Friday, September 27, 2019
In Tuesday’s Part One of a two-part series on family limited partnerships (FLPs), I looked at where an FLP might fit as part of a business or succession plan for a farm or ranch operation. Today, in Part Two, I examine the relative advantages and disadvantages of the FLP form.
The pros and cons of the FLP – that’s the topic of today’s blog post.
Advantages of an FLP
Income taxation. An FLP is generally taxed like a general partnership. There is no corporate-level tax and taxes are not imposed on assets passing from the FLP to the partners (unlike an S corporation). Thus, the FLP is not recognized as a taxpayer, and the income of the FLP passes through to the partners based on their ownership interest. The partners report the FLP income on their individual income tax returns and must pay any tax owed. Income is allocated to each partner to the extent of the partner’s share attributable to their capital (or pro rata share).
This tax feature of the FLP can be an attractive vehicle if a transfer of interests to family members in a lower tax bracket is desired. Transfers of FLP interests can also be made to minor children if they are competent to manage their own property and participate in FLP activities. But, such transfers are typically made in trust on behalf of the minor. Also, unearned income of children under age 18 (and in certain cases up to age 23) may be subject to the “kiddie tax” and thus be taxable at the parents’ income tax rate.
Avoidance of transfer taxes. Another advantage of an FLP is that it can help avoid transfer taxes - estate tax, gift tax and generation skipping transfer tax. Transfer tax avoidance is accomplished in three ways: 1) by the removal of future asset appreciation; 2) the utilization of the present interest annual exclusion for gift tax purposes; and 3) the use of valuation discounts for both gift and estate tax purposes. Of course, the federal estate and gift tax is not much concern for very many at the present time with the applicable exclusion amount set at $11.4 million for deaths in and gifts made in 2019. But, the present high level of the exclusion is presently set to expire after 2025. Depending on politics, it could be reduced before 2025.
Transfer of assets yet maintenance of control. Another advantage of an FLP is that it allows the senior generation of the family to distribute assets currently while simultaneously maintaining control over those assets by being the general partner with as little as a 1% interest in the FLP. This can allow the general partner to control cash flow, income distribution, asset investment and all other management decisions.
But, a word of caution is in order. I.R.C. §2036(a)(1) provides that a decedent’s gross estate includes the value of property previously transferred by the decedent if the decedent retained the possession or enjoyment of, or the right to the income from, the transferred property. I.R.C. §2036(a)(2) includes in the gross estate property previously transferred by the decedent if the decedent retained the right, either alone or in conjunction with any person, to designate the persons who are to possess or enjoy the transferred property or its income. Thus, pursuant to §2036(a)(2), the IRS may claim that because a general partner controls partnership distributions, a transferred partnership interest should be taxed in the general partner’s estate.
In the typical FLP scenario, the parents establish the FLP with themselves as the general partners and gift the limited partnership interests to their children. In this situation, if the general partners have the discretionary right to determine the amount and timing of the distributions of cash or other assets, rather than the distributions being mandatory under the terms of the partnership agreement, the IRS could argue that the general partners (who have transferred interests to the limited partners) have retained the right to designate the persons who will enjoy the income from the transferred property. An exception exists for transfers made pursuant to a bona fide sale for adequate and full consideration.
Consolidation of family assets. An FLP also keeps the family business in the family, with the limited partner interests restricted by the terms of the partnership agreement. Such restrictions typically include the inability of the limited partner to transfer an FLP interest unless the other partners are first given the opportunity to purchase (or refuse) the interest. This virtually guarantees that non-family members will not own any of the business interests. These agreements (buy-sell agreements and rights of first refusal) must constitute a bona fide arrangement, not be a device to transfer property to family members for less than full and adequate consideration, and have arm’s length terms. An agreement structured in this manner will produce discounts from fair market value for transferred interests that are subject to the agreement.
Provision for non-business heirs. The FLP can also provide for children not in the family business and allow for an even distribution of the estate among all family members, farm and non-farm. The limited partner interest of a non-farm heir can allow that heir to derive an economic benefit from the income distributions made from time to time without being involved in the day-to-day operation of the business.
