Objectives
A family limited partnership (“FLP”) is a limited partnership in which members of the same family hold interests. An FLP offers advantages in asset protection, income tax reduction and estate planning.
Introduction
The FLP is a major asset protection and estate planning tool in the United States, and is a preferred vehicle for holding and managing family wealth. Use of FLPs can substantially reduce the value of property to both judgment creditors and the IRS. In addition, these partnerships can be used to shift income to family members which enables the family members to benefit from the owner income tax brackets that apply when a number of parties hold partnership interests.
A family limited partnership is managed by at least one general partner which can be a person or a corporate entity. In addition to the general partner(s), there are several limited (or silent) partners.
Advantages of the Family Limited Partnership
Litigation Protection
An FLP is an excellent tool for providing protection of family assets against litigation. By transferring assets into an FLP, an individual no longer owns a direct interest in these assets. Rather he only has an interest in the FLP, although he may have control of the FLP as the president of the General Partner entity. The general partner has management authority over the affairs of the partnership and can buy or sell any of the assets, retain in the partnership any proceeds from such asset sales, or distribute the proceeds out to the partners.
Generally, a limited partnership cannot be dissolved if a limited partner or the general partner is sued, and limited partnership statutes provide protection for the partnership assets from the creditors of the sued partner. The FLP litigation protection advantages are:
A family limited partnership is managed by at least one general partner which can be a person or a corporate entity. In addition to the general partner(s), there are several limited (or silent) partners.
Advantages of the Family Limited Partnership
Litigation Protection
An FLP is an excellent tool for providing protection of family assets against litigation. By transferring assets into an FLP, an individual no longer owns a direct interest in these assets. Rather he only has an interest in the FLP, although he may have control of the FLP as the president of the General Partner entity. The general partner has management authority over the affairs of the partnership and can buy or sell any of the assets, retain in the partnership any proceeds from such asset sales, or distribute the proceeds out to the partners.
Generally, a limited partnership cannot be dissolved if a limited partner or the general partner is sued, and limited partnership statutes provide protection for the partnership assets from the creditors of the sued partner. The FLP litigation protection advantages are:
- They protect their own assets from personal judgement creditors. Partnership law provides creditors with only a charging order.
- Creditors cannot seize any assets of the FLP unless they are creditors of the FLP itself and the source of the lawsuit comes from an action or activity of the FLP. In that situation all assets of that FLP are vulnerable.
- Creditors cannot remove a general partner of the FLP, so the general partner continues to control all FLP assets.
- Creditors have no management powers or vote in the FLP.
- Creditors cannot demand income from the FLP. They receive income only if distributed.
The Charging Order
A charging order is generally the only remedy available to creditors attempting to realize any value from a partnership interest owned by a debtor. It is also one of the factors that renders a limited partnership interest less valuable to creditors as it often is cumbersome and has adverse income tax aspects. This is because although the holder of a charging order is treated as an assignee entitled to partnership distributions under state law, the holder is treated as a partner for income tax purposes. The result is that a creditor obtaining a charging order will be taxed on the income attributable to the partnership interest, regardless of whether he receives any distributions. Thus, he will be taxed on income without the corresponding cash with which to pay the tax. Consequently, the income tax consequences of a charging order imbues the partnership interest with a negative value and may prove to be a substantial inducement for creditors to settle their claims.
Finally, under the operating agreement, the General Partner may have the right to redeem the right of any partner whose interest is subject to a charging order.
A creditor judgement against a particular partner cannot force a liquidation of the FLP (unless he is a creditor of the FLP itself), and cannot unwind the partnership and force a sale of the assets. The judgement creditor who holds the charging order does not become the owner of the interest or a substituted limited partner. He is merely an assignee of the income interest held by the judgement debtor. Also, the creditor cannot remove a general partner. Nor can he vote or manage the affairs of the limited partnership. The general partner continues to maintain control of the assets within the FLP.
The charging order is available only against a partner’s individual creditors and a limited partnership does not protect the FLP assets against the creditors of the FLP itself. If the partnership has liability or a judgement, the charging order provides no protection for the assets in the FLP. Creditors with a charging order are entitled to the assets held by the FLP.
Finally, under the operating agreement, the General Partner may have the right to redeem the right of any partner whose interest is subject to a charging order.
A creditor judgement against a particular partner cannot force a liquidation of the FLP (unless he is a creditor of the FLP itself), and cannot unwind the partnership and force a sale of the assets. The judgement creditor who holds the charging order does not become the owner of the interest or a substituted limited partner. He is merely an assignee of the income interest held by the judgement debtor. Also, the creditor cannot remove a general partner. Nor can he vote or manage the affairs of the limited partnership. The general partner continues to maintain control of the assets within the FLP.
