Question 32: What Is a Family Limited Partnership?
In the past few years, the Family Limited Partnership (FLP) has gained popularity as an asset protection, tax planning, and estate planning vehicle. A Family Limited Partnership is a partnership made up of family members. Typically, the parents are the general partners, controlling the partnership and making all decisions. The limited partners are often children or grandchildren who receive gifts of partnership interests.
In order to understand an FLP, it is best to first understand a General Partnership. A General Partnership is formed when two or more people intend to work together to carry on a business activity. No local or state filings are required to create this type of partnership. This is different than a corporation, which does not come into existence until Articles of Incorporation have been filed with the Secretary of State.
The distinguishing feature of a General Partnership is the unlimited liability of the partners. Each partner is personally liable for all of the debts of the partnership. That includes any debts incurred by any of the other partners on behalf of the partnership. Because each of the partners has unlimited personal liability, a General Partnership is the single most dangerous form for conducting one’s business. Not only is a partner liable for contracts entered into by other partners, each partner is also liable for the other partner’s negligence.
A General Partnership has potentially harsh consequences for each general partner. One way around the unlimited liability is a type of partnership known as a Limited Partnership. A Limited Partnership consists of one or more general partners and one or more limited partners. The same person can be both a general partner and a limited partner, as long as there are at least two legal persons who are partners in the partnership. The general partner is responsible for the management of the affairs of the partnership, and he has unlimited personal liability for all debts and obligations.
Limited partners have no personal liability. The limited partner stands to lose only the amount which he has contributed and any amounts which he has obligated himself to contribute under the terms of the partnership agreement. The Family Limited Partnership (FLP) is one such Limited Partnership.
Let’s now take a look at some of the advantages of using an FLP.
The Family Limited Partnership is an outstanding device for providing lawsuit protection for your family’s assets. Under the typical arrangement, the FLP is set up so that you and your spouse are each general partners. As such, you may own only a 1 or 2 percent interest in the partnership. The remaining interests are in the form of limited partnership interests. You, your spouse, or other family members will hold these interests, directly or indirectly.
After setting up the FLP, all family assets are transferred into it, including investments and business interests. When the transfers are complete, you and your spouse will no longer own a direct interest in these assets. Instead, you own a controlling interest in the FLP, and it is the FLP which owns the assets. As general partners, you have complete management and control over the affairs of the partnership and can buy or sell any assets you wish. You have the right to retain in the partnership proceeds from the sale of any partnership assets, or you can distribute these proceeds out to the partners.
Now, let’s see what happens if there is a lawsuit against either you or your spouse. Assume that you have a judgment against you for $1 million because someone was attacked by your pet dog. The plaintiff in the action is now a judgment creditor, and he will try to collect the $1 million from you.
The judgment creditor would like to seize your bank accounts and investments in order to collect the amount which he is owed. However, he discovers that you no longer hold title to any of these assets. In fact, since all of these assets have been transferred to the FLP, the only asset held by you is your interest in the FLP.
Can the creditor reach into the partnership and seize the investments and bank accounts? The answer is no. Under the provisions of the Uniform Limited Partnership Act, a creditor of a partner cannot reach into the partnership and take specific partnership assets. The creditor has no rights to any property that is held by the partnership. Since title to the assets is in the name of the partnership and it is you, rather than the partnership which is liable for the debt, partnership assets may not be taken to satisfy the judgment.
Since your only asset is an interest in the FLP, the creditor would apply to the court for a charging order against your partnership interest. A charging order means that the general partner is directed to pay over to the judgment creditor any distributions from the partnership which would otherwise go to you, until the judgment is paid in full. In other words, money which comes out of the partnership to you can be seized by the creditor until the amount of the judgment is satisfied.
Under the circumstances in which a creditor has obtained a charging order, the partnership would not make any distributions to you. This arrangement would be provided for in the partnership agreement and is permissible under partnership law. If the partnership does not make any distributions, the judgment creditor will not receive any payments. The partnership simply retains all of its funds and continues to invest and reinvest its cash without making any distributions.
