Family Limited Partnership

Related Terms: Tax Planning; Succession Planning

Family limited partnerships (sometimes known as FLPs and pronounced "flip" by tax experts) are an increasingly popular tool utilized by owners of family businesses who wish to pass on their companies to their children while minimizing the federal tax burden that sometimes accompanies such a transfer. The family limited partnership is a legal agreement that allows business owners and their children to address tax issues, business-succession, and estate-planning needs all at once. In simple terms, a parent may transfer assets, such as a family business, into a family limited partnership formed with the children. The parents, as general partners, maintain control of the assets. The children are limited partners. The assets that are transferred to the FLP are restricted—less liquid, harder to sell—and consequently, their value is discounted for tax purposes. The result is that a typical business may have a discounted tax value of 20 to 50 percent under its pre-FLP value. After the older family member dies, the FLP is taxed as part of his or her estate but the amount due is reduced since the value within the FLP has been reduced. Thus, a tax saving is realized. The resulting reduction in tax burden 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 encourage 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 balance is paid in annual installments over a ten-year period.

CURRENT ESTATE TAX RATES

Recent changes in estate tax law have resulted in a great reduction in the number of estates that are subject to any federal estate taxes. In fact, in 2006 only 0.27 percent of all U.S. estates will be affected by federal estate tax, leaving 99.23 percent able, if necessary, to pass on all of their assets to heirs on a federal tax-free basis. State taxes on inherited property are another subject. Each state assesses its own estate tax.

In 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was passed. This act substantially changed federal estate and gift tax laws. The new law increases estate exemption levels every two years—from 1 million in 2003 to 3.5 million in 2009—and abolished the estate tax completely in 2010. EGTRRA also gradually reduces the top marginal federal estate tax rate to a low of 45 percent in 2009. In 2011, unless Congress votes to repeal the tax altogether, estate and gift laws will revert to their pre-EGTRRA form. The very unusual single-year abolition of federal estate taxes in 2010 has led to many jokes along the lines of the one in the title of a 2006 Money magazine article: "Could You Please Die Sometime in 2010?"

This law has been highly controversial and there is much uncertainty surrounding what will happen with estate taxes after 2010. Congress was scheduled to vote on a permanent repeal of the estate tax in 2005 but the measure was tabled in the wake of devastating hurricanes that hit along the Gulf Coast in the summer. According to editors of Mondaq Business Briefing, "The consensus among observers appears to be that permanent repeal is not likely to occur in the immediate future, if at all. While a total permanent repeal would obviously remove a major obstacle in estate planning, we will probably have to settle for legislation that would set the exemption at a definite amount (e.g., $3-$5 million) with an inflation index." In the absence of legislation clarifying what will occur after 2010, the prudent action is to plan well and as flexibly as possible. Family limited partnerships are one useful tool for preparing to minimize estate taxes now and in the uncertain tax environment future.

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 may be included in the parent's estate when he or she dies. The estate tax is one of the highest taxes levied. It is only born by individuals with very large estates. The first $2 million of an individual's estate is exempt from federal estate tax, but amounts above the exempt portion are subject to a tax rate of 46 percent (in 2006). One way to dampen the impact of this tax is to make use of an Internal Revenue Service (IRS) rule that allows individuals to make annual gifts of up to $12,000 ($22,000 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 as follows. 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, usually over a number of years. The general partner, or partners, retain complete control over the assets in the partnership, and no management authority is given to the limited partner(s).

In the most basic terms, a family limited partnership allows the business to be transferred to the next generation at considerably less than its full 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. For example, if a $15,000 limited partnership share is appraised at $8,000, the parents can transfer that share to a child plus $4,000 worth of something else in a single year and stay within the $12,000 annual tax exclusion on gifts. Second, this reevaluation also applies to the shares in the FLP that 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 annual tax purposes as well.

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