Family Limited Partnership: Structure, Tax Planning, & Compliance

A family limited partnership (FLP) is an estate planning option typically employed to champion a family’s wealth transfer objectives. Historically, FLPs have helped families address both collective and individual goals and coordinate and consolidate family assets and investments, such as closely-held business interests. These partnerships have been used to streamline the investment process by providing economies of scale for investors and helping them avoid probate for assets held in multiple jurisdictions. While FLPs come with benefits for some taxpayers, the benefits are not as easy to take advantage of today, and there are tax planning, compliance, and other matters related to impending legislation to consider ahead of formation and on an ongoing basis. 

Structure of a Family Limited Partnership 

Family limited partnerships are businesses made up of one or more general partners and limited partners, consisting mainly and collectively of family members. General partners have an active management role, while limited partners have minimal involvement. General partners also hold personal responsibility for the partnership’s obligations, while limited partners are only liable to the extent of their capital contributions. For children, spouses, grandchildren, or others holding limited partnership interests, this structure also provides asset protection from creditors for interests held in the FLP. 

The family limited partnership operates based on state laws and the partnership agreement. FLP agreements allow for flexibility, as they may be amended or subject to future changes. Through the FLP agreement, general partners can change the conditions in the agreement to realign the FLP with any changes in family members’ personal lives and situations. For example, they may set interest transfer restrictions to protect assets when a child goes through a divorce.

As a pass-through entity, partnership income and deductions are allocated directly to the partners. Parents commonly act as general partners with their children as limited partners. The parents may issue themselves personal salaries. Because the parents may pay higher rates, they may shift the remaining income to the children, allowing them to take advantage of lower income tax rates, even if no distributions are made. 

Annual Gift Tax Exclusion

The structure of a family limited partnership makes it conducive to take advantage of the federal annual gift tax exclusion. For example, when a parent places assets into an FLP, they can gradually transfer the FLP interests to their children. Provided the transfer amount is within the gift tax exclusion threshold for each year, that process can occur over the years without incurring gift tax liabilities. However, gifting assets to an FLP in estate planning is complex. Taxpayers should consult their CPAs and estate planning attorneys ahead of making these decisions. 

The Infrastructure Bill proposes significant changes to the federal annual gift tax exclusion. The current exemption is set to sunset after 2025, but, if the provisions in the latest proposal made by the House of Ways & Means Committee pass, the exclusion could be reduced from $11,700,000 to $6,030,000. However, the effective date of the new estate and gift exemptions is set for January 1, 2022. 

Restrictions on Asset Transfers & Exchanges 

A family limited partnership is a business, so transferring your personal assets into it should be considered carefully. If you transfer a personal asset into an FLP, you may deny yourself the use of the annual gift tax exclusion in transferring limited partnership interests to your heirs. In addition, future returns generated by an asset placed in an FLP will not be included in the parent’s estate. They will stay in the FLP, meaning the estate will include only the value of the asset at the time it was transferred. 

Let’s say a general partner transfers an investment property into the FLP valued at $200,000. If that general partner passes away in 5 years, the amount included in their estate will be $200,000, even if the asset’s value has increased to $600,000 over the five years. The remaining increase of $400,000 goes to those holding an interest in the FLP.

For like-kind exchanges of real property, the House of Ways & Means Committee’s proposal does not address the previously proposed limit on the deferral of gains. Previous iterations included a limit on the deferral of gains of up to an aggregate amount of $500,000 per entity, regardless of the number of owners, and would affect exchanges in tax years beginning after December 31, 2021.

Valuation of Family Limited Partnership Interests

Because family partnership interests lack marketability and control, valuations can be challenging. “Marketability” in this case is the inability to convert property to cash quickly and at minimal cost. “Control” is the ability to control managerial decisions and other aspects of an entity for a less-than-majority interest held. The legal precedent supports the premise that the value of publicly traded interests is usually higher than the value of similar closely-held interests. However, the topic of valuation adjustments and discounts is controversial. 

Under current law, FLP agreements, in conjunction with the basic characteristics of the transferred interest and state laws, determine the valuation adjustments used to determine fair market value (FMV). The Infrastructure Bill proposes that, for estate and gift tax valuation purposes, valuation discounts for lack of control and marketability for any assets that are not used in the active conduct of a trade or business be disallowed. As it stands, however, general partners can apply significant discounts to the value of gifts to limited partners to avoid gift tax.

Contact Livingston & Haynes

Tax planning and compliance for family limited partnerships can be complex. Whether you plan to form an FLP or have already established one, these additional tax planning and compliance considerations can help you promote the success of your family’s investments. 

Based on their specific circumstances, we help affluent individuals and families ensure their family limited partnership tax planning and compliance needs are addressed. I would welcome the opportunity to help you create a plan that helps you ensure your family’s investments will thrive. Contact us today to get started.