Designed to preserve family businesses for future generations, Family Limited Partnerships (FLPs) and Family Limited Liability Companies (FLLCs) can help shelter your assets and reduce overall estate and gift taxes. FLPs are also utilized as an integral part of business succession planning.
A Family Limited Partnership is typically established by married couples who place assets in the FLP and serve as its general partners. They may then grant limited-partnership interests to their children, of up to 99% of the value of the FLP’s assets. When this occurs, two things happen a) the value of the partnership interests transferred to the children is deemed to be lower than the respective pro-rata value because of minority and marketability discounts and b) the assets are removed from the general partners’ estates. This allows a transfer of significant assets to the children at lower valuation which results in reduced estate taxes. The general partners continue to maintain control of the FLP and its assets, even though they may own as little as just 1% of the partnership’s valuation.
Limited partners may receive distributions from the FLP which can serve to transfer additional assets from the older generation to younger beneficiaries at more favorable income tax rates.
How Minority and Marketability Interest Discounts Work
Since limited partners do not have the ability to direct or control the day-to-day operations of the partnership, a minority discount can be applied to reduce the value of the limited partnership interests that are transferred. Furthermore, because the partnership is a closely-held entity and not publicly-traded, a discount can be applied based upon the lack of marketability of the limited partnership interests. This allows the older generation to leverage the FLP as a vehicle to transfer more wealth to its beneficiaries while retaining control of the underlying assets.
With these significant tax benefits, it’s no surprise that many FLPs have attracted scrutiny from the IRS. Many family partnerships have run into issues with tax authorities due to mistakes or outright abuse. Care must be taken to ensure your FLP is properly established and operated.
Specifically, the IRS may look at the following issues when assessing the viability of the FLP:
- Whether the establishment of the FLP was created solely for tax mitigation objectives. You stand a better chance of avoiding – or surviving – a challenge from the IRS if you can show a legitimate non-tax-related reason the FLP was created.
- Whether the partnership functions like a business. Keep your personal assets out of the FLP. You can reasonably expect to transfer closely held stock or interests in commercial real estate into a Family Limited Partnership. However, personal property such as cars or residences may not fare well against an IRS challenge. Similarly, the FLP’s assets should not be used to pay for any personal expenses. The FLP must be a legitimate business entity operated to fulfill business purposes.
- Whether the valuations are based on objective criteria. Rather than have a partner or family member determine the valuations or discounts for any assets transferred into the FLP, you should have your FLP professionally appraised. A qualified appraiser has a much better chance of withstanding IRS scrutiny.
An FLP can be a powerful planning tool to enable business owners to transfer their stake to the younger generation while allowing the senior generation to continue conducting operations and mentoring and grooming the young owners. However, an FLP can be incredibly complex and should only be established with the help of a qualified team of estate planning attorneys, accountants, and appraisers.