grants them full control over managing the properties, making investment decisions, and distributing income. Over several years, they begin gifting portions of their 99% limited partnership interest to their three children.
For example, each year, they might gift a percentage of the limited partnership interest to each child, taking advantage of the annual gift tax exclusion. Because the limited partnership interests represent non-controlling, illiquid shares in a private business entity, they may qualify for valuation discounts for gift tax purposes. This means the taxable value of the gift is less than a pro-rata share of the underlying assets' fair market value, potentially allowing Maria and Javier to transfer more wealth over time without incurring substantial gift tax liability. The children become limited partners, owning a share of the family wealth, but Maria and Javier retain control as general partners.
Practical Applications
Family limited partnerships are primarily applied in sophisticated wealth transfer and asset protection strategies for affluent families. They are commonly used to:
- Facilitate Gifting Programs: By allowing the transfer of discounted interests over time, FLPs can enable parents to gift significant wealth to their children or grandchildren within the annual gift tax exclusion or utilizing lifetime exemptions, reducing the size of their taxable estate.
- Centralize Asset Management: An FLP provides a formal structure for managing family assets, ensuring continuity and consistency in investment decisions across generations, regardless of the individual limited partners' financial sophistication.
- Protect Assets: FLPs can offer a degree of creditor protection. Because a limited partner's interest is not typically easily transferable or subject to direct seizure, creditors may only be able to obtain a "charging order," which gives them the right to any distributions made to that partner, rather than direct access to the underlying assets of the partnership.
- 5 Estate Tax Reduction: The ability to apply valuation discounts (due to lack of control and marketability) to transferred interests can significantly reduce the taxable value of assets for estate tax purposes upon the death of the general partner. The IRS compiles data on the impact of FLPs on estate tax returns, including the reported valuation discounts.
- 4 Promote Family Governance: The partnership agreement can establish rules for how the family's assets are managed, how disputes are resolved, and how future generations will be involved, promoting a structured approach to family wealth.
Limitations and Criticisms
Despite their potential benefits, family limited partnerships come with significant limitations and are often subject to scrutiny, particularly from the IRS. A primary criticism is that some FLPs are perceived to be created primarily, or solely, for the purpose of avoiding estate taxes rather than for legitimate business or financial reasons. If the IRS successfully argues that an FLP lacks a genuine business purpose or that formalities were not properly observed (e.g., commingling personal and partnership assets, using partnership funds for personal expenses), it may disallow valuation discounts and include the full value of the transferred assets back into the gross estate under Internal Revenue Code Section 2036.,
A3n2other limitation is the cost and complexity involved. Establishing and maintaining an FLP requires significant legal and accounting fees, as well as ongoing administrative effort to ensure compliance with the partnership agreement and tax laws. Poorly managed FLPs can lead to severe tax implications and family disputes. The effectiveness of valuation discounts is also a frequent point of contention, with courts often disagreeing on appropriate discount percentages. The legal landscape surrounding FLPs is continuously evolving, with court cases and proposed legislative changes creating uncertainty about their long-term viability as a primary estate tax reduction tool. Add1itionally, general partners bear unlimited personal liability, and all partners have a fiduciary duty to the partnership and other partners.
Family Limited Partnership vs. Limited Liability Company (LLC)
While both a family limited partnership (FLP) and a Limited Liability Company (LLC) are popular business entities used in estate planning and asset protection, they have distinct characteristics.
| Feature | Family Limited Partnership (FLP) | Limited Liability Company (LLC) |
|---|---|---|
| Structure | Requires at least one general partner (unlimited liability, control) and one or more limited partners (limited liability, no control). | Can be structured with members or managers. Members can manage or delegate management to managers. |
| Liability | Limited partners have limited liability; general partners have unlimited personal liability. | All members (owners) generally have limited liability, akin to shareholders of a corporation. |
| Control | Concentrated with the general partner(s), often the older generation. | Can be flexible: member-managed (all owners participate) or manager-managed (appointed managers control). |
| Formalities | More stringent, often requiring strict adherence to partnership formalities to avoid IRS challenges. | Generally fewer ongoing formalities compared to a partnership or corporation, but still requires adherence. |
| Flexibility | Less flexible in structure due to general/limited partner distinction. | Highly flexible in terms of management structure and allocation of profits/losses. |
| Primary Use | Historically favored for multi-generational wealth transfer and specific valuation discounts. | Versatile for various businesses, real estate holdings, and general asset protection. |
Confusion often arises because both structures offer pass-through taxation (avoiding corporate double taxation) and can provide some level of asset protection. However, the FLP's rigid general partner/limited partner structure is specifically designed to create the lack-of-control and lack-of-marketability characteristics essential for certain valuation discount strategies in estate tax planning. LLCs, while also able to achieve some discounts, are generally more flexible and commonly used for active businesses or holding a broader range of assets without the explicit distinction in liability roles found in a traditional limited partnership.
FAQs
What assets can be placed into a family limited partnership?
Almost any type of asset can be placed into a family limited partnership, including real estate, marketable securities (stocks, bonds), closely held business interests, and other investment assets. The choice of assets can impact the potential for business valuation discounts and the partnership's overall management.
Can a family limited partnership protect assets from creditors?
Yes, a family limited partnership can provide a degree of asset protection. Generally, a creditor of a limited partner cannot directly seize the partnership's assets. Instead, the creditor's remedy is typically a "charging order," which only grants them the right to receive distributions that would otherwise go to the debtor-partner. This makes the partnership interest less attractive to creditors and may encourage settlement.
Is an FLP subject to probate?
Assets held within a family limited partnership are generally not subject to probate upon the death of a partner, particularly for limited partnership interests. This is because the assets are owned by the partnership entity itself, and the partnership interest typically passes according to the terms of the partnership agreement, avoiding the public and often lengthy probate process. The value of the partnership interest, however, will still be included in the deceased partner's estate for estate tax purposes.
Are there ongoing costs associated with an FLP?
Yes, there are ongoing costs associated with a family limited partnership beyond the initial setup fees. These can include annual state filing fees, legal expenses for maintaining the partnership agreement and ensuring compliance, and accounting fees for preparing annual tax returns (partnerships typically file Form 1065, U.S. Return of Partnership Income). Proper record-keeping and adherence to formalities are crucial to maintain the FLP's integrity, especially against potential IRS challenges.
Can I dissolve a family limited partnership?
A family limited partnership can be dissolved, typically as outlined in its partnership agreement or by state law. Dissolution usually involves winding up the partnership's affairs, liquidating its assets, paying off liabilities, and distributing any remaining proceeds to the partners according to their interests. The process can be complex and may have significant tax implications, making professional guidance advisable.