If you own and operate a family business, a family limited partnership (FLP) or family limited liability company (FLLC) has the potential to become a valuable component of your overall estate plan. A properly formed and maintained FLP or FLLC offers the opportunity for families to transfer limited partnership or membership interests to future generations in a tax efficient manner, ultimately helping to facilitate the transfer of a family business or other family assets, while protecting from potential creditors.
What is an FLP?
The FLP is a limited partnership created under and governed by state law that divides rights to income, appreciation, and control among family members, according to the family’s overall objectives as outlined in the FLP partnership agreement. Organizing the family business as an FLP allows for the shift of income and future appreciation of the business assets to other members of your family[1]. An FLP consists of two classes of Partners, who are all family members. The General Partner (GP) controls the partnership and assumes majority of the liability, whereas the Limited Partners (LPs) are essentially investors. GPs typically own the largest share of the business; however, the GP may own as little as one percent.
GPs are responsible for the day-to-day management of the business, such as overseeing all cash deposits and investment transactions, while LPs have no say in how the business is managed. The GP also has the option of taking a management fee from profits if agreed upon and outlined in the partnership agreement. LPs have little to no management responsibilities, they purchase or are gifted shares of the business with the expectation of receiving dividends, interest, and/or profits the FLP may generate.
Advantages of An FLP
- The ability to use the annual gift tax exclusion.
- The structure of the FLP allows GPs to continue to maintain control over the management of the FLP.
- Is a pass-through entity for income tax purposes – partners are allocated their pro-rata share of partnership income, report and pay any taxes due.
- The FLP agreement may be drafted to include restrictions on the transfer of FLP interests and/or allow the GPs the ability to change the conditions in the agreement.
- Asset protection to LPs by preventing creditors from gaining control of an LPs interests unless the GPs provide consent.
- May also guarantee that there will be continuous family ownership of the business by restricting a family member’s ability to sell or transfer his or her interest to nonfamily members.
Disadvantages Of An FLP
- GPs have direct exposure and potential liability, susceptible to claims by creditors of the GPs.
- FLP is a business and must be run accordingly, avoiding any comingling of personal assets that would undermine the FLP structure and therefore expose the business to review by the IRS.
- Costs and complexity. An FLP is a complex structure, requires the advice of a number of professionals during setup and in an ongoing basis. The professionals needed may include an estate planning attorney and/or tax professional and a property valuation expert with the ability to assess the value of property being transferred into the FLP.
- Restriction on the types of assets transferred into the FLP – personal assets may not be transferred into an FLP, for that reason, an FLP is only beneficial if there are substantial nonpersonal assets such as investment properties and securities to be transferred.
What is an FLLC?
A family LLC is a limited liability company formed primarily among family members under a specific state’s limited liability company act. Family members enter into a written agreement – FLLC’s operating agreement – that clearly outlines the terms and conditions as it relates to ownership rights, functional decision making, and transfer of assets. The members of an FLLC jointly own all assets transferred into the FLLC. Not all members of an FLLC are afforded decision-making privileges. The decision makers are deemed “managing members”, while nondecision makers are simply “members.” Managing members exercise shared control over the FLLC and may manage the assets within the FLLC in accordance with the operating agreement, often allowing them to buy, sell, or trade, and operate FLLC assets without obtaining consent from the non-managing members.
Advantages To Forming An FLLC
- Allows for an easier transfer of a family business to the next generation.
- Is a pass-through entity for income tax purposes – members are allocated their pro-rata share of income, report and pay any taxes due.
- Protects member assets from the creditors of members. Typically, a creditor may only obtain a charging order against the member’s interest in the FLLC and not the underlying assets.
- All members are insulated from liability.
- Families with diversified investment portfolios have the ability to gift membership interests to other family members maintaining the integrity of the diversified portfolio.
- Transfer of LLC member interests to future generations (or to trusts for their benefit) may be an effective estate freeze technique thereby removing future appreciation from the owner’s estate.
- Managing members have the ability to retain control over assets.
- Potentially provides some asset protection against failed marriages of family members.
Disadvantages To Forming An FLLC
- Must meet strict IRS requirements for a business.
- There may be adverse tax consequences if the FLLC seems to have been formed solely to avoid paying taxes.
- Managing members must only transfer business assets into their FLLC to avoid commingling of business and personal assets.
Key Differences Between An FLP and FLLC
- The most notable difference involves liability. While FLP’s are managed by GP(s) who have direct liability vs their LPs who enjoy greater protection, the FLLC provides limited liability protection to all members.
- FLPs delineate power between GPs and LPS with only GPs having managerial control, whereas, LLCs allow all members to participate in managerial decision making.
- FLPs offer unique taxation benefits when shares are gifted as inheritance, which allows senior members to pass down money in the form of membership.
[1] For tax purposes, ‘family’ includes spouses, ancestors (parents or grandparents), lineal descendants (children and grandchildren), and trusts created for the benefit of any member of the family.
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