What They Are

Recently, family limited partnerships (FLPs) have received considerable publicity. Some promoters are touting FLPs as the ultimate asset protection and estate planning solution. While they may not live up to that billing, FLPs are often an effective tool for addressing client asset protection and estate planning concerns.

This chapter explains how FLPs work, summarizes their advantages and disadvantages, and discusses the issues that should be addressed when an FLP is formed and funded, including the types of assets that are suitable for an FLP. It also covers the income and estate tax savings and asset protection benefits that FLPs can provide.

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) repeals the estate and generation-skipping transfer taxes effective for decedents dying after December 31, 2009. Prior to repeal, EGTRRA provides for a gradual increase in the applicable exclusion amount for estate tax purposes from $675,000 in 2001 to a maximum of $3.5 million. (The GST exemption remains at $1,000,000, adjusted for inflation, until 2004 when it becomes the same as the estate tax applicable exclusion amount.)

 In general, a family partnership is a noncorporate entity created by transferring property from one or more individuals to the entity for the common economic benefit of family members. Family members include spouses, ancestors and lineal descendants, and any trusts established for the benefit of those persons.

In the typical situation, senior family members (parents) transfer assets to an FLP in exchange for partnership interests. This initial capitalization of the partnership is typically a tax-free event (IRC Sec. 721). Partnership interests are then gifted or sold to junior family members (children), or to trusts established for the children’s benefit, during the parents’ lifetimes.

In the authors’ opinion, an FLP generally should not be considered for families who would be able to contribute less than $2–$5 million to the FLP. Estate planning techniques such as using the gift and estate tax exemption amounts, annual exclusion gifts, irrevocable life insurance trusts, and possibly split-interest trusts should be used before considering an FLP. Additionally, the client’s goals and preferences (which are not always compatible) must be thoroughly analyzed before any planning technique is recommended. The IRS often scrutinizes FLPs. For example, the valuation discounts that are usually an important reason for using an FLP can be contested. Conservative clients who want no chance of controversy would not be good candidates for an FLP.

Since a general partner is liable for the partnership’s debts, some form of liability protection for the general partner is often desirable. When this is the case, the general partner can be structured as a corporation (S or C) or an LLC. To avoid double taxation on the partnership income, the general partner should be an S corporation or LLC. When liability issues are less of a concern (which would be rare), outright ownership of the general partnership interests by individual family members (usually the parents) is preferable from an administrative (and cost) standpoint.

General partners assume management responsibility for the assets and operations of the enterprise, including control over distributions to partners. The general partners are usually senior generation family members, who, by virtue of being general partners, can retain control over family assets while retaining only a small ownership interest (as little as a one percent general partner interest in the FLP).

Limited partners who are not also general partners are not liable for the liabilities of the partnership beyond their investment (and possibly any additional capital contributions called for in the partnership agreement). Therefore, partnership creditors cannot reach the personal assets of a limited partner to satisfy the partnership’s debts. This is the same kind of protection available to corporate shareholders. In addition, the limited partnership’s assets are not subject to claims of creditors of individual limited partners.

Limited partners may not participate in the management or control of the business, except to the extent allowed by the partnership agreement. Limited partners are typically allowed to consult with or advise general partners, act as agents or employees of the partnership (but not in a managerial capacity), and vote in certain matters. However, if a limited partner “crosses the line” and participates in partnership management, that partner’s liability protection under state law may be lost.

Most FLP agreements prohibit limited partners from (1) withdrawing from the partnership without the consent of all other partners and (2) transferring their interests to outsiders without offering existing partners an opportunity to purchase the interests. The lack of free transferability is one of the most significant features of the limited partnership form of business and distinguishes it from the direct ownership of assets (and from corporate ownership). Absent such a restriction in the partnership agreement or state law, a withdrawing partner will be entitled to receive “fair value” for the interest. Thus, it will be advisable to limit a limited partner’s ability to withdraw if valuation discounts are to be maximized.

Observation: The Section 704(e) family partnership rules require the transfer of FLP interests to be “real” and for donees to acquire dominion and control over the interests. If limitations on the right to transfer or liquidate a limited partner’s interest are too restrictive compared to the rights ordinarily exercisable by unrelated limited partners in normal business relationships, the donee’s interest will not be recognized for income tax purposes.

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