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6 pitfalls that clients eyeing an FLP need to consider

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Family limited partnerships seem like an almost foolproof idea: A client can shield just about any amount of money from creditors while maintaining full control of the assets, and getting tax advantages to boot.

What’s not to like? There’s a reason these vehicles have become so much more popular in recent years.

FLPs were established within the law to help families preserve family owned businesses as they are passed from one generation to the next. Only family members are permitted to share in its assets.

The structure is simple: The grantor places assets into the FLP, which are divided into two classes of stock. One class is issued to general partners; and the second class to limited partners (generally the next generation of the family, or other far-flung family members). The creator of the partnership can retain the general Partnership stock and keep sole control over the buying and selling of assets. The limited partners have virtually no control over the assets — and thus they are reduced in value.

That’s a primary benefit of the FLP: its creation reduces the value of the grantor’s assets for gift and estate tax purposes. Another benefit is that the assets are no longer legally under the control of the grantor, and are thus shielded for the most part from lawsuits, divorce proceedings, and other such takings. And assets within the FLP are not considered testamentary dispositions and pass outside the estates of the Partners.

But they’re not for everyone, and there can be serious pitfalls to an FLP that is carelessly invoked or improperly constructed. The IRS is vigilant about monitoring strategies it deems to be undertaken to evade paying taxes. So for instance, an FLP cannot be created while the client is on a deathbed, since the IRS will consider that to be a last-minute tax-avoidance ploy.

Other concerns to keep in mind:

FLPs can be expensive. In addition to legal costs, the assets put into the FLP must be appraised, making them typically more expensive to set up than other estate planning tools. As more assets are added to the partnership, the appraisal fees will increase as well. The suitable assets are limited. FLPs are designed to own a closely held business and its affiliated real estate, securities, and most other types of investment asset. It’s generally not a good idea to fund them with only stocks or other marketable securities. Personal-use assets such as the grantor’s home are normally not suitable for an FLP. Also, if the FLP is funded with real properties, transfers of more than half of their value could result in serious tax consequences.

They leave conflicts between children untouched. Some parents may believe that by being in control as the general partners, conflict among the members of the next generation can be ignored. But these problems (such as decisions about whether to sell a family business after the death of the parent founders) can be exacerbated by a family limited partnership, wherein the limited partners exercise no real control and often have future control divided equally. In other words, an FLP shouldn’t be considered a substitute for effective succession planning.

The Assets are out of the family’s hands. An FLP is a business entity, so the client cannot use its assets to pay normal family expenses such as mortgage on the family home, utilities, educational expenses, and so forth. Using an FLP for personal purposes could result in the IRS deciding it should be disregarded for tax and asset protection purposes.

Children may be exposed to major capital gains liability. Property that’s assigned to the FLP does not receive the stepped-up basis treatment that property bequeathed through an estate receives. Especially if the FLP consists of property that has greatly appreciated in value, the limited partners could be stuck with a massive capital gains tax bill.

It can be difficult to include minor children. For family members under the age of 18, the interest in the FLP would have to be held by a parent or guardian. In addition, partners in the FLP — even the limited partners — are expected to play a role in the day-to-day management and operations of the business. There’s no point in going to the bother and expense of setting up an FLP if the IRS will disallow the entire thing.

See also:

The Medicare surtax: Is it avoidable?

Letter of intent: a useful component of an estate plan

Living trust scams: What to watch for