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A Family Limited Partnership?
U. S. Income tax benefits of a FLP
U. S. Estate and gift tax benefits of a FLP
Asset protection benefits of a FLP
Control benefits of a FLP
What's The Catch?
SPECIAL THANKS TO BILL COMER AND TERRY COXON
What if you could sign a document, write a check for a few thousand dollars and begin to ....
Those are the promised benefits of a "family limited partnership" or FLP.
However, before describing the mouth watering menu of financial benefits
that can be realized with a FLP, I must caution you to realize that there
is a price to be paid. That price is the need to have competent advisors
with experience in setting up and administering a FLP..
However, huge amounts have also been lost by investors in corporations. Over time, the greatest losses occur in unincorporated proprietorships and informal general partnerships. It isn't the form of the business that causes the losses.
A limited partnership is simply a legal arrangement where investors are treated like partners for tax purposes, but like corporate stockholders for liability purposes. The limited partner is not subject to any debts of the partnership in excess of the limited partners' capital. Each limited partnership must have one or more general partners who are personally liable for any debts of the partnership. In order to avoid partnership liability, the limited partner gives up any management of the partnership. The general partner(s) have total discretion regarding the management of the partnership.
A "family" limited partnership is a limited partnership where most of
the partners are members of the same family group. For this purpose, the
"family" label is simply an adjective. The law doesn't really distinguish
between a family limited partnership and any other type of limited partnership.
In addition, in a FLP, someone in the family is the general partner so
that control is retained by one or more family members. When a FLP operates
a family business, the parent that manages the business is the general
partner. The children, a spouse or other family members are limited partners.
When the FLP is used to own family investments, the high risk spouse and
children are often the limited partners and a spouse who is not susceptible
to lawsuits is usually the general partner.
Even so, there are still substantial income tax benefits available by shifting investment or business income to dependents. With personal tax rates of up to 39.6%, the benefits of income shifting have become more popular.
However ... most taxpayers are reluctant to give unlimited control of substantial amounts of money to their children - even when their children are adults. With a FLP, you can retain control of the money. With the FLP, you can also retain the cash in your business or for reinvestment. Generally, you only need to distribute enough cash each year to pay the taxes that are due by the partners on the income of the partnership.
The general partner in an investment partnership can also control the taxes that will be due by the type of investments that are used. The partnership can invest in growth stocks, land, cash value life insurance or some other tax deferred investments. (However, this should not be construed to mean that the partnership can invest in annuities. Only individuals or grantor trusts can enjoy the tax benefits of a deferred annuity.)
When any appreciated assets of the FLP need to be sold, the taxable gain is allocated to the various family members who are partners. Thus, part of the capital gain is shifted to lower bracket family members. If there is a desire to contribute highly appreciated assets to a charitable trust the partnership can usually make a tax free distribution of the appreciated asset to the various partners who can then contribute the asset to the charitable trust in exchange for a lifetime income.
Where a FLP is used to operate a family business, some self employment tax savings can be achieved to the extent that there are profits to be allocated to the limited partners. The self employment tax is only imposed on those who earn the profits. Limited partners (who are not active in the business) are not subject to the self employment tax on their share of the profits. (The IRS does require that the general partners be paid adequate compensation for their work on behalf of the partnership and that capital must be a significant income producing factor.)
For one of my clients, a FLP was recommended instead of a trust to provide for the future college education of his children. After exploring the benefits and problems associated with using an educational trust, a FLP turned out to be a far better vehicle than a trust. The FLP allows the children to pay the income taxes on any income earned on the investments in the partnership, while the parents retain control of the assets and the timing of distributions from the partnership.
The S corporation has become a popular device to shift income from a family business to dependent family members. However, until the 1996 tax law, there were severe restrictions on who could be a shareholder of an S corporation. It appears from an early review of the new tax rules for S corporations that most of the problems have been eliminated. In time, more families might decide to use S corporations instead of FLPs to operate family businesses.
In the past few years, the Limited Liability Company (LLC) has become very popular among lawyers as the preferred form of business for family businesses. It's still not clear whether the LLC is an effective alternative for a family investment fund, whereas the FLP hs been the preferred entity for that purpose.
To realize the great asset protection benefits of the FLP (which are
discussed later), transfers of FLP interests to children, a spouse and
parents will give the courts more reasons to protect the assets of the
partnership from the creditors of the parent.
