Family Limited Partnership (FLP) For Estate Planning And Asset Protection: Benefical Or Risky?

Family Limited Partnership (FLP) For Estate Planning And Asset Protection: Benefical Or Risky?

By:

Roman P. Mosqueda, B.S., LL.B., LL.M., S.J.D.

If you have assets of $1,000,000 (or even less in certain circumstances) to contribute, and still retain other assets sufficient to support you for the remainder of your life, you may consider forming and operating a family limited partnership (FLP) among members of your family.

Yes, a FLP is only for wealthy persons, who have significant assets and can afford to pay thousands of attorney’s fees to set it up, defray expert’s valuation costs, as well as bankroll operating expenses to properly maintain it.

It can be as simple as husband and wife-donors creating a FLP with $1,000,000 or less worth of assets, whether real estate such as rental property (but not primary residence), cash, securities, business interests, etc.

As general partners in a FLP, the husband and wife may hold ten (10) percent general partnership interest and ninety (90) per cent limited liability interest.

The husband and wife, as general partners retaining general partnership interest, may then transfer limited partnership units, representing the remaining 90% of the partnership interests to their children.

I. Benefits Of A FLP:

A. Control Over Transferred Assets:

The FLP operating agreement governs the administration, management, investment, and distribution of income and assets upon termination. It can also restrict the transfer of partnership units or interests to others.

The general partners-parents would have management and investment control over the partnership assets to the exclusion of limited partners-children.

More importantly, the general partners decide when and how much of partnership income may be distributed to partners. They can also prohibit the transfer of partnership units or interests outside of the family.

The general partners may further form an irrevocable trust to which their general partnership interests would be transferred and administered by an independent trustee, or form an entity as the general partner managed by an independent fiduciary.

B. Discounted Valuation Of Gifts To Children:

Parents are allowed to give tax-free gifts to children or grandchildren valued at $12,000 (or $24,000 of split gift by both parents) each year.

These annual gifts may take the form of limited partnership units in a FLP, thereby taking advantage of the annual $12,000 gift-tax exclusion to lower estate taxes.

In the context of a FLP, the parents can further take advantage of gift and estate tax valuation rules on minority interests, resulting in lack of control, as well as lack of marketability (non-liquidity) to reduce transfer taxes.

A valuation expert may determine a 20 percent discount in value to a partnership unit given as a gift, due to lack of control, as well as another 20 percent discount due to lack or marketability. Such discounts cannot normally be done in a gift of similar value given outright to children.

The estate values of the partnership units belonging to the parents may also be reduced by aforesaid discounts, resulting in reduced estate taxes when they pass way.

C. Income-Tax Benefits:

A FLP, as a partnership, is a pass-through mechanism, whereby partnership deductions and incomes are charged directly to the partners, general and limited, and taxed at their individual tax rates.

Thus, a FLP allows the shifting of the proportionate share of the partnership’s income from the parents’ relatively higher tax rate to the lower income tax rates of the children with limited incomes.

Moreover, a FLP may make income distributions to limited partners-children to assist them in paying income taxes attributed to the FLP.

D. Asset Protection Benefits:

Another benefit of a FLP is asset protection of general and limited partners from their creditors, seeking to execute judgments against the underlying partnership assets. But the lack of business purpose of a FLP may cause the court to pierce its veil, and find it an alter-ego of the general partners.

Indeed, general and limited partners own only general or limited partnership units or interests (personal property) in a FLP. They do not own directly the (real or personal property) of the FLP.

Limited partnership interests may be gifted to minor children through irrevocable children’s trust that would provide additional asset protection from the general partner-donor’s and children’s creditors.

II. RISKS OF A FLP:

A. Court Determination That Assets Transferred To A
FLP Are Includable In Parent’s Gross Estate:

A FLP would not work as discussed above, if a court determines that a FLP is not created, implemented, and operated correctly, that is, an implied agreement existed that the parents-general partners would retain lifelong enjoyment and economic benefit of the FLP assets.

The Internal Revenue Service (IRS) seeks to show no discount in gift valuation, as well as to include in a parent-donor’s gross estate assets transferred to a FLP, pursuant to Internal Revenue Code § 2036(a), which allows only a bona fide sale exemption.

Indeed, a FLP is vulnerable if it does not have a legitimate business purpose, not have business property as assets, nor a non-tax purpose. Avoidance of gift or reduction of estate and income taxes may be found to be insufficient rationale for its existence.

B. Lack Of Step-up In Cost Basis For Partnership
Asset At Death Of General Partner:

If an asset with low cost basis is transferred to a FLP, the owner-parent relinquishes the potential step-up in basis at the parent’s death. If an asset has been fully depreciated and/or highly appreciated, a FLP may not be advantageous at all, even risky, because of the inability to use the original cost basis of the asset.

Indeed, transfers of assets to a FLP result in transfer taxes, which could have been avoided, as well as the resulting inability to pass on to heirs the asset with a full step-up cost basis.

III. Conclusion:

A Family Limited Partnership (FLP) presents complex issues and pitfalls of gift valuations, inclusions of transferred assets to donor’s gross estate, tax burdens, and applications of the criteria for bona fide sale at fair market value.

As a vehicle for estate planning and asset protection, a FLP is meant for wealthy individuals, who are not faint at heart and willing to spend for their proper set up, funding, implementation, active management, and operation.

(The Author, Roman P. Mosqueda, has practiced partnership and family law for over 15 years in California.

This article is meant for information only, and is not legal advice. If the reader has specific issues on family limited partnership, he or she is well-advised to consult with a competent attorney and an accountant.)

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