Consider Using an FLP to Keep Your Business in the Family

As a family business owner, you're not just building wealth; you're also creating a legacy. But when it comes to transferring that legacy to the next generation, taxes, control and family dynamics can complicate even the best intentions. A family limited partnership (FLP) or family limited liability company — let's refer to them collectively as FLPs — can be a flexible estate-planning tool that offers tax advantages while allowing you to retain some control over the assets.

Whether you're looking to transition your business, gift investment assets or manage your wealth more effectively, FLPs may be worth exploring.

FLP Basics

An FLP is a partnership formed by family members to hold and manage assets such as a business, real estate or investment portfolios. Typically, the older generation (parents or grandparents) establishes and controls the FLP and gradually transfers interests to children or other heirs over time.

There are two key roles in an FLP:

1. General partners who control the management and decision-making of the entity, and
2. Limited partners who have an ownership interest but no managerial control.

Note: In a family limited liability company, the terminology may differ (managing vs. nonmanaging members), but the structure and goals are similar.

After you set up an FLP, you can transfer family business interests to it, along with marketable securities, real estate or other assets. In exchange, you'd usually receive a small general partnership interest (say, 1%) and a large limited partnership interest. Over time, you can transfer limited partnership interests to your children, removing the value of those interests from your taxable estate while retaining management control.

Tax Benefits

The value of limited partner interests in an FLP, even those that family members hold, is typically discounted from the net asset value of the partnership's underlying assets to account for the interests' lack of marketability and lack of control. The size of these discounts varies, based on such factors as:

• The type and nature of the FLP's underlying assets,
• The size and structure of the ownership interest,
• The FLP's distribution history and income characteristics, and
• Contractual restrictions on transfers and withdrawals

Important: Valuation discounts should always be supported by a qualified appraisal from an experienced business valuation professional.

The discounted value of limited partnership interests is generally lower than the proportionate share of the FLP's underlying assets. Therefore, transfers result in lower reportable gift values and reduced gift tax exposure. Moreover, upon the death of the general partner who established the FLP, his or her taxable estate may be smaller because it includes only the value of the general partnership interest and any untransferred limited partnership interests, not the value of all the FLP's assets.

Bona Fide Business Purpose

When establishing an FLP, it's essential to maintain formal documentation proving a legitimate nontax purpose for the arrangement. If not, you might attract unwanted attention from the IRS. FLPs that hold family business interests can offer many nontax business benefits, including:

• Maintaining ownership within the family,
• Allowing the older generation to transfer ownership interests without diluting their control, and
• Providing some protection against creditors' claims.

When challenging an FLP's legitimacy, the IRS might assert that its underlying assets are includable in the general partner's taxable estate under Internal Revenue Code Section 2036(a). Under Sec. 2036(a), the fair market value of assets transferred by a decedent during his or her lifetime generally must be included in the taxable gross estate if the decedent retains the (actual or implied) possession or enjoyment of the assets or the right to designate who will benefit from the assets.

A transferor retains the enjoyment of assets if an actual or implied agreement exists at the time of the transfer that the transferor will retain the assets' present economic benefits. Factors that suggest a retained interest include:

• Transfer of most of the transferor's assets or the transferor's primary residence,
• The transferor's continued use of the assets,
• Commingled personal and FLP assets,
• Disproportionate distributions to the transferor, and
• The use of FLP funds for the transferor's personal expenses or the estate's expenses.

Estates can avoid Sec. 2036(a) by showing that assets were transferred in a bona fide sale for adequate and full consideration. The bona fide sale exception applies if the transferor has a legitimate and significant nontax reason for creating the FLP. Conversely, transfers weren't bona fide sales where FLP funds were used to make personal gifts to grandchildren, fund life insurance premiums for the benefit of the transferor's children, and pay legal fees related to the transferor's estate planning. The IRS has also argued that transfers weren't bona fide sales because the FLP failed to observe partnership formalities.

Tips for Avoiding IRS Scrutiny

In general, an FLP will be deemed to observe partnership formalities if it operates according to the terms of its operating agreement and follows certain precautions. For example, the FLP should keep separate bank accounts (as opposed to depositing income in partner accounts or paying partners' personal expenses with FLP funds), keep detailed accounting records, prepare annual financial statements and file partnership federal and state income tax returns. The FLP also should:

• Hold partner meetings with formal minutes taken at least once a year,
• Execute documents in the name of the FLP,
• Make distributions on a pro rata basis and at the same time to all partners,
• Use letterhead in the FLP's legal name for business operations,
• Avoid commingling partners' personal assets and FLP assets,
• Execute agreements for all transactions, and
• Record any real estate transfers.

Failure to adhere to such formalities could severely undermine the validity of an FLP and the tax benefits available.

Is an FLP Right for Your Family Business?

Despite many IRS challenges over the years, FLPs remain a useful estate planning tool if they're properly formed and managed. If you're considering establishing an FLP to transfer your business to the next generation, the earlier you start, the more flexibility you have to structure gifts, time transfers and respond to changing tax laws. Contact your tax and financial advisors for more information.