The Family Limited Partnership
Many legal experts call the family limited partnership the most effective took for lawsuit and asset protection. Some even call, it a fortress you build around your wealth. It is also a highly effective strategy for achieving these estate-planning goal
- It can help you lower estate taxes or eliminate them completely.
- It can help you avoid both living probate and death probate, as long as you coordinate it with other estate planning tools.
- It may allow you to reduce your income taxes.
- It helps you provide for the successful transition of your business to the next generation.
- It can help you keep a family-owned business intact and thriving, long after you're gone.
The FLP is a partnership to which you transfer ownership of your business or investments. Ownership of the FLP is determined by who owns interests in the partnership. You can own them all, or you can make gifts of interest in the FLP to whomever you want.How does a FLP differ from other partnerships?
In a typical partnership, all partners are treated equally. Each partner is a "general" partner, meaning each has the same right to manage and control the partnership. In addition: each partner has full responsibility for whatever liability the other partners creates in their role in the partnership. It's bad enough that your own actions could put you at risk of a lawsuit. But with a general partnership, you could be held equally accountable for other people's mistakes or misdeeds. And what's at stake is not only your partnership assets, but your personal assets as well.In contrast, a Family Limited Partnership has two types of partners: a general partner and a limited partner.General partners have the right to manage and control the partnership. They invest in the partnership and make all the decisions. In turn, general partners assume responsibility for the liability the partnership creates.A limited partner, however, has virtually no rights, including:
- Limited or no voting signs
- Limited or no right to control or manage the partnership
- Limited or no rights to income
- And possibly even no right to sell interests to anyone other than other partners in the FLP.
Both general and limited partners share in the profits of the Limited Partnership. The distribution of profits from the business is called a "distributive share". In addition, general partners may receive compensation for their role as managers of the partnership.Income is distributed to the partners according to the amount of interests they own. So, the more interests you hold as a partner in the FLP, the greater your proportion of the FLP income.What is the "Valuation Discount?"
It's hard to imagine an outsider wanting to buy interests in a Family Limited Partnership. Consider what the buyer would be acquiring: no voting rights, no rights to control distribution of income, and no opportunity to manage or control the partnership's assets. So, even though the partnership may own assets that are extremely valuable, individual interests may find few, if any, buyers. Of course, that assumes that interest may even be sold. FLP may prohibit partners from doing so to anyone other than another partner in the FLP.Although these limitations sound like disadvantages, nothing could be farther from the truth. Because these interests are worth significantly less than other kinds of investments on the open market, the Internal Revenue Service has long established practice of discounting their value.This so-called valuation discount means that, for tax purposes, the interests of the FLP are worth less than the value of the assets the FLP owns. How much of a discount the interest receives is based on many factors. But in general, discounts range from 30 percent to as high as 70 percent. That means that a $1 million's worth of assets that you transfer to your FLP could be treated for tax purposes as if they were worth as little as $300,000.How does the fact that my FLP interests are worth less than the actual assets benefit me?
Once you've transferred assets to your FLP, you've still got to transfer ownership of the interests to your loved ones. You can do that in two ways: one is to apply the gifts of interests to your lifetime estate-tax exemption of $600,000. The other way is to make annual gifts of $10,000 to your loved ones. In this way, a married couple could provide heirs with assets worth $1.2 million, while giving away an additional $20,000 per recipient each and every year.Now consider how much more you can give away if the interest in your FLP have received a valuation discount of 50 percent. You can now pass on to your loved ones assets worth $2.4 million, with annual gifts worth $40,000...all estate and gift tax-free!I want to give up ownership of my assets, but I don't want to give up control. Can the FLP help?
That's one of the beauties of the FLP. As long as you are the general partner, and your loved ones are only limited partners, you remain in complete control of the partnership and the underlying assets, just as before. And if the FLP owns your source of income---such as a business or an investment portfolio---you can continue to pay yourself reasonable income. For the most part, very little really changes---except your estate tax bill!How does my FLP protect my assets?
