Family Limited Partnerships

What You Need To Know About Family Limited Partnerships

The differences between Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs)

Family business owners usually choose a business entity, i.e., proprietorship, partnership, corporation or limited liability company (LLC), in order to take advantage of what the entity offers in capitalization, income tax and management structure.  But an often-overlooked consideration in selecting a business entity is transferring ownership to your offspring or other family members during your lifetime or after your death.

There are two excellent entities to choose from for transferring ownership to family members: Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs).

Family Limited Partnerships and Limited Liability Companies share these advantages:

Both allow you to transfer shares while you retain control of the business.

Transferring shares will qualify you for the gift tax annual exclusion and the lifetime estate and gift tax exemption.

Transferring shares reduces your estate’s value and, therefore, your federal estate tax.

For income tax purposes, business income and deductions will pass through to individual owners, such as in a partnership, proprietorship or S corporation.

Both entities offer some protection of assets from creditors.

Although Family Limited Partnerships and Limited Liability Companies are alike in many respects, deciding which one is best for your business requires a better understanding of their differences.

The choice between a Family Limited Partnership and a Limited Liability Company is dependent partly on which state you live in. All fifty states have statutes involving these entities, with each state law varying slightly, though the main features are quite similar.

But first, what exactly is a Family Limited Partnership, or FLP?  An FLP is basically a limited partnership in which partners are members of the same family or related entities. All limited partnerships have one or more general partners and one or more limited partners.

General partners are the ones responsible for managing the business and bear unlimited liability for business debts. Limited partners are simply passive investors: They aren’t able to participate in managing the business, and their liability is limited to their respective investment amounts.

A Family Limited Partnership can hold a family business or separate business assets leased to the business.  But in order to protect an FLP’s tax benefits, the entity has to have a valid business purpose. For instance, the IRS would likely challenge a Family Limited Partnership formed soon before the general partner’s death on the grounds that the formation of the partnership was primarily to reduce estate tax.

In a typical scenario, a married couple who owns a family business sets up a Family Limited Partnership with the interest of the general partnership totaling 10% of the company’s value and the limited partnership’s interest totaling 90%. Each year, both parents give each child limited-partnership shares with a market value not to exceed the gift tax annual exclusion amount. In this way, the parents progressively transfer business ownership to their children without having to incur estate or gift taxes. Even if the limited partners together own 99% of the company, the general partner will retain all control and is the only partner with unlimited liability.

Now, then, what is a Limited Liability Company (LLC)?  Limited Liability Companies have only been around since the late 1970s.  They combine the advantages of a corporation’s limited liability with the pass-through taxation of a partnership’s. In the majority of states, owners of a Limited Liability Company are called members. Membership of a Limited Liability Company can be restricted to family members, or two classes of membership can be created, which are voting and nonvoting.

By law, the founding members make the decision as who is eligible to participate in the company’s management. 

Founding members may:

Restrict management to one or both parents.

Open management to any or all members, or reserve the right to hire outside managers.

All Limited Liability Company members have the benefit of limited liability protection, whether they participate in company management or not.

Usually, a couple owning a family business will form a Limited Liability Company that assigns a 50% interest to each parent. Then they give ownership interests each year to their children, with most of the same tax advantages that the Family Limited Partnership offers.

n important difference between Family Limited Partnerships and Limited Liability Companies, and that is their level of liability protection. Generally, Limited Liability Companies do a better job because they protect all members, while a Family Limited Partnership protects only limited partners and not general partners.

overcoming liability concerns, a family might create a corporation to act as the general partner.  However, this structure can be both cumbersome and expensive.

Management participation:  

In a Family Limited Partnership, limited partners participating in managing the business (or any assets held by the FLP), would probably lose their liability protection and possibly some tax advantages. But members of a Limited Liability Company may be managers without having to sacrifice any advantages, depending on how the company is set up.

There is passive loss to worry about.  Ordinarily, limited partners in an FLP can’t deduct partnership losses against earned income or investment income. Limited Liability Company members and general partners of Family Limited Partnerships who actively participate in the business can deduct their share of any losses, but this area of tax law is especially complicated. Finally, because Limited Liability Company statutes are relatively new, there are few legal guidelines issued by the courts to assist in interpreting them. This contrasts Family Limited Partnerships, which have a both a longer history and more case law for guidance.

In conclusion, there is no easy choice.  As you see, choosing between a Family Limited Partnership and a Limited Liability Company isn’t clear-cut.  Always get good advice from an expert and involve your local CPA and attorney.