Family limited partnerships (sometimes known as FLPs) are an increasingly popular succession planning alternative utilized by owners of family businesses who want to pass the establishment on to their children without being hit by heavy federal taxes. Neil Alexander, writing in Best's Review, described the family limited partnership as "a legal agreement that allows business owners and their children to address several tax, business-succession, and estate-planning needs all at once. This vehicle allows parents to gift assets to their children at highly discounted rates while still maintaining lifetime control of those assets. In addition, eventual estate taxes are reduced by virtue of reducing the total estate." This reduced taxation, said Nation's Business contributor Marsha Bertrand, "has propelled family limited partnerships to the forefront of estate-planning techniques."
Estate Planning in the Family-Owned Business
When considered in the context of family-owned businesses, estate planning is basically the practice of transferring ownership of the family business to the next generation. Families must plan to minimize their tax burden at the time of the owner's death so that the resources can stay within the company and the family. The complexity of American tax law, however, makes it necessary for most estate planning to be undertaken with the assistance of professionals in the realms of accounting and law.
Since estate planning is such a vital element of long-term family business strategies, consultants en-courage business owners to establish an estate plan as soon as their enterprise becomes successful, and to make sure that they update it as necessary as business or family circumstances change. A variety of options are available that can help a business owner defer or otherwise minimize the transfer taxes associated with handing down a family business. A marital deduction trust, for example, passes property along to a surviving spouse in the event of the owner's death, and no taxes are owed until the spouse dies. It is also possible to pay the estate taxes associated with the transfer of a family business on an installment basis, so that no taxes are owed for five years and the remainder are paid in annual installments over a ten-year period. As of 2000, the U.S. Congress began considering ways to reduce or eliminate the estate tax. Until then, however, business owners continue to seek ways to exclude some or all of their assets from estate taxes, such as the family limited partnership.
Advantages of Family Limited Partnerships
The primary purpose of family limited partnerships is to blunt the impact of estate taxes. "Estate taxes can hit family businesses hard because the full value of a parent's business can be included in the parent's estate when he or she dies," explained Joan Szabo in Entrepreneur. "Estate tax is one of the highest taxes levied on individuals. The first $675,000 of a person's estate is exempt from federal estate tax, but amounts above the exempt portion are subject to a graduated tax ranging from 37 percent to a whopping 55 percent." One way to dampen the impact of this tax, noted Szabo, is to make use of an IRS rule that allows individuals to make annual gifts of up to $10,000 ($20,000 if joined by your spouse) to other individuals without incurring gift taxes. The other way to elude the full brunt of this tax is via an FLP.
A basic family limited partnership operates in fairly simple fashion. "Under a typical family limited partnership," wrote Bertrand, "the parents (or a single parent) retain a general partnership interest in the property—as little as 1 percent—and give limited partnership interests to their children over a number of years. The general partners retain complete control over the assets in the partnership, and no management authority is given to the limited partner or partners."
In the most basic terms, a family limited partnership allows the business to be transferred to the next generation at considerably less than its value. This reduces the size of the estate and thus the amount of federal taxes owed. Indeed, observers indicate that these discounts can amount to as much as 50 percent of a business's value. The discounted valuation occurs because the shares cannot be easily sold or otherwise transferred and because such partnership interests do not carry any voting rights or control in the business in question. "Since the gifted shares are discounted, the partnership pays lower gift taxes on those shares," explained Alexander. "For example, if a $15,000 limited partnership share is appraised at $7,500, the parents can transfer that share to a child plus $2,500 worth of something else that year and still stay within their $10,000 annual exclusion. Second, this reevaluation also applies to the shares the parents continue to hold. Third, because the parents are transferring shares out of their estate, they're reducing the value of the estate for tax purposes."
Other Considerations
Many estate planners and business consultants encourage their clients to look into FLPs, but they do note that family business owners should weigh some other non-tax factors as well. These include:
TIMING OF THE FORMATION OF THE LIMITED PARTNERSHIP. Estate planners and business consultants warn that the Internal Revenue Service will not necessarily approve a family limited partnership if it is transparently obvious that the step has been taken simply to skirt paying taxes. Family business owners who attempt to institute an FLP a few weeks before their death from some foreseeable illness will likely find their efforts blocked.
DIVORCE. In most instances, a child's ownership of limited partnership shares will not be impacted by a divorce action between that child and his or her spouse, but business owners seeking to ensure protection for their child can take a couple steps to provide additional insurance. Writing in Best's Review, Neil Alexander explained that since limited partners (children) receive their shares as a gift and are not permitted to vote or "otherwise exercise any authority in the partnership," the child's shares will not be considered part of the marital assets. Instead, they will remain the sole and separate property of the child. The key, say legal experts, is to make sure that the shares were never formally made part of the marital property. In addition, Alexander wrote that "in the event that a spouse can persuade a court that the family limited partnership shares are marital assets, the general partners can still exercise their option not to distribute income to their limited partners. In that situation, the limited partners assume the tax liability without receiving the income—a situation known as phantom income. It is a good idea to communicate to the in-law at the time the family partnership is established that it is the separate property of the recipient of the gifted shares. This will avoid any future misunderstanding if the marriage ends in divorce."
