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What is a Family Limited Partnership?

A Family Limited Partnership is an entity created when two or more members of a family file a limited partnership document to jointly conduct a business or hold assets. In such arrangement, one or more of the partners is called a “limited partner,” is liable only for the amount that has been invested in the partnership. The other partner, called the “general partner” controls the partnership.

Why Use a Family Limited Partnership?

Families with assets often face challenging decisions. For instance, they need to consider how to both handle and protect their assets, whether it be property, money, real estate, or any other investments. One path any family can take to protect its wealth, and especially its real estate ownership, is to establish a Family Limited Partnership (FLP).

As long as the FLP is both setup and utilized correctly, the formation of this entity can not only help to protect assets but also bring with it a enhanced profitability as well as increased tax savings. An FLP, when formed the right way, can substantially decrease what the family pays in taxes on real estate because it offers the opportunity to cut taxes via gift and estate taxes. [1]

Furthermore, an FLP offers a shield against creditors seizing assets through litigation. At the same time, an FLP brings an increased number of flexible options typically not offered by trusts. The reason why an FLP offers families much more leeway with planning and asset management is that unlike most irrevocable asset protection trusts set up for family use, an FLP allows for families to make amendments. [2]

Family Limited Partnership (FLP) Background

An FLP works as a limited partnership, but its ownership and power lies with family members. Just as other limited partnerships do, an FLP houses two partner types: a general partner and a limited partner.

A general partner in an FLP retains power over every management or investment decision. In addition to this control, the general partner also retains all of the liability for all actions as well as the FLP itself. When the FLP is sued, the general partners are vulnerable. That is why a corporation or LLC is often put in that position. On the other hand, a limited partner typically does not participate in the control or management of the FLP. As such, the limited partner has limited liability from the FLP. [3]

A limited partnership as an entity itself is typically not taxed. However, there are still specific tax law requirements owners of the FLP must meet and follow legally. Those who own the FLP by law must state how much income the FLP earned, as well as the amount of deductions, all on their personal taxes [4]

The main contributors of the assets in an FLP are usually the primary family members, such as the parents or grandparents. The formation of an FLP is essentially the forming of a trust with the added benefits of asset protection, flexibility and tax savings. By placing their assets in the FLP, they typically receive a lesser general partner interest and a greater limited partner interest. If the primary family members them so decide, they can share a percentage or redistribute all of the interest to other members of the family. The interest being distributed can be awarded to family members directly or can be placed in a trust for estate planning purposes.

Getting Started with A Family Limited Partnership

When forming an FLP, it is important to structure it properly. The primary family members usually act as the present owners, but the future ownership of the FLP also needs to be addressed. [5]

Getting the FLP started requires a legal document to be filed with the state of choice. Then one creates what is known as a written limited partnership agreement. Next, a bank and/or brokerage account is typically opened in the name of the FLP with the general partners (or representatives of the corporate or LLC serving as general partners) as signatories on the accounts. Once the documents are filed, agreement is completed, and accounts are opened, then the primary family members can complete all of their desired asset transfers, including items such as cash, stock, or real estate. FLPs do not hold primary family member’s individual life insurance, home, or retirement accounts. [6]

Why Choose a Family Limited Partnership?

There are several reasons why families decide to create FLPs, and most of these concepts have to do with asset protection and wealth distribution. Some benefits of an FLP include the following:

  • Making a transfer of a limited partnership’s interest and redistributing it to family members decreases the amount that can be taxed on the estate of the primary family members. Since limited partners do not have control, the value of the holdings of the limited partners are considered less valuable for accounting purposes. This is called a “valuation discount.”
  • The primary family members who serve as general partners can maintain control over how assets are distributed. [7]
  • The annual gift tax exclusion can be used when transferring limited partnership interest to others, allowing you to reduce or eliminate gift taxes.
  • When the primary family members make a transfer of interest, they can also reduce or discount the value of the limited partnership shares for tax purposes.
  • The primary family members retain not only control but flexibility. An FLP allows for the primary family members to make changes as needed.
  • An FLP also offers protection from litigation. Judgment creditors will have difficulty breaking through the FLP structure. With a properly drafted partnership agreement, creditors are prevented from seizing a debtor’s limited partnership interest or taking assets held by the LP.
  • If a divorce occurs, and the FLP was structured properly, the FLP can prevent one spouse from taking the assets from the other spouse or touching the assets inside.
  • An FLP can group all family investments in one place to reduce fees and taxes. Instead of trying to keep multiple accounts active, such as one for each child or family member, an FLP allows you to place everything in one account and then award children or family members a specified percentage of ownership interest.