The charging order is available only against a partner’s individual creditors and a limited partnership does not protect the FLP assets against the creditors of the FLP itself. If the partnership has liability or a judgement, the charging order provides no protection for the assets in the FLP. Creditors with a charging order are entitled to the assets held by the FLP.
Income From the FLP
The General Partner corporation can pay you, as well as other family members, a salary for managing the partnership assets. The payment of management fees is generally the main method of distributing income from the FLP to family members. If family members are appointed to be officers or employees of the General Partner corporation, they will be paid salaries for their services. This allows for income distribution to lower tax-bracket family members. Other additional means of compensation, which are also advantageous from a tax-minimizing point of view, include medical, health, accident, and disability insurance; cafeteria benefit plans; pension, profit sharing, and 401(K) plans; and certain retirement benefit and contribution/split-dollar life insurance plans (such as a CEFIRP).
There are also several other ways to derive income from the FLP which include:
1.Distributions. The General Partner can make a distribution of income or assets to the partners in proportion to their partnership interests.
2.Draws against capital. With the consent of the General Partner, a Limited Partner can draw against their specific capital account. “Special allocations” can also be made occasionally, provided the meet certain criteria and have “substantial economic effect.”
3.Loans. Under the discretion of the General Partner, the FLP can make loans to the Limited Partners or even certain third parties.
Liquidation. Upon liquidation, income and assets are distributed to the partners on a pro rata basis.
There are also several other ways to derive income from the FLP which include:
1.Distributions. The General Partner can make a distribution of income or assets to the partners in proportion to their partnership interests.
2.Draws against capital. With the consent of the General Partner, a Limited Partner can draw against their specific capital account. “Special allocations” can also be made occasionally, provided the meet certain criteria and have “substantial economic effect.”
3.Loans. Under the discretion of the General Partner, the FLP can make loans to the Limited Partners or even certain third parties.
Liquidation. Upon liquidation, income and assets are distributed to the partners on a pro rata basis.
Income Tax and Estate Planning Protection
Unlike corporations and irrevocable trusts, a partnership is not a taxpaying entity. A partnership files an annual information tax return setting forth its income and expenses, but it doesn’t pay taxes on its net income. Instead, each partner’s proportionate share of income or loss is passed through from the partnership to the individual or entity. Each partner then claims their share of deductions or reports their share of income on their own tax return.
Since the partnership is a “pass-through” entity, there is no potential for double taxation as with a C-Corporation. Typically, when a business is expected to show a net loss rather than a gain, the partnership format is used so that losses can be used by the partners. Although the Tax Reform Act of 1986 now limits the ability to immediately deduct losses from “passive entities” to offset wages or investment income, the partnership format is still desirable if the circumstances of the partner are such that they can take advantage of these losses. In general, however, transfers of property into and out of a partnership ordinarily will not produce any tax consequences.
Since a partnership can be totally managed by a parent controlling the General Partner entity may hold a mere 1% interest in the FLP. The other 99% of the FLP interests could be held by other interests such as spouses, children, etc. as limited partners, Thus, up to ninety-nine percent of partnership income can be taxed to lower-income taxpayers, and 99% of the value of the partnership assets can be out of the parents’ estate for estate tax purposes. In addition, the parents can control all FLP principal and income for the duration of their lives without interference from the limited partners, and can reduce the risk to FLP assets from potential problems the limited partners may have (divorce, bankruptcy, IRS difficulties, auto accidents, etc.). Also, a limited partner’s risk is “limited” to the value of that partner’s partnership interest.
As we discussed in the previous section, partnerships provide one of the safest ways to involve children in the parents’ estate planning. They can also provide an effective means of getting assets to heirs at a discounted value. There are several techniques that can be used with the FLP to take full advantage of federal estate and gift tax reduction. The two most important are: (1) discounting of the children’s limited partnership interests; and (2) systematic annual gifting of $10,000 worth of interest in the limited partnership to the children.
Since the partnership is a “pass-through” entity, there is no potential for double taxation as with a C-Corporation. Typically, when a business is expected to show a net loss rather than a gain, the partnership format is used so that losses can be used by the partners. Although the Tax Reform Act of 1986 now limits the ability to immediately deduct losses from “passive entities” to offset wages or investment income, the partnership format is still desirable if the circumstances of the partner are such that they can take advantage of these losses. In general, however, transfers of property into and out of a partnership ordinarily will not produce any tax consequences.
