Is a Family Limited Partnership a Good Choice for You?July 1, 2019 June 26, 2019 /
A big part of estate planning for families is the question of how to best manage the various assets.
A family limited partnership is one possible avenue to take, particularly for tax purposes and asset protection. This is often used by families that have considerable real estate assets, as it can provide protection from creditors and has the flexibility to allow changes to be made.
Is a family limited partnership a good choice for your situation? We always recommend meeting with an estate planning professional to discuss your personal situation, but we provide some general information below.
What is a Family Limited Partnership?
Firstly, what exactly is a family limited partnership? As the title suggests, it is a limited partnership that is controlled by members of a family. The partnership is formed over some type of family business or trade. There are two kinds of partners in this situation:
- General partner (or partners) – This partner controls all decisions over assets and investments. They bear 100% of liability for the family limited partnership.
- Limited partner – This partner does not participate in the management of the family limited partnership and has limited liability. For example, a limited partner might be a child of the original business owners.
All partners must be able to play a day-to-day role in the running of the business, which usually makes a family limited partnership unsuitable for those who are under 18 or away from home studying in college. They would be unable to exercise a partnership interest.
It’s important to note here that the term “family business” doesn’t have to mean a business in the traditional sense. Some families form a family limited partnership as kind of asset protection when they have considerable real estate, but not so much in terms of liquid assets, for example. The family farm, rental properties, or other real estate investments could fall under this type of partnership.Family limited partnerships have conditions placed upon who can be involved Click To Tweet
Family limited partnerships are formed for tax purposes and estate planning. Under tax rules, “family” is considered to include the following people:
- The person’s spouse
- Their children
- Ancestors including parents and grandparents
- Trusts associated with these people.
While a newly-married spouse can become part of a family limited partnership, a second cousin cannot.
A unique feature of family limited partnerships is that the partnership itself is not taxable. Instead, the owners (both types of partners) report partnership income on their personal tax return. This is done in proportion with their partnership interests and taxed at their own income tax rate.
There are a few ways you might set up a family limited partnership, but a relatively common structure is that senior family members (parents or grandparents) might contribute their assets in exchange for a small general partnership and larger limited partner interest. They can then gift all or a portion of the limited interest to their heirs, either directly or via a trust.
What are the benefits of a Family Limited Partnership?
One of the primary reasons people might form a family limited partnership is for estate tax savings. Basically, when limited partnership interests are transferred over time, it reduces the taxable estate of the senior family members.
If you consider the scenario of a family that has large real estate holdings but perhaps not as much in cash, estate taxes can be a considerable liability and necessitate the sale of the property. A family limited partnership can bring estate tax savings and keep the property in the family (for example the family farm).
When the interests in the family business are transferred to children, any appreciation of the asset after the transfer is not included in the estate of the general partner/s when they pass away. So for example, if the value at transfer was $1 million, but that value appreciates to $8 million at the time of their death/s, only the $1 million is included in their estate.
The major benefit to the general partner here is that they continue to retain all control over the decisions for the investment. As the limited partners cannot control investments or distributions, they may be eligible for valuation discounts at the time of transfer. This can get them a gift tax exclusion, which is a great tool for reducing taxes on income, gifts, and estates.
Income tax benefits
A family limited partnership can bring tax benefits for the personal tax returns of partners. For example, let’s say a mother is a general partner and her three children are limited partners. The mother might choose to share income with the three children in order to reduce her own taxable income.
The important caveat to know here is that those children should be over the age of 14 in order to receive the tax benefit. Back in the day, wealthy people might put their seven-year-old on the payroll in order to reduce their taxable income, but this is no longer allowed. Children who are younger than 14 will be taxed at the top marginal rate of their parents for any income over $1600.
A family limited partnership can also be effective as a means of asset protection. Future creditors and spouses from failed marriages will be unable to lay claim to the estate.
Any creditors looking to claim from limited partners are not able to force cash distributions, have a vote, or own the interests of a limited partner without the consent of the general partner. In the event of a divorce where a current limited partner ceases to be a family member, the partnership documents can stipulate that transfer of interests must be made back to the family at fair market value.
Another benefit can be a reduction in brokerage fees. A family limited partnership can hold one brokerage account, incurring one lot of brokerage fees instead of separate accounts for each child and trust.
What are the disadvantages of a Family Limited Partnership?
One potential disadvantage is that property transferred via a family limited partnership may be subject to a steep capital gains tax — more so than if that property had been bequeathed outside of a partnership.
Why does this happen? Because property that is gifted does not get the same “stepped-up” treatment that bequeathed property does. The term stepped-up refers to the value of an asset when a person dies and leaves it to an heir. Under a bequeathment, the value of shares for example is based on the market price on the day the heir took ownership. If it were based on the day of purchase, there could be a significant difference and large capital gains liability (think about some high-value tech stock, for example!)
The treatment of assets depends on the type being transferred and what has happened to it in the interim. The best course is always to talk with a qualified estate planner about the types of assets you have and their potential exposure to capital gains tax.
Another downside is that general partners are not protected from liability issues. Their assets can be subject to judgments relating to creditors or lawsuits. In this way, a family limited partnership may not be as strong as some other entities for asset protection.
While a family limited partnership can be an effective tool for tax mitigation, it can also attract IRS scrutiny. The partnership is supposed to serve a bonafide business purpose so the IRS may check if you meet that expectation. If they label it an “investment company” for example, the transfer of property can attract a large capital gains tax.
Lastly, it can be expensive to set up a family limited partnership. Minimum fees tend to be in the range of $5000 to $10,000, although this can be similar for other types of entities too.
Should you choose a Family Limited Partnership?
Whether or not a family limited partnership is the right choice for you very much depends upon your circumstances. Factors that affect it can include the amount of wealth at play, the types of assets and your plans for how you want to distribute it over time.
It is very important that any type of estate planning initiative is entered into with good, qualified advice. If avoiding estate taxes is your main concern, remember that the rules were changed under the Tax Cuts and Jobs Act. Individuals now get an $11.18 million lifetime exemption from estate taxes, while married couples get $22.4 million. Avoiding estate taxes is increasingly a problem only for the wealthiest among us.
In any case, talk to your attorney or to trusted estate planners, such as ours at Coker James. Understand all of your options before taking the plunge.