Family Limited Partnership (FLP)

What is a Family Limited Partnership (FLP)?

A Family Limited Partnership is a holding company owned by two or more family members wherein family members pool money to run a business project. 

FLP is a legal entity that plays a vital role in the estate planning process by holding -

• interests 
• real estate 
• publicly traded and privately held securities 
• and other assets 

Its members contributed to them. All the partners in this kind of partnership are family members.

Family businesses often create Limited Partnership (LP) or Limited Liability Partnership (LLP) to hold their assets, real estate, etc., for business purposes. 

However, it is often formed for non-business purposes like asset protection, succession planning, estate and income tax reduction, etc., especially for wealthy families whose wealth is increasing.

Types of Partners in an FLP

A few of the types are:

1. General Partners 

General partners are generally the family's senior members, like the parents or grandparents who started the organization. They have complete control over the assets and activities of the businesses. 

These partners manage the business's day-to-day activities and often charge management fees from the partnership as an incentive for their efforts. 

Their stake in the business is comparatively much higher than the limited partners because they are the ones who introduce most of the assets and resources to the company.

General partners hold the majority of shares and retain complete control over the assets contributed to the business. Furthermore, they make all the managerial and executive decisions for the company. 

2. Limited Partners

As the name suggests, limited partners have limited company ownership. Their stake in the business is only limited to the limited partnership interest they own. 

Limited partners are mere investors in the business who buy shares of the FLP to help the general partners raise capital or pool their resources. As a reward for their investment, they earn interest or dividends from the business. 

However, unlike the general partners, they do not participate in the partnership's operations nor get involved in managerial and executive decision-making. They are investors who buy shares in the league to earn interest or dividends.

How Does FLP work?

These partnerships are formed for numerous reasons. It might be incorporated so that the family can pool their assets and wealth together to set up a large business model.

It might be formed simply so that the older members of the family could pass on their wealth to their children, grandchildren, and the coming generations. 

This kind of business organization depends on the business's nature or the intention behind formulating such an entity. 

Let's go through the following examples for a better understanding of FLPs:

Example 1

Suppose Tim wants to start a luxury restaurant chain that would cost him $2.4 million, including working capital, and it should generate $400,000 in earnings before amortization, depreciation, and income taxes. 

However, he needs at least a 50% down payment to get a loan from the bank. 

Hence, he calls his family for help and forms an FLP as follows:

• To raise the down payment, he issues 12,000 limited partnership shares, at $100 each, accumulating to $1.2 million. 
•  Shares cannot be sold for five years, and the partnership will pay out 70% of cash earnings in dividends.
• Tim buys 1200 shares contributing $120,000 to the business, giving him 10% ownership. 
• He will be named general partner and receive the first 5% of profit before tax as a management fee for handling the day-to-day operations.
• The other family members buy the remaining 10,800 shares giving factorial ownership to the family members. 

Tim controls the business with $1.2 million in cash, so he goes to a local bank and gets a first mortgage loan for the remaining $1.2 million, giving him the $2.4 million he needs to fund his business.

The partnership launches its restaurant chain and begins to collect revenue which is further used to pay off the mortgage and to distribute profit among the partners as per their ownership of the business. Once the mortgage is paid off, the revenues can be redirected to further expansion, maintenance, and new projects. 

Hence, by establishing this business model, Tim could pool his family's resources and increase their net worth while establishing a business venture that can be passed through generations.

Example 2

Suppose an old couple, Jack and Stella, have two children, Rose and John. Jack and Stella run a very successful family business proliferating. Their daughter Rose is actively involved in the industry and would likely be a successor of the company. 

On the other hand, John is an investment banker and is not interested in joining or participating in the family business. However, Jack and Stella want to share their business equally with their children, although they do not wish to retire. 

To land a win-win situation, they formed an FLP in which Jack and Stella will be the general patterns, and their children, Rose and John, will be the limited partners. Doing so will prove to be very advantageous for the family in the following ways:

• Jack and Stella will transfer all the assets and resources of their business into the FLP and become the firm's general partners. By doing that, they will be able to hold power over the company still and wouldn't need to retire.  
• Now they will make Rose and John limited partners so their children can share the economic ownership of the business by splitting their limited partnership equally. 
• In the future, when Jack and Stella wish to retire, they can make Rose a general partner so that she can inherit the business. John will remain a limited partner to continue to share the business' economic growth without participating. 

Hence, this business model allows Jack and Stella to be flexible about their retirement while dictating the line of succession for their business. 

However, adopting this business model will bring more benefits for the family. After transferring their assets into the FLP, the value of their business would not be the same. 

Rose and John, the limited partners, will share some percentage of the business and profits per their partnership interest. Hence, Jack and Stella would be able to receive a 30% discount to the fair market value on the grounds of lack of control and marketability. It will decrease their net worth and help them with tax reductions. 

Interestingly, as their business and its valuation continue to grow, this growth will continue to occur outside Jack and Stella's estate, comparatively decreasing their tax liability every year.

Advantages of Family Limited Partnerships

A business structure such as a Family Limited Partnership can be valuable for various purposes. There can be several reasons behind the incorporation of such an entity, like pooling family resources, transferring wealth to children, or simply starting a family business.

