what is a family limited partnership (flp)?

Family Limited Partnerships Chapter 43Tools & Techniques of

Estate Planning

Copyright 2011, The National Underwriter Company 1

• Two types of Family Partnerships: General and Limited

• Under the General Partnership:– all partners have a voice in management by percentage vote– all partners are personally liable for all debts and other

liabilities of the general partnership– partners may share in losses generated by the partnership for

income tax purposes

• The Limited Partnership is used most often for families:– an FLP agreement exists– under state law, limited partners have limited liability to the

extent of their capital contribution

What Is A Family Limited Partnership (FLP)?


Estate Planning


• An FLP is a partnership that exists between members of a family– Family is defined as an individual’s spouse, ancestors, lineal

descendants, and any trusts established primarily for the benefit of such persons

• Upon formation, family members contribute property in return for an ownership interest in the capital and profits of the FLP

• The partners designate a general partner who assumes– management responsibility, and– personal liability for all debts and other liabilities not satisfied from the

assets of the FLP

What Is A FLP? (cont’d)


Estate Planning


• General purpose of an FLP is to manage and transfer family assets

• Tax-wise an FLP is treated the same as any other partnership

• It is a technique used to shift the income tax burden from parents to children or other family members in lower income tax brackets– “Kiddie tax” rules for children under 18 lessen the income

tax benefit of the FLP

• There is no gift on formation where each investor’s interest is proportional to the capital contributed

What Is A FLP? (cont’d)


Estate Planning


• FLPs are often used to– fractionalize the ownership of business assets or real estate,

and– take advantage of valuation discounts, to significantly

reduce transfer taxes

• In most cases, parents will make gifts of limited partnership interest to children and other family members, without divesting themselves of control

• In other cases, an FLP will be used to ensure continuous ownership of assets within a family unit for several generations

When Is Use Of An FLP Appropriate?


Estate Planning


• FLPs are also used to “freeze” the value of assets by shifting future growth in various assets to other family members

• Other situations where an FLP would be appropriate:

– Where it is desirable to conduct a family business in a form other than a sole proprietorship or a corporation

– Where it is desirable to protect assets from creditors of the partners

– Where a parent wishes to protect assets which are transferred to younger generations from being dissipated through mismanagement or divorce

When Is Use Of An FLP Appropriate? (cont’d)


Estate Planning


• Other situations where an FLP would be appropriate: – Where flexibility for setting the rules for managing property is

desired – To simplify ownership of assets– To ease the distribution of assets at death among family

members without having to remove the assets from the partnership

– To avoid out-of-state probate costs– To discourage family members from fighting over FLP

assets and to provide a forum for the resolution of disputes that arise among family members

When Is Use Of An FLP Appropriate? (cont’d)


Estate Planning


• Refer to the state law that will govern the partnership for specific requirements

• In general, these are the requirements for an FLP:– A written agreement setting forth the rights and duties of the

partners– Filing a certificate of limited partnership and obtaining all

necessary business licenses and registrations– Obtaining a separate tax identification number for the

partnership– Transferring title of all contributed assets into the name of

the partnership and opening new accounts in the name of the partnership

What Are The Requirements?


Estate Planning


• General requirements (cont’d):– Amending contracts to show the partnership as the real

party in interest– Avoiding commingling of partnership assets with those

assets of the individual partners, or using partnership assets for personal business of the partners

– Filing annual state and federal income tax returns and allocating partnership income to the partners

– Paying annual state franchise taxes, if applicable, and making any other filings required under state law

What Are The Requirements? (cont’d)


Estate Planning


– John and Robin are in their 70’s and have 4 children and 6 grandchildren

– Their estate consists of marketable securities, a residence, an apartment complex, and other real estate totaling $4,500,000

– During year 1, they contribute all but their residence to an FLP totaling $4,000,000 in partnership assets

– In return for their capital contribution, they each receive a 1% general partner (GP) interest and a family trust is established to receive the 98% limited partner (LP) interest