Family Limited Partnerships and Asset Protection

FLPs often are used by families to increase asset protection. Any assets that are titled to the limited partnership are considered owned by the limited partnership. This factor offers a good deal of protection to family members because acts and decisions of one partner outside of the FLP, even if they create a liability problem for that individual, cannot cross over to the FLP or the other partners’ interests.  The law protects the partners from each other, because if one partner does make a bad decision and gets himself or herself in legal trouble, the other partners will not feel the effects or lose their interest in the FLP.

The most important concept associated with the FLP is that it must be formed and drafted correctly in order to provide superb asset protection. For instance, a partnership agreement can, in writing, layout rules, regulations, and limitations as to what partners are allowed to do. Adding written rules into the FLP partnership agreement that take case law rulings into account can offer even further protection.

Legally, if one partner’s actions create liability for himself, only the distributions from that partner’s percentage can be made available to creditors. This is called a “charging order.” If the general partner decides not to make distributions, the one who holds the charging order gets nothing. Revenue Ruling 77-137 says that whoever has the rights to receive distributions must pay taxes on them whether they are actually distributed or not. So, the one who has the charging order against your family member’s interest gets nothing but a tax bill. No money. Just a bill. That is the beauty of the FLP because you have family members working together for the best interest of each partner.

The formation of the FLP prevents, by law, any creditor from taking over the entire partnership, trying to manage things, or forcing a percentage of the partnership’s wealth that may be tied up with other partnership owners. So, the FLP keeps the control in the hands of the family and out of the hands of its enemies.

How Family Limited Partnerships Reduce Income Taxes

A partnership differs vastly from a corporation because a partnership is not required to pay taxes, itself. Instead, FLPs traditionally use a method known as pass-through taxation. Pass-through taxation means that each year, the partnership must file its taxes and declare its income and expenses, but the partnership as an entity does not pay those taxes. Instead, the taxes on profits generated from within the partnership must be paid by each partner on each one’s personal tax return. The partnership annually needs to send a statement to every single partner declaring the total income, deductions, or losses he or she is responsible for.

How does this method help to reduce taxes? Because the tax responsibility is shared amongst the primary account holders and their children. So, since the children are often in lower tax brackets, it typically reduces the amount of annual income earned for all. The parents may, if they wish, pay these taxes, albeit at a lower rate.

Furthermore, if the primary account holders so decide and include this concept in their partnership agreement, the income earned by the children does not necessarily need to be awarded to them immediately. Distribution to children can be held by the FLP to be released elsewhere, and that distribution can be controlled further by the primary account holders. For instance, if the concept is laid out in the partnership agreement, part of each child’s distribution can be made to pay income taxes, and the rest can go into a savings account to be distributed to the children at a later date.

How a Family Limited Partnership Can Reduce Estate Taxes

With an FLP, general partners can help cut back taxes by gifting the FLPs interest to their children. This move allows for the primary account holders to keep control over the FLP while transferring their assets to the next generation. The partnership agreement can be written such that Mom and Dad can spend all of the money on themselves during their lifetimes should they so choose.

The IRS also provides a tax break for the primary account holders that transfer their asset interest to other family members. As stated above, when the transfer is made, the assets can be discounted to demonstrate real market value. These discounts can range anywhere from twenty to fifty percent. There were some fairly recent changes regarding the calculation of valuation discounts. So, be sure to check with an experienced CPA come tax time.

Using the knowledge obtained here regarding FLPs. Hopefully you can now make a solid decision about whether or not you want to form one, how you will go about forming one, and some things you want to include in your original FLP documentation agreement. All of these factors deserve careful consideration so that you can make the proper decision you need to not only protect your personal wealth but the wealth of your family for years to come. There are numbers on this page as well as a form to complete should you want to proceed or if you need further guidance.