The law considers that assets owned by the partnership belong to the FLP partnership it self, not the partners. So, liability created by the individual actions of a partner won't expose partnership assets to creditors. Just keep in mind, however, that liability created by the partnership will expose partnership assets to creditors.Here is the most important fact to remember about laws governing Limited Partnerships: They protect the rights of the partners who have done nothing wrong. If the partnership itself is not at fault or has not incurred the debts, its assets are off-limits to an individual partner's creditors. So, creditors cannot:
- Seize partnership assets
- Interfere in the management of the partnership
- Demand a partnership distribution of income or assets
- Terminate the partnership
Let's say you have assets that you'd like to protect. You create a Family Limited Partnership, and assign many of your assets---real estate investments, stocks, bonds, collectibles, etc.---to the partnership.You and your spouse will become general partners, each with a one-percent general partner interest in the Family Limited Partnership. You and your spouse are also limited partners, each with a 49 percent interest.As general partners, you and your spouse can manage your investments just as before. Meanwhile, you have provided a measure of protection for your wealth.Now let's say that you become involved in a traffic accident for which you are at fault. You are sued by the person whose car you struck, and he obtains a judgment against you that exceeds your coverage under your auto insurance. When your creditor tries to satisfy his judgment by seizing your property, he discovers it is owned by your Family Limited Partnership, and is therefore, off-limits.What recourse does a creditor have?
Under Limited Partnership laws in most states, assets owned by the partnership can not be seized by a creditor. Instead, creditors usually have only one course of action against a debtor's partner's interests.The creditor can have the courts issue a charging order against the debtor partner's distributive share to satisfy his judgment. That means that if the Limited Partnership distributes income to the partners, the creditor gets the income that would have gone to the debtor partner. In fact, the creditor becomes the "assignee" of the partner's distributive share.So, in our example, if you lose a lawsuit and a creditor receives a personal judgment against you, the best he can do is to obtain a charging order against any distributive share you might receive from your Family Limited Partnership. But the creditor's charging order can quickly become a hollow victory, as you'll soon see.As defined by the partnership agreement, general partners have complete control over distributive shares to Limited Partners. They can decide, for example, to withhold payment of the distributive shares. So, the mere fact a creditor might have a charging order against you doesn't mean he will ever receive a dime.Back to our example: Say your Family Limited Partnership earned returns of $100,000. As a limited partner with a 49 percent interest in the partnership, your distributive share would be $49,000. But you and your spouse, as general partners elect to withhold payment of distributive shares. As a result, your creditor receives no income.Of course, this strategy also means that all other partners in your FLP will not receive income either; so it is a short-term solution at best. In most cases, the fact that your assets are owned by your FLP is an excellent bargaining tool that may help you negotiate a more favorable settlement with your creditor than under other circumstances.How does a FLP help me solve my business succession plans?
Your FLP can become owner of your family business. You can then distribute shares and income to family members in a way that helps you achieve your goals for the transition of your business.Let's say, for example, that your own a farm. You have two sons, one who now works the farm with you and who would like to take over someday, and another son who has chosen a career off the farm.You can give both sons limited partnership interests in your FLP, tipping the scale in the favor of the son who is working the farm, and helping to ensure its survival. To compensate him for his work, the FLP can also pay his salary. And in the future, when you retire or when you pass away, you can direct that your farming son assumes your role as general partner.In this way, your FLP can not only help you pass on your legacy to your loved ones in a way that makes sense, but it will also help you ensure the successful transition of your business from one generation to the next.Will the FLP give me enough options for controlling how my legacy is distributed to loved ones?
Absolutely: you have complete discretion over who receives interests, and how much they receive. One of the axioms of good estate planning is that "fare" doesn't necessarily mean "equal". A child or grandchild who may need greater support through life can thus be given more interest.At the same time, the FLP helps you ensure that your legacy doesn't become the inheritance of some unintended heir. For example, you may be concerned that the FLP interests you give to your son or daughter today may one-day become the property of an ex-spouse should your child get divorced. As long as your children keep their FLP interests separate from their marital assets, however, the interests are not likely to be subject to a divorce settlement, and will thus stay in your immediate family, as you intended.Can I use a FLP to lower my income taxes?