Asset protection. The FLP can also serve as an asset protection device. This is particularly the case for the limited partners. A limited partner has no ownership over the assets contributed to the FLP, thus the creditor’s ability to attach those assets is severely limited. In general, a court order (called a “charging order”) would be required to reach a limited partner interest, and even if the order is granted, the creditor only receives the right to FLP income to pay the partner’s debt until the debt is paid off. The creditor still does not reach the FLP assets. The limited partnership agreement and state law are crucial with respect to charging orders. Also, a charging order could put a creditor in a difficult position because tax is owed on a partner’s share of entity profits even if they are not distributed. Thus, a creditor could get pinned with a tax liability, but no income flowing from the partnership to pay the obligation. However, a general partner does not receive the same creditor protection unless the general partner interest is structured as a corporation.
Establishing a corporation as the general partner should be approached with care. It cannot be established as merely a sham to avoid liability. If it is, IRS and/or the courts could ignore it and pierce the corporate veil. To avoid this from happening, the corporation must be kept separate from the FLP. Funds and/or assets must not be commingled between the FLP and the corporation, and all formalities must be observed to maintain the corporate status such as keeping records and minutes, holding directors and shareholders’ meetings and filing annual reports.
- The FLP can also provide flexibility because the FLP agreement can be amended by vote in accordance with the FLP agreement.
- Consolidation of assets. The assets of both the general and limited partners are consolidated in the FLP. That can provide for simplification in the management of the family business assets which could lead to cost savings. In addition, the management of the assets and related investments can be managed by professional, if desired.
- Minimization or elimination of probate. Assets may be transferred to the FLP and the ownership interests may be transferred to others, with only the FLP interest owned at death being subject to probate. Upon death, the FLP continues to operate under the terms of the FLP agreement, ensuring continuity of the business without any disruption caused by death of an owner. Relatedly, an FLP will also typically avoid the need for an ancillary probate (probate in the non-domiciliary state) at the FLP interest owner’s death. Most states treat FLP interests as personal property even if the FLP owns real estate. To the extent probate is avoided, privacy is maintained.
- Partnership accounting rules. The rules surrounding partnership accounting, while complicated, are relatively flexible.
- Ease of gifting. The FLP structure does provide a mechanism that can make it easier for periodic gifting to facilitate estate and tax planning goals.
Disadvantages of an FLP
While there are distinct advantages to using an FLP in the estate and business succession planning context, those advantages should be weighed against potential drawbacks. The disadvantages of using an FLP can include the following:
- An FLP is a complex form of business organization that requires competent legal and tax consultation to establish and maintain. Thus, the cost of formation could be relatively higher than other forms of doing business.
- Unlimited liability of the general partners. However, slightly over one-half of states have enacted legislation allowing the formation of a limited liability limited partnership (LLLP), which is typically accomplished by converting an existing limited partnership to an LLLP. In an LLLP, any general partner has limited liability for the debts and obligations of the limited partnership that arise while the LLLP election is in place. In addition, some states (such as California) that do not have a statute authorizing on LLLP will recognize LLLPs formed under the laws of another state. Also, while Illinois does not authorize LLLPs by statute, it does allow the formation of an LLLP under the Revised Uniform Limited Partnership Act.
- Ineligibility of FLP members for many of the tax-free fringe benefits that employees are eligible for.
- The gifts of FLP interests must be carefully planned to not trigger unexpected estate, gift or GSTT liability.
- Establishing and FLP can be costly in terms of the legal work necessary to draft the FLP agreement, changing title to assets, appraiser fees, state and local filing fees, and tax accounting fees.
- There could be additional complications in community property states. In community property states, guaranteed payments (compensation income) from an FLP are treated as community property. However, FLP income distributed at the discretion of the general partner(s) is classified as separate property.
The FLP can be a useful business organizational form for the farm or ranch business. Careful considerations of the pros and cons of the entity choice in accordance with individual goals and objectives is essential.