Estate taxes can be greatly reduced by making annual gifts of up to $10,000 to each heir by each spouse. If a family has four children and six grandchildren, each parent can make tax free gifts of up to $100,000 a year. Each parent can also make a tax free one time gift of up to $600,000 to use up their estate tax exemption. Over a period of ten years, a couple could give away $3.2 million - tax free. If a large part of the assets given to the heirs are used to buy life insurance on the parents, the heirs can leverage their gifts by five to twenty times the actual amount of the gifts. Thus, if the $3.2 million were used to buy life insurance on the parents beginning at age 45 to 50, the total amount transferred to the children and grandchildren could exceed $60 million - free of any estate or gift taxes.
Not only are the annual gifts free of estate and gift taxes, the future income and appreciation on those assets will be transferred to the next generation. In the case of an ownership interest in a family business, the future income value of the transfers will often exceed the initial value of the gifts.
Using annual gifts to buy life insurance owned by the beneficiaries can provide income tax benefits as well as estate tax benefits.
By operating a business as a FLP, the parents can make gifts of the limited partnership interest to their heirs without giving up future control of the business. When you give your children shares of stock in a family corporation every year, the children will eventually acquire more and more voting control. Creating a second class of stock runs head-on into some complex tax rules that limit the value of gifts of interests where different interests are retained by the parents. For example, making gifts of common stock when preferred stock is retained by the parents may result in a minimal gift value for the common stock, leaving most of the value in the parent's preferred stock.
Recently, the courts and the IRS have been more willing to accept the economic fact that transfers of closely held stock and limited partnership interests aren't worth as much as the full per share value of the property. Discounts for lack of control or lack of marketability can greatly cut the estate and gift tax.
One of the most popular estate tax planning techniques used today is
the irrevocable life insurance trust. The parent makes gifts to the heirs
(indirectly) which are used to buy life insurance through an insurance
trust. Some commentators are beginning to suggest that the FLP may be a
better device than the irrevocable trust to own and manage insurance for
the children. An extra benefit of the insurance FLP is that income received
by the partnership could be used to pay the insurance premiums.
If you are a general partner, you might be able to force the partnership to liquidate your interest - unless a written partnership agreement is carefully drafted to prevent a liquidation upon the withdrawal of a partner. While the courts will not force your partners to accept your judgment creditor as a partner in your place, the risk is whether you may be required by the court to exercise your right to liquidate your interest.
However, if you are a limited partner, you usually have no right to force a liquidation of the partnership and you have no right to participate in any management of the partnership. All of the states (except Louisiana) have adopted a uniform law regarding limited partnerships. That law gives your personal creditors the right to a "charging order" for any distributions that are made to you as a limited partner.
A general partner is a fiduciary (essentially the same as a trustee) for the limited partners and can't be forced to act in a manner that is harmful to the limited partners. Some advisors claim that you can be the sole limited partner and a general partner and can still avoid having the partnership assets taken by a creditor. Other advisors argue that the U.S. courts will not respect such a transparent device to foil your creditors and that the courts will not respect the partnership status unless there are other limited partners who would be harmed by a forced liquidation of the partnership. Some legal advisors also argue that if all of the other limited partners are related to you, the courts will be less reluctant to ignore the legal existence of the partnership than where there are unrelated limited partners.
When a creditor gets a charging order against a limited partner, the general partner is required to give any future distributions to the creditor. But the general partner may not choose to make any distributions at all. The creditor is then forced to wait. That alone will usually get the creditor to negotiate a very substantial discount. The creditors might agree to accept as little as ten cents on the dollar to resolve their claim.
And ... a charging order can be a poisoned asset to a creditor. If a creditor gets a charging order against a limited partner, the IRS says the partners' share of the income is now the property of the creditor. The creditor must therefore pay the taxes on that income - even though the creditor hasn't received any cash distributions. Thus, the creditor is stuck with a legal "asset" that is really a liability in terms of cash outlays. Once the creditor realizes the full import of this "poison pill", he will usually settle for a few cents on the dollar. Actually, most creditors will simply give up and waive any claims upon the FLP.
One of the problems people encounter when they try to protect their assets from creditors is that the law gives creditors the right to recover assets that have been transferred without adequate compensation in contemplation of a judgment. The laws vary greatly from state to state in the details. An attorney who is knowledgeable in bankruptcy and fraudulent conveyance law must be consulted for the details that apply in any specific state. (In most cases, attorneys who specialize in bankruptcy law will be very familiar with these rules.)
