For many families that own a business or commercial real estate property that generates income, a family limited partnership (FLP) is often the best and most practical way to hold onto that business and the wealth it generates for the entire family. In cases where the value of the property is appreciating, an FLP also proves beneficial when it comes to estate tax, asset protection, partnership interests and succession planning for families.
What Is a Family Limited Partnership?
A family limited partnership, or FLP, is a company owned by two or more family members, in which the family members combine their money to run a business. Everyone involved in the limited partnership owns shares of the business and profits in proportion to the number of shares they own.
Just like in a standard limited partnership, FLPs have a general partner or partners and limited partners. The general partner owns the largest share of the business and is responsible for business management and decisions. Sometimes, a general partner might take a fee for that work, depending on the terms of the partnership agreement.
Limited partners do not make decisions in the business, nor are they involved in any management, even though it is family-owned. Instead they invest a certain amount into the business and receive profits the business generates. This dynamic is called a limited partnership interest.
With an FLP specifically, all members of the limited partnership are part of the same family, and this structure serves as a way for wealthy families to maintain generational wealth by becoming partners in the business and passing down or purchasing shares for children and grandchildren.
An Example of a Family Limited Partnership
One example of a family limited partnership is that of a married couple who owns a commercial property like an apartment building. Let’s say they have adult children who they would like to take over the building after they pass. The couple, rather than bequeathing the property to their children, can gift them shares of the property, making the children their limited partners. In this instance, the parents are general partners, and the adult children own a stake in the company, or property.
FLPs apply to any number of commercial real estate deals, such as townhouse development, storefronts, and more. Parents can also form the FLP at the start of the business, in which their adult children or relatives buy into the property at the beginning, and benefitting from the initial profits.
Advantages of Family Limited Partnerships
There are several advantages to FLPs, especially regarding taxes, the transfer of wealth and maintaining family control of a business.
One of the biggest benefits of an FLP is the money saved on taxes. With an FLP, an individual is able to gift FLP shares tax-free to others, up to the amount of the yearly gift tax exclusion. Currently the annual gift tax exclusion is $15,000 for individuals, and $30,000 for married couples.
Opting out of the gift tax means, each year, a married couple can give up to $30,000 in FLP shares to each child and grandchild without being taxed. For instance, if a couple has three children and six grandchildren, they can gift up to $270,000 of business shares to those children and grandchildren in one year, tax-free. Those children and grandchildren would then be able to collect interest and profit on those shares for as long as they have them. This is one common method the wealthy use for asset protection and to maintain that generational wealth.
In addition to saving on gift taxes, FLPs allow for savings on estate taxes as well. When a parent gifts their money to a child, they are essentially gifting a part of their estate. When that money is put into the FLP, the future returns stay within the FLP instead of being included in the parent’s estate, avoiding estate tax altogether.
This savings is beneficial for a number of reasons. First, after a parent’s death, the estate would only include the value of their asset at the time it was transferred into the FLP. Children would not be taxed on any additional profits.
Say the parent transferred $30,000 into the FLP, and after their death the shares were worth $50,000. Their benefactors would only pay taxes on the estate’s assets valued at the original $30,000.
In addition, according to Lou Nimkoff at Brio Real Estate, with FLPs, the IRS provides “minority and marketability discounts.” To understand the exact amount and conditions of these discounts, it’s best to talk to a tax specialist about your individual case. But, generally, “if you have a minority interest or lack of control, you can take a further deduction,” said Nimkoff.
General Partners Retain Control
Typically with an FLP, the parents act as the general partners. This management structure is advantageous for the GPs because they can then stipulate the terms for their limited partners, or children.
“Mom and Dad can still exercise total control, while transferring the value of the asset to the next generation,” Nimkoff explained.
Parents generally like this capability because it allows them freedom to include stipulations in the limited partnership agreement, such as restrictions on transfer of investments, or beneficiary age. As an added bonus, those conditions can be changed as needed.
All partnership interests are protected from creditors in an FLP. So for children, spouses, grandchildren, etc., because they don’t control the business, creditors are unable to go after that money without the general partner’s consent. In this way, the LP’s interests and assets are protected. This freedom also makes estate planning easy.
Disadvantages of Family Limited Partnerships
Despite all of those advantages, there are a few risks and setbacks when it comes to FLPs.
General Partners Are More Liable
Because limited partners don’t play a role in day-to-day management, the general partner is legally liable for any business lawsuits and creditor claims. Although creditors cannot go after LPs, the business itself is fair game, and the FLP is susceptible to creditors.
Capital Gains Tax
Although the tax savings are great with an FLP, there is also the risk of capital gains tax liability. If the FLP shares appreciate, children could be taxed on that profit, depending on the circumstances. It’s best to talk to a tax attorney and review the terms of your FLP before gifting any shares.
Cannot Be Transferred to Minors
Children under the age of 14 cannot participate in an FLP, and minors under 18 cannot gain ownership of the FLP. If parents want to transfer money to their underage children, they would have to do so through a trust, rather than the business.
How Are Family Limited Partnerships Taxed?
Family limited partnerships are taxed in the same way as a general partnership. Profits between partners are reported as income on their individual tax returns, and there is no corporate tax imposed on the partners.
Assets that are gifted to other partners — up to a point, depending on the IRS’s annual gift tax exclusion — are not taxed.
So, Are Family Limited Partnerships Still Viable in 2021?
FLPs are certainly a viable option for families wishing to pass down their business and its wealth to future generations. The way taxes are set up in 2021, an FLP is advantageous to all partners involved.
Family Limited Partnerships Can Keep Your Family Business in the Family
Overall, a family limited partnership is a good way to keep a family business within the family. For the very wealthy, it’s long been a way to maintain generational wealth. Even for the less wealthy, it’s a good way to get that generational wealth started.
However, it’s important to consult a tax attorney to figure out what steps are best for you and your family, and to avoid common tax planning mistakes when it comes to FLPs.