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.
The discounts may be permitted because the limited partner cannot cash in his or her interest and because he or she is usually unable to sell or transfer his or her interests. As a result of these restrictions, the value of the interest can be discounted, sometimes by as much as 35%.
Valuation discounts can be a dicey area of FLP planning, and taking unreasonable discounts can invite an IRS challenge. If done properly, valuation discounts allow partnership interests to be transferred to a successor generation at a fraction of the asset’s actual value, resulting in measurable gift and estate tax savings.
Managing the risks
The annual gift tax exclusion and valuation discounts can provide an efficient way to transfer business interests from a gift tax perspective; however, it can take several years to transfer significant business interests. In the interim, it is important to protect the plan in the event the parents die while still holding a substantial portion of the partnership assets. Life insurance owned by the partnership can be used to offset the loss of a parent who is a general partner and key employee.
For a family-owned closely held business, the FLP could purchase insurance on one or both parents. The FLP, as the policy beneficiary, would receive the insurance proceeds upon the death of the parent(s). The death benefit could then be used to provide liquidity for estate tax purposes or to act as the funding mechanism for a buy-sell arrangement.
IRS scrutiny of FLPs and other considerations
FLPs offer many attractive features when they are properly structured; however, the IRS has scrutinized FLPs based on what it perceives as aggressive valuation discounts and cases where it believes there is no valid business purpose to the partnership. The IRS has also been successful in challenging deathbed formations of FLPs.
Recent court cases have also featured victories by the IRS against FLPs where the IRS contended that the senior generation retained too much control or enjoyment of the assets after transfer to the FLP, or where the IRS argued that a substantial business and other non-tax purpose did not exist when the FLP was established.
Mistakes in these areas can be costly, possibly pulling significant assets back into the estate of a deceased parent.
Keeping the IRS at bay
An FLP can be an effective way to transfer a business within a family; however, it is a sophisticated strategy that necessitates proper legal and financial professionals. An FLP should always be formed for a valid business purpose and be operated as a bona fide business. Violations of these principles may cause the IRS to disregard the FLP and deny valuation discounts on gifted limited partnership interests.
In order for an FLP to be recognized by the IRS and to provide some tax savings advantages, the senior generation business owners must give up some control of the business, treat the younger generation as actual partners and co-owners, and permit the successor generation to participate in management. Following these and other important provisions may help increase a client’s chance of success against an IRS challenge.
David Juliano, CLU, is an advanced planning consultant in Wealth Management at Commonwealth Financial Network in Waltham, Mass. He can be reached at