Family limited partnership flp: Meaning, Criticisms & Real-World Uses

What Is a Family Limited Partnership (FLP)?

A Family Limited Partnership (FLP) is a legal entity commonly used in Estate Planning that allows individuals to transfer assets to family members while retaining some control over those assets. It falls under the broader financial category of Wealth Management and is primarily structured as a limited partnership. In an FLP, there are typically two types of partners: at least one General Partner and one or more Limited Partners. The general partner, often the older family member who establishes the FLP, maintains management control over the partnership's assets. Limited partners, usually younger family members, hold ownership interests but have no active role in management. This structure allows for the centralized management of family assets and can facilitate the transfer of wealth across generations.

History and Origin

The concept of the limited partnership, upon which the Family Limited Partnership is based, has historical roots in various forms of business associations designed to limit liability for certain investors while allowing others to manage the enterprise. In the United States, limited partnerships gained legal recognition to encourage investment by individuals who wished to provide capital without incurring unlimited personal liability. The formalization of these structures paved the way for their adaptation into Estate Planning tools.

Over the past few decades, Family Limited Partnerships emerged as a popular strategy for high-net-worth families to transfer assets and potentially reduce future estate taxes. Estate planners widely adopted FLPs to help clients transfer wealth within families, allowing assets to pass at reduced gift and estate tax values. The Internal Revenue Service (IRS) scrutinizes FLPs, requiring them to have a legitimate business purpose beyond solely reducing tax liability to be considered valid.⁴

Key Takeaways

A Family Limited Partnership (FLP) is a partnership structure used for transferring family assets and wealth management.
It typically involves a general partner with management control and limited partners who are passive investors.
FLPs can offer benefits such as asset protection, consolidated management, and potential reductions in gift and estate taxes.
The valuation of interests in an FLP can be subject to discounts for lack of marketability and lack of control.
Proper legal and tax advice is essential for establishing and maintaining a compliant and effective FLP.

Interpreting the Family Limited Partnership

A Family Limited Partnership is interpreted primarily as a vehicle for structured asset ownership and intergenerational wealth transfer within a family. The general partner's retention of control over the underlying assets, even as ownership interests are transferred, is a key characteristic. Limited partners, while owning a share of the partnership, do not typically participate in the day-to-day management or decision-making. This separation of control from beneficial ownership is central to understanding the FLP's application.

The value of the interests gifted to Beneficiaries is often subject to certain Valuation Discounts. These discounts arise because the limited partnership interests are typically illiquid (lack of marketability) and do not convey control over the partnership's assets (lack of control). These factors can reduce the taxable value of the transferred interests for Gift Tax and Estate Tax purposes.

Hypothetical Example

Consider the case of the Sterling family. John and Jane Sterling, both in their 70s, own a substantial portfolio of investment properties and marketable securities valued at $20 million. Their goal is to transfer this wealth to their three adult children while maintaining control during their lifetime and potentially reducing future estate tax liabilities.

They decide to establish a Family Limited Partnership, the "Sterling Family Holdings FLP." John and Jane contribute all their investment properties and securities to the FLP in exchange for a 1% general partnership interest and a 99% limited partnership interest. As general partners, they retain full management control over the properties and investments.

Over the next few years, John and Jane begin to gift portions of their 99% limited partnership interest to their children, utilizing their annual gift tax exclusions. For example, they might gift 5% of the limited partnership interest to each child annually. Because these interests represent non-controlling, illiquid shares of a private entity, they can be valued at a discount compared to the pro-rata value of the underlying assets. This allows John and Jane to transfer more economic value to their children over time, potentially consuming less of their lifetime gift tax exemption. The partnership continues to manage the assets, and any income or losses are passed through to the partners for tax purposes, avoiding double taxation inherent in some other business structures, due to Pass-Through Taxation.

Practical Applications

Family Limited Partnerships are primarily used in sophisticated Estate Planning and Asset Protection strategies. Their applications include:

Wealth Transfer: Facilitating the transfer of wealth to future generations while potentially reducing Gift Tax and Estate Tax liabilities through valuation discounts.
Asset Management: Centralizing the management of family assets, such as real estate, investment portfolios, or closely held businesses, under the control of the general partner. This can ensure continuity and professional management across generations.
Asset Protection: Shielding assets from potential creditors, lawsuits, or divorce claims against individual family members, as the assets are held within the partnership structure rather than directly by the individual.
Education and Philanthropy: Providing a structured vehicle for family members to learn about managing wealth or to coordinate philanthropic endeavors.

