Some common elements inherent among founding owners of closely held family-operated businesses are a strong work ethic and an unmitigated will to succeed. These people spend countless hours cultivating and nurturing the business, which likely represents the largest asset in their estate.
All of this usually adds up to a strong sense of accomplishment, but this scenario also generates a list of tricky decisions when it comes time to transition the business and properly position assets for estate planning. One solution available to owners of a family business who wish to pass the business down to the next generation is to establish a family limited partnership (FLP).
How do FLPs work?
Parents who have spent many years creating a successful family business may find themselves with a highly valuable asset, which could create a substantial taxable estate. If the parents want to keep the business in the family, they are usually interested in minimizing the tax costs of transferring the business to family members. But members of the “senior generation” may not be ready to yield complete control of the business to the next generation.
FLPs are an increasingly popular and effective succession planning tool that allow business owners to safely pass the business to younger generations while achieving some transfer tax savings and maintaining some control of the business.
Generally, when an FLP is formed, family members–both parents and children–transfer assets to the partnership in exchange for partnership interests. The parents, or a corporation owned by the parents, often become the general partners and convert the remaining interests to limited partnership interests.
The general partner has the exclusive right to manage and control the partnership. He or she does not need to own a majority of the partnership, however. In fact, the general partner typically owns as little as a 1% or 2% interest in the partnership; the balance of the partnership is owned by the limited partners. Conversely, limited partners have no right to control or manage the partnership.
In addition to being the general partners when the FLP is formed, the parents can initially be the limited partners as well. The leverage of this strategy comes when parents then make gifts of limited partnership interests to their children, resulting in a shift of wealth–but not control–to the next generation. Over time, these transfers facilitate effective business succession planning, particularly if the strategy is implemented early enough to take advantage of several years of the annual gift tax exclusion before the parents plan to retire.
Perhaps the most compelling advantage of an FLP is the ability to avoid or minimize transfer taxes, which can be achieved in a couple of ways: using the annual gift tax exclusion and taking advantage of possible valuation discounts.
Using an FLP for business succession purposes usually involves transferring partnership interests from parents to children. Gifts of partnership interests are subject to gift tax; however, if the situation is managed properly, the annual gift tax exclusion (currently $12,000 per year, per donee) can be used. It is important to ensure that the partnership agreement is drafted properly so the gift is considered a present interest gift, which thereby qualifies it for the exclusion.
As an ancillary benefit, this gifting strategy removes future appreciation of the asset from the donor’s estate. This can be particularly effective in situations where the business is growing rapidly.
FLPs also offer the potential to leverage valuation discounts. This feature is rooted in the fact that the FLP agreement typically restricts the transferability of partnership interests and the withdrawal of partnership assets. Additionally, limited partners are precluded from participating in management.