How It Is Done – An Example


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– At the end of year 1, John and Robin each give a 6.25% LP interest to each of their four children, totaling 50% of the partnership interest or $2,000,000 in underlying asset value

– An appraiser concludes that a combined 40% discount for lack of control, lack of marketability, and “lock-in” status is appropriate for the LP gifts

– For gift tax purposes, after the discount, John and Robin are each found to have given LP interests worth $150,000 to each child for a total of $600,000 in gifts by each of them

– Both John and Robin apply their unified credit exemption, and no cash payment of gift tax is required

How It Is Done – An Example (cont’d)


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– Over the next 10 years, John and Robin make gifts of LP interests worth $10,000 to each of their four children and six grandchildren, using the same 40% discount to value the gifts

– The assets in the FLP over the 10 year period grow at 5% annually

– When John dies in year 10 the value of the FLP is worth $6,205,313



Estate Planning


GP LP

John 1% ---

Robin 1% ---

Family Trust --- 18.4%

Child 1 --- 15.46%

Child 2 --- 15.46%

Child 3 --- 15.46%

Child 4 --- 15.46%

Grandchild 1 --- 2.96%






TOTALS 2% 98%

The ownership of the FLP is as follows in year 10:



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Value

General Partner (1%) $ 46,540

Limited Partner (9.2%) Family Trust 342,533

TOTAL $389,073

Prior Taxable Gifts 600,000

TOTAL GIFTS AND INTERESTS $989,073

By implementing the FLP program John’s taxable estate for his interest in the apartments, real estate and marketable securities was reduced by $2,113,584 resulting in estate tax savings of $739,754 assuming a 35% tax rate

• In determining the value of FLP interests includable in John’s estate a 25% discount was applied to the GP interest and a 40% discount to John’s LP interest held in the name of the Family Trust



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• Control over assets contributed to an FLP is achieved by retaining ownership of the general partner (GP) or managing partner interest

– GP decides if, when, and how much partnership income is to be distributed to the partners

• For estate planning purposes it is advisable to designate a non-managing partner who will succeed in the duties of management and control upon vacancy of the GP’s interest

Providing Management And Control


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• GP’s usually include:– one or both parents, either individually or as trustee of a

family living trust,– an S-Corp or LLC controlled by one or more persons, or– mature and financially experienced children or

grandchildren, either individually or as trustee of a trust for their benefit

• While much of the value of an FLP may be transferred away through gifts of LP interests to the children, the GP with their small percentage of ownership still controls the assets in the FLP

Providing Management And Control (cont’d)


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• GP’s should have the necessary willingness, knowledge, and experience to do the following:– Manage and invest partnership assets

– Make decisions as to distributions of partnership income and/or assets

– File income tax returns on behalf of the partnership and understand the income tax law



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• GP’s do the following (cont’d):– Furnish annual partnership income tax information

(Schedule K-1) to the partners

– Make necessary filings with the state’s Secretary of State

– Give or withhold consent to transfers of partnership interests and amendment of the FLP agreement



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• Continuous family ownership of the FLP is guaranteed by restricting each partner’s ability to sell or otherwise transfer his interest to non-family members including:– rights of first refusal,

– buy-sell provisions, and

– limiting new non-family partners to only receive income distributions and a proportionate share of partnership income, expenses, deductions, and credits, with no voting rights

• Careful drafting is required to avoid transfer tax pitfalls of IRC Chapter 14 rules

Ensuring Family Ownership


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• As a general rule, the value of an FLP interest is worth less than direct ownership of the same percentage interest in the underlying assets of the FLP

• Transfer tax values are reduced by the application of discounts, determined by appraisal to reflect an LP’s– Lack of control over the underlying partnership assets and

management of the FLP– Lack of ability to freely transfer LP interests to non-family

members– Combined discounts usually range from 25% to 35%

Reducing Transfer Taxes


Estate Planning


• Reduced transfer values allow for– Shifting of a greater amount of partnership interests by

percentage from parents to subsequent generations, and

– Lower overall estate tax liability on those interests retained by the deceased partner

