In the next couple of weeks, the Internal Revenue Service is expected to issue new guidelines governing Family Limited Partnerships (FLPs). These guidelines can’t come soon enough. The new regulation is a positive step forward to ending the abuse of an investment vehicle that provides very significant benefits to families.
What exactly is an FLP and how does it help families of significant wealth?
An FLP is typically set up to promote the gifting of assets, via FLP interests, to children while allowing the parents to retain control of the assets. Here’s an example: Parents create an FLP and contribute to the FLP a business that they own. They then gift 98% of their Limited Partner interest to their children, and the parents retain a 2% General Partner interest. The Limited Partners, by definition, have zero control in running the FLP, and the General Partners have all the control. However, the Limited Partners own 98% of the value of the FLP, and the General Partners only own 2% of the value.
Discounts determine the value of the gift to the children. The discounts are commonly based on the lack of control and lack of marketability of the asset. For example, if someone gives you a $1 million asset and the next day you can sell it for $1 million, the gift is clearly worth $1 million. On the other hand, if someone gives you the same $1 million asset, but it is in an FLP and you are a Limited Partner, is it worth $1 million? It is clearly not, since someone else (the General Partner) controls the asset and determines when and if it will be sold. If the discount was determined to be 30%, this gift will thus only be worth $700,000. That amount would be the gift amount, not $1 million.
Unfortunately, some have abused this strategy, and the IRS recognized that something needed to be done. One of the more common misuses is when an FLP is created only with liquid assets, such as cash and publicly traded stocks, and Limited Partner interests are gifted to children. In this instance, the parents retain all the rights of income generated by the investments in the FLP. In essence, it really wasn’t a gift at all. That’s because the parents, who were still in charge, were using all the income generated as if they owned 100% of the liquid assets. In cases like this, the IRS has successfully argued that an FLP interest was not gifted and the liquid assets were therefore part of the parents’ estate.
Benefits Of An FLP
There are many other reasons besides the estate tax savings why an FLP can and should be used to transfer FLP interests to children. These include the following:
- An FLP can allow family businesses to be passed down to the next generations. In fact, an existing tax law was created to help this exact situation. The law allows your estate to pay the estate tax due on transfers of small family businesses over time. This enables a small family business to be transferred to the next generation without being sold when a parent passes just to pay the estate tax. This still happens all too often.
- Even though income-producing real estate activities are not considered a trade or business and under current tax rules are treated as passive activities, an FLP can ensure a seamless transfer of the real property to future generations. I know of many instances in which commercial or apartment buildings have remained in the same family for many generations because they were in a properly structured FLP.
- FLPs are also used to protect assets given to children from themselves. A child at the time of gifting may not be ready to run the family business. With someone else retaining control, the business is less likely to be run into the ground. The child can obtain control at a later date, when they are mature enough to manage it. Also, many FLPs are structured in a way to provide creditor protection for claims arising outside of the FLP. If a child goes through a divorce, for example, the FLP assets can be considered their separate property and thus not subject to the divorce settlement.
All of these benefits should be considered when creating an FLP. If an FLP is created only for tax savings, it can more easily turn into tax abuse.
Properly Structuring An FLP
To ensure that an FLP structure will be not be considered a tax abuse arrangement, the following issues must be addressed and documents created. They are:
- The FLP needs to be formally created as a legal entity.
- Partner meetings should be held, and records about those meetings should be maintained.
- Separate books and records need to be maintained without comingling funds with other entities or other parent accounts.
- The gift needs to be properly recorded for tax purposes, as does the annual income for each partner’s share in the FLP.
- Capital cash distributions, as well as contributions, need to follow the ownership structure. For example, if a child owns 20% of the FLP, then that individual should receive 20% of any distributable cash.
We work with a number of families who have used an FLP quite successfully, so we are very interested in seeing the new IRS guidelines. However, we truly hope that any new rules service to shutdown abusive FLPs and do not go too far and cripple the use of Family Limited Partnerships as a tool to transfer long-time held family assets.