RSM Resources

Transferring family wealth to your children and grandchildren helps them financially — and you from an estate planning perspective — but it’s no secret there are tough tax and succession issues involved. It pays to have a clear, detailed plan in place, and one of the most commonly used strategies is the family limited partnership (FLP).

It’s a popular arrangement because with an FLP, parents (or other senior family members) may maintain control over family assets while gradually moving ownership to their heirs — and may achieve significant estate tax savings in the process. But be advised: Experts warn that due to the potential savings involved, the IRS is likely to take a close look to ensure your FLP is set up and run the right way.

Andrew Keyt, executive director of the Loyola University Family Business Center, says that beyond specific estate- and tax-management benefits, arrangements like the FLP provide a blueprint for working through family issues and planning for the future.

"Lack of family communication is the key reason why only 30 percent of family businesses survive to the second generation, and 11 percent to the third," Keyt says.

A couple establishing an FLP typically transfers assets — usually real estate, securities or ownership in a family business — to the FLP in exchange for general partnership interests (accounting for 1 percent of the value of the partnership) and limited partnership interests (the remaining 99 percent). General partners run the operation, while limited partnership interests or units are passive, like shares of stock in a public company.

Over time, the parents can then reduce the taxable value of their estate by gifting limited partnership interests or units to younger family members — slowly and gradually if the parents want to retain some income from those assets, or more quickly to move a valuable piece of land or other fast-appreciating asset off the estate.

Besides allowing you, as the general partner, to retain authority over investment and distribution decisions, an FLP can benefit your family by providing:

• A structure for managing family wealth. The partnership agreement establishing your FLP is an opportunity to lay down responsibilities, succession plans and other family business procedures in black and white, which can promote communication and decision-making across generations.
• A way to pool — and protect — assets. An FLP can hold many types of assets, which generally can’t be sold without unanimous consent of the partners. Wealth held in a partnership also receives some protection from creditors and divorce settlements; and probate of real estate in nonresident states may be avoided.
• Income shifting. Income from partnership assets can be shifted on a pro rata basis to younger family members in lower tax brackets to reduce your overall tax burden.
• Simplified gifting procedures. Certain assets such as real estate can be difficult and time-consuming to transfer to your heirs as separate entities. As part of an FLP, the gift can be made via a simple transfer of limited partnership interests.
• Flexibility. FLPs are easy to customize to your family’s unique wealth-management needs, and you can modify them if your situation changes. Other asset-transfer setups such as trusts are less flexible once they are set up.

Plus, since the partnership interests you pass to your children come with significant restrictions — limited partners don’t control assets and can’t sell them on the open market or cash them in — the value of those interests is discounted for tax purposes. Discounts can range from 15 to 60 percent depending on the type of asset and the provisions of the FLP agreement. The benefit of discounting is to allow the transfer of wealth to the younger generation at a significantly lower estate tax cost than would otherwise be possible.

Assuming a 30 percent discount, for example, you could transfer $15,000 in value to each of your children while staying within the $11,000 annual gift-tax exemption. Discounting is also available to reduce the value of assets included in your estate. Assets can be passed to beneficiaries with less estate tax cost.

A caveat is that the IRS has a history of challenging discounts it thinks are overly aggressive, and legal cases currently pending could affect how the relevant laws are applied. It’s critical to work with a financial expert to appraise the value of your assets and determine an appropriate discount that will pass IRS scrutiny.

Other key steps

To make an FLP work for you and your next-generation heirs, professionals recommend keeping the following key issues in mind.

Don’t wait until it’s too late. FLPs must have a demonstrable business purpose, beyond tax savings. Thus, don’t wait until a senior family member is in failing health to set one up. At that point, it could be viewed as a last-ditch tax-saving gimmick that has no real economic substance.

Work with a financial advisor and an attorney. Establishing an FLP has significant tax and legal implications. That’s why it’s wise to consult with both a tax and estate planning advisor and an attorney in drafting an FLP — preferably a team that has worked together on similar projects in the past. That way you’re likely to get the best tax and legal advice.  

Run it like a business. Put operating procedures down in writing. Set up regular meetings and document the results. Maintain a separate bank account for the partnership. By running the FLP like a business and not an informal family affair, you’ll derive more benefit from it and be in better shape in the event you’re audited. A rule of thumb: Operate it like you would if you were partnering with strangers rather than family members.

Too often, families think an informal management system is sufficient to manage family wealth, Keyt says. "People don’t have bad intentions, but mixing family and business relationships can breed resentment if there’s no formal structure in place for working through conflicts and reaching consensus."

Meet the legal requirements. The partnership itself is not subject to tax, but partners are required to report their proportionate share of income or loss on individual income tax returns. Tax returns have to be filed in all states where the partnership does business, even if you or your family don’t live there.

Keep a distinct line between personal- and business-use assets. The IRS has successfully challenged FLPs used to hold vacation homes, artwork, retirement accounts and other personal-use assets. If an asset such as a family home is transferred into the FLP, be sure to pay a fair rental value to the partnership for its use.

Make legitimate asset transfers. To be valid, asset transfers must be more than "in name only." If you transfer 90 percent of a piece of rental property to your limited partners, but continue to personally draw most of the income from it, there’s a good chance that the asset ultimately will be considered part of your estate.

Consider your options. Talk to your financial adviser about alternative arrangements such as the limited liability company, which gives you less control than you’d have as general partner of an FLP, but reduces your personal liability.

A family business study conducted by Cornell University projects that between now and 2040, more than $10 trillion in family net worth will be transferred. Consider an FLP as one of the tried-and-true solutions for effectively managing wealth and passing it along to future generations of your family.