Since a partnership can be totally managed by a parent controlling the General Partner entity may hold a mere 1% interest in the FLP. The other 99% of the FLP interests could be held by other interests such as spouses, children, etc. as limited partners, Thus, up to ninety-nine percent of partnership income can be taxed to lower-income taxpayers, and 99% of the value of the partnership assets can be out of the parents’ estate for estate tax purposes. In addition, the parents can control all FLP principal and income for the duration of their lives without interference from the limited partners, and can reduce the risk to FLP assets from potential problems the limited partners may have (divorce, bankruptcy, IRS difficulties, auto accidents, etc.). Also, a limited partner’s risk is “limited” to the value of that partner’s partnership interest.
As we discussed in the previous section, partnerships provide one of the safest ways to involve children in the parents’ estate planning. They can also provide an effective means of getting assets to heirs at a discounted value. There are several techniques that can be used with the FLP to take full advantage of federal estate and gift tax reduction. The two most important are: (1) discounting of the children’s limited partnership interests; and (2) systematic annual gifting of $10,000 worth of interest in the limited partnership to the children.
Discounting
Gifting of FLP assets is an excellent way to annually transfer limited partnership interests to children. A tax exclusion of up to $10,000 per year to each child is available to each parent. However, due to the availability of discounting the value of a partnership interest, more than $10,000 may be actually gifted to a child and without exceeding the $10,000 exclusion limit.
For example, assuming a discount rate of 33%, a gift of $15,000 in limited partnership interests could be made and still meet the $10,000 exemption. Such gifts can be made annually on an ongoing basis and therefore the entire FLP could eventually be gifted to the children without any gift tax liability ever being incurred. Hence, an parent’s entire estate could be passed on to children through the gifting of partnership interests without being subject to estate taxes.
Furthermore, under current Federal tax law, each individual can pass up to $625,000 worth of property to beneficiaries free of Federal inheritance tax. However, given the discounting of partnership interests, more than $625,000 of a decedent’s estate could be passed on to heirs tax free if done through an FLP.
The Internal Revenue Service has articulated its rationale for discounting the value of partnership interests in Revenue Ruling 93-12. Its reasoning was two-fold. First, because limited partnership interests are not publicly traded, they are much less marketable. Therefore, it is more difficult to sell them except at a greatly discounted price. Secondly, because a limited partner has no voting rights or control over the daily operations of the partnership, the limited partner’s interest is dependent upon the management of the General Partner. This lack of control therefore devalues the limited partner interest.
For example, assuming a discount rate of 33%, a gift of $15,000 in limited partnership interests could be made and still meet the $10,000 exemption. Such gifts can be made annually on an ongoing basis and therefore the entire FLP could eventually be gifted to the children without any gift tax liability ever being incurred. Hence, an parent’s entire estate could be passed on to children through the gifting of partnership interests without being subject to estate taxes.
Furthermore, under current Federal tax law, each individual can pass up to $625,000 worth of property to beneficiaries free of Federal inheritance tax. However, given the discounting of partnership interests, more than $625,000 of a decedent’s estate could be passed on to heirs tax free if done through an FLP.
The Internal Revenue Service has articulated its rationale for discounting the value of partnership interests in Revenue Ruling 93-12. Its reasoning was two-fold. First, because limited partnership interests are not publicly traded, they are much less marketable. Therefore, it is more difficult to sell them except at a greatly discounted price. Secondly, because a limited partner has no voting rights or control over the daily operations of the partnership, the limited partner’s interest is dependent upon the management of the General Partner. This lack of control therefore devalues the limited partner interest.
Determining the Discount Rate
While there is no formula for finding the discounted value of limited partnership interests, it is generally arrived at by determining their “fair market value” which is defined as, what a reasonable buyer would pay to a reasonable seller for those interests. Cases in the Federal Tax Court and Federal District Court evidence “discounting” rates from 15% to 50%. Thus, a donor may be able to reduce his or her taxable estate by as much as 50%. Often, it is advisable to retain a 3rd party valuation or appraisal to substantiate the fair market value.
However, there are some circumstances where the difference between the appraised value and the discounted value will be considered a taxable transfer of the estate and taxed as such under the Internal Revenue Code Section 2704(a). Such circumstances involve the death of the primary family member who controls the General Partnership corporation. After the death of the individual, the remaining family members cannot immediately liquidate their own interests, i.e., the limited partnership interests continue to be restricted. This means that the limited partnership interests must continue, and for a while, everything must go on as if the individual did not die. In order to avoid this tax, the partnership agreement should provide the following:
However, there are some circumstances where the difference between the appraised value and the discounted value will be considered a taxable transfer of the estate and taxed as such under the Internal Revenue Code Section 2704(a). Such circumstances involve the death of the primary family member who controls the General Partnership corporation. After the death of the individual, the remaining family members cannot immediately liquidate their own interests, i.e., the limited partnership interests continue to be restricted. This means that the limited partnership interests must continue, and for a while, everything must go on as if the individual did not die. In order to avoid this tax, the partnership agreement should provide the following:
- A date certain for termination of the FLP, and stating that no limited partner may withdraw before that time;
- No assignment of a partnership interest may occur without the consent of the other partners; and
- No partner may force the liquidation of the partnership without the consent of a majority of the partners.