However, it is important to acknowledge if such an organization would benefit one's business needs and requirements. 

Let's go through the following examples for a better understanding of this kind of organization:

1. Asset protection 

Being a separate legal entity, the assets transferred in an FLP becomes the organization's property. 

It shields those assets from any future or potential creditors of the general partner who owned those assets before transferring them into the partnership.

Suppose a limited partner no longer qualifies as a family member, such as in the case of a divorce. In that case, the partnership agreement may stipulate that their shares must be returned to the business, mostly at fair market value. The result is that assets stay within the family structure.

2. Control and flexibility 

Like a limited partnership, a Family Limited Partnership is run according to the partnership agreement. It means that the general partner retains control over the partnership's assets. 

Moreover, as the partnership agreement is open to amendment, the firm retains a certain level of flexibility for the general partners.

3. Estate tax reduction

Once the general partner's assets are transferred to an FLP, it substantially reduces his net estate worth and lowers the estate tax burden.

4. Wealth distribution 

By incorporating this kind of organization, individuals can distribute their investments, real estate, and other assets to their heirs by transferring them to the partnership and issuing limited partnership shares to their heirs. 

The value of such shares is comparatively lower than the assets held under the FLP because their appraised value is discounted due to factors of their limited marketability. 

5. Gift tax reduction 

Once assets are given to the firm, the general partners can undertake a phased transfer of the partnership's interests to their children and grandchildren by using the annual gift tax exemption. 

As long as the value of the limited partnership shares falls under the annual gift tax exemption limits, such distribution will not be subject to the gift tax. 

6. Income tax reduction 

Since a Family Limited Partnership is a limited partnership, the tax liability levied on such an organization is passed on to the general and limited partners. Tax liability is an expense for the business shared among the public and limited partners as per their stake in the firm. 

Hence, individuals can take advantage to decrease their tax liability because limited partners, who are generally young, might have a lower tax liability bracket. 

For instance, a young limited partner attending college would likely fall under a lower tax bracket than their parents, reducing the business's tax liability. 

Disadvantages of Family Limited Partnerships

Despite the numerous advantages, it also has some demerits. Determining and examining all the factors involved in incorporating an organization is essential. 

Following are the disadvantages which would help in understanding the drawbacks of starting such an organization:

1. Complexity

Incorporating such an organization could be very complex, as it often requires hiring experienced professionals to undertake the incorporation properly. Hiring an estate planning attorney with experience in that area might not be enough. 

Sometimes it becomes necessary to hire other professionals like appraisers, valuation experts, and tax experts to establish and maintain the enterprise. 

2. Cost

Despite having many advantages, people often do not prefer forming an FLP due to the high cost of incorporating and maintaining such an entity. 

Hiring experienced professionals and experts for the establishment and maintenance could be more costly than the actual benefits the partners would get through tax exemptions, etc. 

3. Capital gain liability

In the case of some assets like marketable securities such as stock, profits from such instruments are taxable. 

Suppose an entity of this kind is created to form a family investment company. In that case, the profits of the assets, which are considered capital gains, and gifted to limited partners, may be taxable.

For instance, if the FLP buys a lot of stocks and transfers them to limited partners as gifts, the limited partners will be taxed on the appreciation of such assets as they come under capital gains.

4. Difficulties concerning minors

As per the law governing the incorporation and conduct of Family Limited Partnership, a minor below the age of 14 years cannot participate in it. Hence, forming such a business entity may not be beneficial for a family in which most members are minors below 14 years.  

Additionally, this partnership model cannot be used to transfer ownership of the family business to a minor because it is prohibited. 

In some cases, a limited partner may need to show the ability to contribute towards the business's day-to-day operations or management of the asset to transfer the assets to them.

5. Limited control for limited partners

As the name suggests, limited partners generally have minimal control over the business. 

Mostly, it is the general partners who not only retain control over the managerial and executive decisions of the business but also exercise complete control over the firm's assets and participate in the organization's day-to-day activities.  

Setting up a Family Limited Partnership (FLP)

This partnership can be helpful for asset preservation and succession planning if established and run appropriately. 

The steps involved in forming an FLP are listed below:

1. Appointment of partners

The first step in creating this kind of organization is appointing a general partner with control over the partnership's managerial and executive decisions. 

Soon after, the limited partnerships are created, and the participating family members are appointed as the limited partners who invest in the business to earn interest and dividends. 

2. Transfer of assets

Once the partnership structure is drawn, and the partners have been appointed, the next step is the identification of assets that the family wants to transfer. 

Mostly, the general partners bring their assets and estate into the business, and the limited partners contribute by buying shares.

3. Valuation of the FLP

The next step after the asset transfer is the FLP ownership interest valuation. The valuation process varies based on the types of assets transferred to the partnership. 

For example, if the FLP owns an interest in a business, a formal valuation may need to be conducted.

A Family Limited Partnership functions somewhat similarly to a business that issues stock, then sells it to raise money. Similar to shareholders, limited partners can share in the most members are minorsn. 

In fact, since common shares of stock typically come with voting rights, one could argue that ordinary stockholders have a greater voice in the asset they have purchased.

Researched and authored by Pratik Chandra | LinkedIn

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