When an individual passes away, the value of their estate may be subject to federal estate tax. The executor of the estate typically uses IRS Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return, to report the estate's assets and determine any tax liabilities.³ Interests held in a Family Limited Partnership are part of the decedent's estate for valuation purposes on this form.

Limitations and Criticisms

While Family Limited Partnerships offer significant advantages, they also come with limitations and criticisms:

IRS Scrutiny: The IRS heavily scrutinizes FLPs, particularly if their primary purpose appears to be solely tax avoidance. To be considered legitimate, an FLP must have a valid business or non-tax purpose, such as consolidated asset management or protection from creditors.² Failure to demonstrate this can lead to the IRS disallowing valuation discounts or including the transferred assets back into the decedent's taxable estate.
Cost and Complexity: Establishing and maintaining an FLP involves legal and accounting fees, including drafting a comprehensive Partnership Agreement and ongoing compliance.
Loss of Liquidity: Assets contributed to an FLP become less Liquidity for the limited partners, as their interests are not easily transferable or marketable like publicly traded securities.
Control vs. Gifting: While the general partner retains control, the gifts of limited partnership interests must be true gifts. Any appearance that the donor still retains too much beneficial enjoyment or control over the gifted assets can trigger adverse tax consequences under Internal Revenue Code Section 2036.
Evolving Tax Laws and Case Law: The effectiveness of FLPs as an estate tax planning tool has been subject to changes in tax laws and numerous court cases. Some experts suggest that recent developments in case law and proposed legal changes indicate a bleaker future for FLPs as a primary estate tax planning tool, potentially leading estate planners to shift away from their reliance on such entities.¹

Family Limited Partnership (FLP) vs. Limited Liability Company (LLC)

While both Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs) are popular structures for holding family assets and facilitating wealth transfer, they have distinct differences.

A Limited Partnership (LP), and by extension an FLP, requires at least one general partner with unlimited personal liability and one or more limited partners with liability limited to their capital contribution. The general partner manages the entity, while limited partners are passive investors. An FLP is specifically designed with family members as partners and is often used with a focus on estate and gift tax planning, aiming for valuation discounts.

In contrast, a Limited Liability Company (LLC) offers limited liability to all its members, meaning no member is typically personally liable for the company's debts or obligations beyond their investment. LLCs offer more flexibility in management structure; they can be managed by all members or by appointed managers. While an LLC can also be used for asset protection and wealth transfer within a family, its primary advantage is often the universal limited liability and operational flexibility it provides. LLCs are not typically associated with the same aggressive valuation discounts sought with FLPs, although some discounts may apply. Choosing between an FLP and an LLC depends heavily on the specific goals, desired level of control, liability concerns, and tax planning objectives of the family.

FAQs

What assets can be put into a Family Limited Partnership?

A wide range of assets can be contributed to a Family Limited Partnership, including real estate, marketable securities, closely held business interests, and other investment assets. The choice of assets depends on the family's overall Wealth Management strategy and the specific goals for the FLP.

How does an FLP help with estate taxes?

An FLP can potentially help reduce Estate Tax by allowing the general partner to gift limited partnership interests to family members over time. Because these interests are typically illiquid and non-controlling, they may be valued at a discount compared to the pro-rata value of the underlying assets. This can reduce the taxable value of the gifts and, subsequently, the taxable estate.

Can the general partner maintain control over assets in an FLP?

Yes, one of the primary features of a Family Limited Partnership is that the general partner retains full management and control over the assets held within the partnership. This allows the older generation to guide investment decisions and manage the assets even as ownership interests are transferred to younger family members. This control can be an important aspect of a comprehensive Trust and estate plan.

Are there risks involved with setting up an FLP?

Yes, there are risks. The primary risk is that the IRS may challenge the legitimacy of the Family Limited Partnership if it does not have a demonstrable non-tax business purpose or if the general partner is deemed to have retained too much beneficial enjoyment of the gifted assets. This can lead to the disallowance of Valuation Discounts and inclusion of the assets back into the taxable estate, negating the intended tax benefits. Complex legal and accounting advice is crucial to mitigate these risks.