Wednesday, September 25, 2019
A family limited partnership (FLP) is a limited liability business entity created and governed by state law. It is generally composed of two or more family members and is typically utilized to reduce income and transfer taxes, act as a vehicle to distribute assets to family heirs while keeping control of the business, ensure continued family ownership of the business, and provide liability protection for all of the limited partners.
What are the key distinguishing characteristics of an FLP? How is an FLP formed? What are the important points to consider upon formation? These are the topics of today’s post, Part One of a two-part series. In Part Two, I will examine some of the basic advantages and disadvantages of the FLP.
Distinguishing characteristics and formation considerations of an FLP – these are the topics of today’s post.
Interests in an FLP interests are usually held by family members (or entities controlled by family members). These typically include spouses, ancestors, lineal descendants, and trusts established on behalf of such family members. A member holding a general partner interest is entitled to reasonable compensation for work done on behalf of the FLP. These payments are not deemed to be distributions and are beyond the reach of judgment creditors. Limited partners take no part in FLP decision making and cannot demand distributions, can only sell or assign their interests with the consent of the general partners and cannot force a liquidation.
An FLP is a relatively flexible entity inasmuch as income, gain, loss, deductions or credits can be allocated to a partner disproportionately in whatever manner the FLP desires. It is not tied to the capital contributions of any particular partner.
It’s important to form the FLP with a clear business purpose and the entity should hold only income-producing family business property or investment property. Personal assets should not be placed in the entity. If personal assets are transferred to the entity, the temptation will be for the transferor to continue to use the assets as their personal assets without respecting the fact that the FLP is the owner. That could cause the IRS to disregard the entity and claim that the transferor retained the enjoyment and economic benefit of the transferred assets for life. See, e.g., Estate of Thompson, 382 F.3d 367 (3d Cir. 2004).
All formalities of existence must be observed. These include executing a written agreement that establishes the rights and duties of the partners; filing all the necessary certificates and documents with the state; obtaining all necessary licenses and permits; obtaining a federal identification number; opening new accounts in the FLP’s name; transferring title to the assets contributed to the FLP; amending any existing contracts to reflect the FLP as the real party in interest; filing annual federal, state and local reports; maintaining all formalities of existence; not commingling partnership assets with the personal assets of any individual partner; keeping appropriate business records; including income from the FLP interest on personal income tax returns annually.
As noted above, an FLP is formed by family members who transfer property in return for an ownership interest in the capital and profits of the FLP. At least one family member must be designated as the general partner (or a corporation could be established as the general partner). The general partner manages and controls the FLP business and decides if and when FLP income will be distributed and in what amount. In return for that high degree of control, the general partner(s) is (are) personally liable for any creditor judgment that is not satisfied from FLP assets. Thus, income is retained in the FLP at the sole discretion of the general partner(s) and the general partner(s) have complete control over the daily operations of the business. Conversely, because a limited partner has no say in how the business is operated, the personal liability of the limited partner is limited to the value of that partner’s capital account (generally, the amount of capital the partner contributed to the FLP).
There are a couple of common approaches in FLP formation and utilization. Often, an FLP is formed by the senior generation with those persons becoming the general partners and the remaining interests being established as limited partner interests. Those interests are then typically gifted to the younger generation. As an alternative, an FLP could be created by spouses transferring assets to the entity in return for FLP interests. Under this approach, one spouse would receive a 99 % limited partnership interest and the other spouse a 1% general partner interest. The general partner should own at least 1 percent of the FLP. Anything less will raise IRS scrutiny. The spouse holding the limited partnership interest could then make annual exclusion gifts of the limited partnership interests to the children (or their trusts). The other parent would retain control of the “family assets” while the parent holding the limited partnership interest is the transferor of the interests.
Consider the following example:
Bob is 55 and owns a farming operation. His wife, Stella, died in 2014. All of the assets were titled in Bob’s name. Thus, Stella’s estate was very small and the unused exclusion of $5 million was “ported” over to Bob. The farming business has expanded over the years and now is comprised of 1,000 acres of farmland valued at $10,000,000, and other assets (livestock, buildings and equipment, etc.) valued at $3,000,000. His three sons (ages 27, 24 and 18) work with him in the farming business. Bob’s objective is for the farming operation to continue to be operated by the family into subsequent generations. He would like to transfer ownership of some of the farming business to his sons, now before the assets appreciate further in value. However, Bob does have some concern that his son’s may not be fully experienced and ready to manage the farming operation. Bob also wants to protect the sons against personal liability that could arise in connection with the business. After consulting with his attorney, Bob decides to have the attorney draw up an FLP agreement.
The terms of the FLP agreement designate Bob as the general partner with a 1% ownership interest. The sons are designated as the limited partners, each having a 33% limited partner interest. Bob transfers the land, farm equipment and some livestock to the FLP, and each son contributes cash and additional livestock and equipment. All other formalities for formation of the FLP are completed. Bob then gifts 99% of the FLP to his sons (33% to each son), reports the gifts and pays the gift tax (using exclusion and unified credit to substantially offset the gift tax). Bob continues to run the farming operation until he is 65, at which point he is comfortable that the sons can manage the farming operation on their own. Up until age 65, Bob filed the required annual reports with the state and followed all necessary FLP formalities. Bob, distributed FLP income annually – 1% to himself and 33% to each son. By shifting most of the income to the sons that are in a lower tax bracket than Bob, the family (on a collective basis) saves income tax.
Upon turning age 65, the partners vote to name the oldest son (now age 37) as the general partner and Bob’s interest is changed to be a limited partner interest. Bob then retires. The value of the business continued to increase over the years, but that appreciation in value would escape taxation in Bob’s estate inasmuch as only 1% of the FLP value at the time of Bob’s death would be included in Bob’s estate for estate tax purposes.
The FLP can be a useful entity form for the transition of a family business such as a farm or ranch. It can also be a good entity choice for transferring that value at a discount. That is particularly important when the exemption for federal estate and gift tax purposes is relatively low (which could be the case again at some future point in time). But, attention to details on formation are important. In Part Two, I will examine the relative advantages and disadvantages of the FLP.