The result of this technique is that family assets have been successfully protected from the judgment against you. Had the FLP arrangement not been used and had you and your spouse kept all of their assets in your own names, the judgment creditor would have seized everything. Instead, through the use of this technique, all of these assets were protected.
Income Tax Benefits
If family assets are held in the form of a Limited Partnership, it will be possible to obtain certain income tax savings in addition to the asset protection benefits. Tax savings can be realized by spreading income from your higher tax bracket to the lower tax bracket of children and grandchildren who are eighteen years or older.
Let’s assume for example, that you have taxable income of $200,000 from various investments and are in the 32 percent tax bracket. This means that you would be paying approximately $64,000 in taxes per year on this income if you leave these assets in your name.
Now let’s see what happens if we put these assets into an FLP.
The FLP will be established with your children and grandchildren (for the sake of this example, the assumption is that you have seven). Under the partnership agreement, the children and grandchildren were taxable on $100,000 of the $200,000 in income generated by the partnership. Each child was in a maximum tax bracket of 15 percent, and thus, the total taxes owed on this $100,000 of investment income was reduced from $32,000 to $15,000. This produced a savings of $17,000 in overall family income taxes.
Under the partnership agreement it was not required that the $100,000 actually be distributed to the children. In fact, you and your spouse, as general partners, retained all of this amount in the partnership except for what was needed to pay the taxes on the children’s share of partnership income. You thereby reduced their annual income taxes by shifting a substantial amount of income to your children.
Estate Tax Benefits
You can also use the Family Limited Partnership to reduce or even eliminate estate taxes. This estate tax reduction can be accomplished because of certain unique attributes of the FLP. Of primary importance is the ability to shift the value of assets out of your estate, through a program of gifting limited partnership interests to your children or other family members.
For example, let’s assume that you own a business with a current value of $5 million, a rental property with equity of $1 million and retirement savings in stocks and bonds equal to $1 million. That’s a total estate of $7 million. Under current law, with a properly designed estate plan, taking maximum advantage of the current exemption of $5.49 million, the estate tax on the balance of $1.51 million might be approximately $604,000 (40 percent in 2017).
One solution is to create an FLP to hold all family assets.
An FLP would be structured as follows:
- 1 percent managing general partners
- 1 percent administrative general partners
- 1 percent voting limited partners
- 97 percent non-voting limited partners
You and your spouse would be managing partners but not administrative partners of the FLP. In other words, you would have control of the day-to-day operations but not the power to dissolve the entity or make distributions to the partners. You would give the 1 percent administrative general partners and the 1 percent voting limited partners to your kids or an Irrevocable Trust for their benefit. By accepting these restrictions, you can get substantial discounts of the limited partnership interests that will be given to your children and even those interests retained in your estate. Discounts of over 30 percent are not uncommon.
As such you would have day-to-day management and control over your property in the FLP. Initially, you could make a gift of the limited partnership interests to your children in an amount equal in value to the combined maximum estate tax credit (currently $10.98 million). In subsequent years, you could gift limited partnership interests equal to the amount of the annual gift tax exclusion of $28,000 per child.
Under this approach, in roughly forty years, you would be able to eliminate potential estate taxes and could preserve $7 million of family wealth (plus much future appreciation).
The Family Limited Partnership offers a unique capability to realize a variety of planning goals.
- Assets held in the FLP are substantially shielded from potential claims.
- Income taxes can be shifted to lower bracket family members to take advantage of deferral and savings techniques.
- Estate taxes on accumulated wealth and future appreciation can be minimized or eliminated by gifting discounted interests in the FLP to children or Trusts established for their benefit.
The FLP can provide a convenient and flexible format as the cornerstone of your overall estate plan. To learn more about Family Limited Partnerships and whether they should be a part of your plan, consult with a qualified estate planning attorney.