Pros and cons of creating a family limited partnership

Properly structured, a family limited partnership (FLP) can be an invaluable tool in your estate planning process. However, while an FLP can provide many advantages, it also comes with a number of drawbacks. Because of this, it's important to do all your research before you take the plunge and decide to implement a family limited partnership as part of your estate planning.

Definition of a family limited partnership

In terms of its structure, a family limited partnership functions just like a normal limited partnership. This means there are two types of partnership interests involved in an FLP:

• General partner. An FLP's general partner or partners, typically the parents, are responsible for making all the necessary decisions involving the management of the FLP. They also have unlimited liability when it comes to the conduct of the FLP's affairs.
• Limited partner. An FLP's limited partner or partners do not have a say in the FLP's management or investment decisions. However, they also have limited liability when it comes to the FLP.

What a family limited partnership is not

While a family limited partnership is essentially a limited partnership, there are important differences between an FLP and two other entities: a trust and an LLC:

• Family limited partnership vs. trust. A trust is a vehicle set up to hold property for the benefit of the trust's beneficiaries. An FLP, however, is a business from which family members profit according to their proportion of general partnership shares and limited partnership shares.
• Family limited partnership vs. LLC. While both an FLP and a limited liability company (LLC) are businesses, an LLC does not provide the same estate planning potential as an FLP. One of the benefits of an FLP is the way it is structured to take advantage of the Internal Revenue Services (IRS) annual gift tax exclusion. Using this exclusion, a parent can place assets into an FLP and then gradually transfer the FLP interests to immediate family members over the years without running into the problem of gift taxes, as long as the amount transferred stays within the gift tax exclusion threshold for each year.

Advantages of a family limited partnership

There are a number of advantages to using an FLP as an estate planning tool, including:

• Family limited partnership taxation. In addition to using the annual gift tax exclusion discussed above, any future returns generated by an asset placed in an FLP stays in the FLP rather than being included in the parent's estate. This means that, on the parent's death, the estate includes only the value of the asset at the time it was transferred into the FLP. For example, an investment property that was valued at $100,000 at the time it was transferred into the FLP is included in the parent's estate at this $100,000 valuation even though it has increased in value to $500,000 by the time of the parent's death. The remaining increase in value belongs to those holding an interest in the FLP.
• Family limited partnership agreement. The structure of the FLP means parents continue to maintain control over the running of the FLPs in their capacity as general partners. Not only can they draft the FLP agreement to include any restrictions on the transfer of FLP interests (for example, dictating what happens in the event of a child's divorce if the child's spouse also holds limited partnership interests), the agreement is also subject to future amendment or change. This means general partners can change the conditions in the agreement in response to any changes in family members' personal situations.
• Limited partners and creditors. Because children, spouses, and grandchildren hold limited partnership interests in the FLP, their creditors cannot gain control of these interests unless the general partners give their consent. These creditors also cannot force the FLP to make any cash distributions. This means that, within the family limited partnership, asset protection can be provided to limited partners, to a certain extent.

Disadvantages of a family limited partnership

In addition to the above benefits, there are also a number of drawbacks in using the FLP as an estate planning tool. These include:

• General partnership interests. Since the FLP must be run as a business, this exposes general partners to any potential liability involving the partnership. Additionally, unlike those holding limited partnership interests, the FLP remains susceptible to any claims by the creditors of its general partners. Finally, the family limited partnership is, at its core, a business, and the general partners must be competent to run it as one.
• Costs and complexity. The family limited partnership is a complex structure, and it's advisable to obtain the advice of a number of professionals during both the setup process and on an ongoing basis. This includes not only an estate planning attorney or tax professional but also a property valuation expert who can assess the value of the property being transferred into the FLP.
• Restriction on the types of assets transferred into the FLP. Because the FLP is a business, personal assets cannot be transferred into an FLP without potentially endangering your ability to use the annual gift tax exclusion to transfer limited partnership interests to your heirs. Because of this, an FLP is only advantageous if you have sufficient nonpersonal assets such as investment properties and securities to be transferred to the FLP.

Depending on your financial circumstances, the family limited partnership might be the ideal vehicle for your estate planning needs. While it is essentially a limited partnership and must be run as one, it also provides both gift tax and estate tax advantages that may make it advantageous for you and your heirs.