Yes! If you transfer ownership of an income-producing asset---whether your investment portfolio or business---you can distribute some of the income it produces and the resulting taxes to the partners who receive income.Let's say, for example, that you transfer ownership of some investment real estate to your FLP. You and your spouse are the general partners. Your two children and three grandchildren are limited partners.Each year, the investment real estate earns income. In the past, you had to pay taxes on that income. Now, however, you can pay out that income to your children and grandchildren through "distributive shares".If your grandchildren are over age 14 (the age at which children are taxed at their own rates, not that of their parents), then it's likely their income---and thus their income taxes---will be much lower than yours. So your family will get to keep more of the income your FLP produces.MORE ADVANTAGES OF THE FAMILY LIMITED PARTNERSHIPYou've just seen the many important estate-planning goals that the FLP can help you achieve. Now, here are just a few more benefits this powerful tool offers:
- Assurance that in the vent of a serious disability others will be able to step in and manage your business or investment assets according to your wishes.
- Safeguards to your privacy in your investment activities.
- A way to distribute funds to family members for special purposes such as a college education, purchase of a home, etc.
A WORD OF CAUTION: "SAFE" VERSUS "DANGEROUS" ASSETSFamily Limited Partnerships offer many advantages, but they should be handled with care. One important safe guard, for example, is to keep "safe assets" separate from "dangerous assets". Here's why.Earlier we explained that the assets in a FLP are safe from seizure by creditors as long as the assets themselves don't create a liability. For example, say your FLP owns your company, which operates in a risky line of business. Now, imagine someone is injured by your business. The injured person goes on to sue you and is awarded damages in court. Under these circumstances, your business might be in jeopardy. The successful plaintiff may be able to seize your business or force its sale in order to satisfy his claim against it.In contrast, safe assets are those not likely to incur legal liability. That means these assets are highly unlikely to create a liability for which you can be sued. Here are examples of what we mean by safe assets:
- Investment portfolios: stocks, bonds, mutual funds, cash accounts, etc.
- Collectibles: art, antiques, coin collections, etc.
- Real estate investments for which you have substantial liability insurance.
That' not to suggest, however, that you shouldn't use a FLP to protect your business or other "dangerous" assets. On the contrary, if you have risky assets with the potential to create a liability, these may be held in their own FLP separate from the FLP that holds your safe assets.Other assets shouldn't be assigned to the Family Limited Partnership for tax and administration reasons. The include:
- Retirement plans
- S corporation stock
- Stock of professional corporations.
STRATEGIES THAT DON'T WORKWhy can't we just give our assets away now?
There's nothing stopping you from giving away your estate now, while you can still see your loved ones enjoy your legacy. And you can do so without incurring estate taxes or gift taxes as long as you remember the guidelines we've discussed earlier. But just remember that along with the loss of ownership, you'll also lose control of the asset. If the asset you are giving away is a business or an investment portfolio, for example, you'll have no guarantees that your loved ones will manage it as successfully as you would. You may also lose out on the opportunity to protect your legacy from unintended benefactors: your loved ones' ex-spouses, creditors or others who might prey on the newfound wealth.GETTING STARTED ON YOUR OWN FAMILY LIMITED PARTNERSHIPWhen is the best time to create a FLP?
Both estate planning and asset protection strategies should be implemented at the same time: before you need themIt's too late to avoid Living Probate when you are so ill or disabled that you can no longer manage your affairs. If you die without an effective estate plan in force, you've lost the opportunity to control distribution of your assets and minimize taxes. Likewise, if you wait until you are in the midst of a lawsuit---or one looms on the horizon---you will be unable to implement these strategies.The courts take a dim view of actions' of individuals undertakes to defraud creditors. And that's how many will appraise eleventh-hour strategies that take assets out of your estate and beyond the reach of a plaintiff. For example, say you are the defendant in a lawsuit that you will probably lose. You give away a sizable share of your assets to your children. The courts will declare the transaction a "fraudulent conveyance", or an action which deliberately seeks to protect assets from plaintiffs and creditors. Thus, the transaction will be declared invalid and the assets will be brought back into your estate.On the other hand, the planning measures you undertake which are deemed to be part of a comprehensive estate plan---and which are not done in response to pending legal action---are completely appropriate.That's why we stress that the best time to implement your estate planning and asset protection strategies is now---before you need them.What other factors do we need to be concerned about?
State laws govern family limited partnerships and the protections they receive in each jurisdiction. And as you know, laws can change, potentially altering the performance of your Partnership and the benefits it provides you and your family. That's why it's so important that you obtain the assistance of a qualified estate planning attorney who will help you derive all the benefits possible from this powerful estate planning strategy.