Transfers of FLP Interests
A transfer of limited partnership interests is straightforward and is done simply by means of a notation in the capital accounts reflecting a decrease in the parents’ ownership and an increase in the children’s ownership. In contrast, transfer of a fractional interest in an asset such as real estate would require the preparation of a new deed each year to reflect the correct ownership percentage held by the children. If a trust is used to hold the limited partnership interests, annual transfers can be accomplished by an assignment of the desired percentage from the trust to the beneficiary each year.
The FLP is one of the best legal devices available for minimizing or eliminating estate taxes through the transfer of ownership to family members. The ability of the parents to maintain control over the assets and the administrative ease with which these transfers are accomplished, makes this device superior to many other available techniques for accomplishing
The FLP is one of the best legal devices available for minimizing or eliminating estate taxes through the transfer of ownership to family members. The ability of the parents to maintain control over the assets and the administrative ease with which these transfers are accomplished, makes this device superior to many other available techniques for accomplishing
Contribution to a Partnership
The formation of an FLP requires the contributions of assets by the partners to the partnership. Under Internal Revenue Code Section 721(a), most contributions to the partnership are tax-free and no gain or loss is recognized to the partnership or any of its partners upon contribution of property in exchange for a partnership interest. However, this “non-recognition” provision does not apply to all partnership transfers. Those not applicable include:
Thus, given these exceptions, the ideal property to be contributed to an FLP are intangible assets with low liability risk, such as most non-commercial real estate, stocks, bonds, mutual funds, securities, etc. High-risk assets, such as active business type assets, certain commercial real estate (such as apartment buildings, office buildings, hotels, night clubs, or any other business where many people work or gather), motor vehicles, aircraft, boats, etc. by their nature, create a substantial risk of liability in the event of some type of disaster and should not be placed in the FLP. The reason for this that you do not want to have the partnership incur liability and be the target of a lawsuit where all of the assets of the partnership will be subject to the claims of the judgement creditor. These types of properties should be kept separate from low-risk assets.
The family home is another asset that can be placed inside the FLP, provided that there are no existing mortgages on the property. (A mortgaged home should generally not be transferred into the FLP, as the owner would then lose the income tax deduction for home mortgage interest under IRC Section 163 which only permits a deduction for “qualified residence interest.” A domestic living trust, however, may be an appropriate entity in which to place title in a mortgaged home without losing the home mortgage deduction).
- Transfer of property to a partnership resulting in the receipt of money or other consideration in addition to a partnership interest;
- Receipt of partnership interest in exchange for services;
- Transfer of property to a partnership solely to effect a tax-free exchange; and
- Transfer of property where the property is subject to a liability that exceeds the property’s basis.
Thus, given these exceptions, the ideal property to be contributed to an FLP are intangible assets with low liability risk, such as most non-commercial real estate, stocks, bonds, mutual funds, securities, etc. High-risk assets, such as active business type assets, certain commercial real estate (such as apartment buildings, office buildings, hotels, night clubs, or any other business where many people work or gather), motor vehicles, aircraft, boats, etc. by their nature, create a substantial risk of liability in the event of some type of disaster and should not be placed in the FLP. The reason for this that you do not want to have the partnership incur liability and be the target of a lawsuit where all of the assets of the partnership will be subject to the claims of the judgement creditor. These types of properties should be kept separate from low-risk assets.
The family home is another asset that can be placed inside the FLP, provided that there are no existing mortgages on the property. (A mortgaged home should generally not be transferred into the FLP, as the owner would then lose the income tax deduction for home mortgage interest under IRC Section 163 which only permits a deduction for “qualified residence interest.” A domestic living trust, however, may be an appropriate entity in which to place title in a mortgaged home without losing the home mortgage deduction).
The Limited Partners
The limited partners often have the right to:
- withdraw from the partnership and to demand their investment back upon such withdraw;
- demand a distribution of the annual profits;
- assign their limited partnership interest;
- consent to the admission of new partners, either general or limited;
- vote on the dissolution or termination of the limited partnership;
- vote on the distribution or liquidation of assets if the limited partnership is dissolved or terminated; and
- vote on any amendments to the Certificate of Limited Partnership or to the partnership agreement.
Conclusion
An FLP may be an attractive asset protection tool as it allows an individual to maintain control of property while divesting the legal attributes of direct ownership. Family investments are consolidated, and centralized control is vested in a managing corporate General Partner. The FLP can also be used to gift and discount limited partnership interests to children, thus reducing overall income tax liability, and federal estate taxation of assets.
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