EXPENSE OF SETTING UP AN FLP. Establishing a family limited partnership can be somewhat expensive, although the price tag depends in large part on the size of the company, the value of its assets, the number of intended minority owners, and other factors.
COMPATABILITY WITH BUSINESS. According to Bertrand, the FLP plan is better suited to some businesses than others. "It's effective for real estate or companies in which capital assets are the essence of the business, but it isn't suited to personal-services companies whose income depends on the activity of the owner, such as consulting firms," she said.
FUNDING THROUGH LIFE INSURANCE. Writing in the Journal of the American Society of CLU & ChFC, James Allen and Thomas Bilello pointed out that family limited partnerships can also be funded through life insurance policies. According to Allen and Bilello, even though life insurance has traditionally been used to fund irrevocable life insurance trusts, they can fund FLPs as well.
INCREASED RISK OF IRS AUDITS. Although family limited partnerships can be very valuable, and their use is increasing, accountants and estate planning attorneys do caution family business owners that using FLPs to transfer ownership of a company does tend to draw the attention of the IRS, which pays particular attention to whether the owners are deemed to have tried to take too great a discount on the value of the business in question. To minimize the risk of an IRS audit, estate planners urge family business owners to have the business appraised by an experienced, respected professional who can provide a solid valuation. For information on securing the services of an established appraiser, contact the American Society of Appraisers.
DISSATISFACTION AMONG MINORITY OWNERS.
Ironically, some family businesses find that FLPs actually spark difficulties between parents and their children, despite the formidable savings that such a plan can provide and the ultimate aim—succession—of the partnership. This is certainly not always the case; many families put together family limited partnerships that garner significant tax savings without a ripple of internal dissension or dissatisfaction. But it is a factor that can crop up, depending on the personalities and financial situations of the persons involved. Writing in Agency Sales Magazine, Leon Danco contended that the financial restraints imposed on minority owners in FLPs—who, after all, do not receive actual salaries from the family business—are usually the cause of this ill will: "Because of the tax laws and the fact that the growing business needs all of the pretax cash it can get its hands on, there are seldom, if ever, any dividends. Because there is no 'market' for a minority share in such a business, the poor minority owner can't even sell his or her shares to convert them into some kind of useable wealth…. This situation is almost guaranteed to encourage the minority owners to see their own self-interest in harassing the management, criticizing decisions, lobbying for dividends, opposing corporate investments, and generally fomenting trouble."
NEED FOR PROFESSIONAL GUIDANCE. Establishing a family limited partnership is a complex estate-planning strategy festooned with regulations. Subsequently, business owners are strongly encouraged to secure qualified legal and/or accounting help in setting up such plans.
Further Reading:
Alexander, Neil. "Limited Partnerships Keep It All in the Family." Best's Review—Life-Health Insurance Edition. November 1995.
Allen, James R., and Thomas C. Bilello. "Life Insurance and the Family Limited Partnership." Journal of the American Society of CLU & ChFC. January 1997.
Bertrand, Marsha. "Keeping Assets in the Family." Nation's Business. July 1997.
Cleary, Jay, and Dave Hunter. "The Family Limited Partnership." Denver Business Journal. November 19, 1999.
Danco, Leon A. "The 'Prisoners' of Family Business." Agency Sales Magazine. August 1991.
Harrison, Ellen. "FLIPs: It's Your Choice, Uncle Sam or Your Family." The CPA Journal. October 1996.
Heidelberger, Suzanne. "Family Limited Partnership." National Real Estate Investor. June 1996.
"Passing IRS Scrutiny of a Family Limited Partnership." Taxes: The Tax Magazine. August 1997.
Plack, Harry J. "Form FLP to Protect Biz Assets." Baltimore Business Journal. November 24, 2000.
Szabo, Joan. "Spreading the Wealth: Transferring Part of Your Business to Your Children Now Could Lower Their Taxes Later." Entrepreneur. July 1997.
Vogelsang, Stephen G., and James B. Bertles. "Effective Drafting Strategies for Family Limited Partnerships." Estate Planning. November 1996.
Ward, John L., and Craig E. Aronoff. "Overcoming a Major Obstacle to Succession." Nation's Business. September 1996.
Washelesky, Frank L. "When is a Family Limited Partnership an Appropriate Tax Savings Vehicle?" The Tax Advisor. October 1997.