• Despite reduction in the value of the FLP interests, the real income production and growth potential of FLP assets remain available to partners

Reducing Transfer Taxes (cont’d)


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• See Chapter 58 for detailed discussion

• Discount for lack of control

• Discount for lack of marketability

• Discount for built-in capital gains

• Discount for lack of liquidity/lock-in discount

Securing Valuation Discounts


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• FLPs provide a limited degree of asset protection to the partners since– Assets of the FLP generally cannot be attached to satisfy

personal debts of the limited partners– A creditor of an individual LP must go to court and get a

“charging order”• A charging order does not give a creditor voting rights• A charging order does give a creditor the right to receive the

distributions that would normally be paid to the LP until the debt is fully paid

• A creditor cannot be assured that the GP will elect to pay out the FLP income to the partners

Protecting Assets


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• In order for a donee-partner to be recognized as a partner for income tax purposes three factors must be satisfied:– Capital must be a material income-producing factor

(inventories or investment in plant, machinery, or other equipment)

– Donee or purchaser of a capital interest in a partnership is not recognized, unless such interest is acquired in a bona fide transaction, not a mere “sham” for tax evasion purposes

– Donee’s distributive share must be included in his gross income with limited exceptions

Income Tax Aspects


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• Transferee of a partnership interest must be the “real owner” of the capital interest and have dominion and control over that interest

Income Tax Aspects (cont’d)


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• Control tests to see if donor is “real owner” for income tax purposes:– Donor retaining control of the distribution of income or restricting

the amount of such distributions

– Donor limiting the right of a donee partner to dispose of his interest without financial detriment

– Donor retaining control of assets that are essential to the partnership business

– Donor retaining management powers which are inconsistent with normal partnership relations

– Other indirect control factors



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• Income tax benefits to partners when the FLP satisfies IRC Section 704(e) and regulations:– Pass through of items of income, expense, credit, and

deductions

– Achieving a step-up in income tax basis for FLP assets for interests received from a deceased partner (or upon purchase by a new partner) if GP elects

– Withdrawal of assets without recognition of taxable gain

– Income shifting to family members

– No income tax gain on contribution of assets to the FLP or upon dissolution of the FLP in most cases



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• Other tax implications:– A reasonable allocation of partnership income must be made to any

donor partner to recognize the value of his services to the FLP in order to satisfy Section 704(e) rules

– Unless the FLP elects to be taxed as a corporation, it is a passthrough entity and does not pay federal income taxes

– Gifts of FLP interests are subject to gift tax and will likely raise questions concerning the value of the transferred interest

• “Adequate disclosure rules” must be met to commence the running of the gift tax statute of limitations

– Increased scrutiny for estate, gift, and GST tax purposes of transaction involving FLP and valuation discounts



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• In AZ, CA, NV, NM, and WA, income from separate property of one spouse is separate property income

• In TX, LA, ID, and WI, income from separate property of one spouse is community property income

• Extra attention needs to paid to whether an FLP interest is owned prior to marriage, is given or inherited, or is separate property of a spouse– A distinction needs to be made between the earnings of the

manager (probably community property) and the income received for ownership of a partnership interest (separate property)

Issues In Community Property States (cont’d)


Estate Planning


• Using separate property income from an FLP to purchase items that are taken in the names of both spouses creates a taxable gift, and may trigger state gift tax– The unlimited marital deduction is available at the federal

level

• Use an agreement to avoid litigation in divorce cases over whether the FLP interest is separate or community property

Issues In Community Property States


Estate Planning


• FLP will be required to pay applicable minimum franchise tax fees in most states which it does business

• FLP must file annual income tax returns and keep separate accounting records

• In states with restrictions on real property tax increases, care should be taken so that the property tax assessment on the real property contributed to the FLP is not adversely changed by transfers of partnership interests

• Costs of formation and transferring title of assets into the FLP

Detriments


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Comparison Of FLPs With Other Business Entities

what is a family limited partnership (flp)?

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