However, transfers of assets to a FLP in exchange for partnership interests of equal value are not usually considered to be a fraud against creditors as long as the partnership interests are retained by the transferor and no effort is made to conceal the transfer of assets. When there are other limited partners, the courts are unlikely to require any liquidation of the partnership or the limited partner's interest. Thus, an attractive asset can be converted into an unattractive asset so that a creditor is likely to accept a substantial discount for payment of his claim.
A limited partnership protects the inactive limited partners from liability flowing from a business to the owners. It also protects the partnership from being liquidated due to claims against a limited partner.
Where a business is involved, liabilities may arise from the operations of the business. Equipment owned by the partnership may injure someone. Employees may bring claims against the business. Employees may cause damages to third parties. Damages caused by the products or services sold by the business may generate huge damage claims. The list of potential claims is endless. In a general partnership, any personal assets of any general partner can be taken to satisfy a judgment against the partnership after the assets of the partnership are exhausted.
The U.S. legal system has become extremely favorable to creditors in the past two to three decades. However, other parts of the world have legal systems that are not as favorable to claimants. If a tax neutral irrevocable trust is established in a foreign legal jurisdiction, and the limited partnership interest is transferred to the foreign trust as an asset of the trust, a creditor would also have to convince the foreign court that a charging order should be granted. Under a different set of rules, the creditor would be far less likely to win. Thus, the combination of an offshore asset protection trust and an FLP would make it extremely frustrating for a potential creditor.
Multiple FLPs offer greater protection when some assets are susceptible to potential claims or when both spouses are in high risk occupations. Because liability flows to the owners from the business, it is not desirable to combine assets like cash and marketable securities with assets like equipment or real estate.
One popular use of a FLP is to put critical business equipment into
a FLP and then rent the equipment to a family business. If creditors win
a claim against the business, the equipment is not an asset of the business.
This approach is also used to provide income tax savings by giving family
members a share of the FLP. It's also an effective way to provide a retirement
income to the parents while transferring ownership and control of the business
to their children.
Some observers might question why? Why do you want to control assets you've given away? Those who don't have responsibility for substantial amounts of money won't understand, but I haven't yet met a well to do client that didn't want to control everything until eternity - if possible. What if things go wrong and you need the income from your assets? What if your kids marry a ne'er-do-well or die early or end up in a divorce? What if you get divorced? The worries are endless.
You can get rid of your assets with an irrevocable trust but you can't change your mind or retain much control over the assets. You can make gifts of shares of stock in your family business, but eventually, your children control the business because they own more than 50% of the stock. Then the assets of the corporation are at risk for the creditors of your children. When you make a gift to a charity, it's a done deal. You can't change your mind a few years later. For an uncertain period of time, there is a window of opportunity to reduce your taxes, to protect your assets and to retain substantial control over your assets. (These marvelous benefits are still available with a FLP but it's my opinion that the Congress will eventually find some way to restrict the tax benefits of a FLP.)
In some cases, you can be the general partner while your spouse and
children are the limited partners. As the G.P., you don't lose control
because of the amount of the business that you give away to others. If
you have minor children, you can have your spouse serve as their guardian
for that property. If you want to be the limited partner, you can make
someone else the general partner and give yourself a restricted power to
change the G.P.
The first thing you need to realize is that very few informed advisors really believe that one FLP can accomplish all of these goodies. A FLP can help you to shift income to family members, but that same FLP may not be suitable for asset protection. If a FLP is designed for asset protection, it might not meet the IRS tests to be treated as a partnership to shift income to your children or other family members.
Further details about the pitfalls, problems and details for creating and administering a family limited partnership are available in our subscriber's web site. Changes in the tax laws and various state laws affecting limited partnerships are provided in our monthly newsletter on Asset Protection Strategies.
Vernon K. Jacobs
Terry Coxon, President of the Permanent Portfolio Family of Funds, also offered many helpful suggestions for this article as it was being written. Terry has developed an asset protection trust package that is an inexpensive way to establish a foreign trust so that you can have access to foreign investments.
Further details about protecting your assets from future lawsuits are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies.
NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.
About the author:
Vernon Jacobs is a CPA/CLU who works as a tax author and consultant. He sponsors and moderates a free discussion group on asset protection and offshore topics. His email address is firstname.lastname@example.org. He can be reached by phone or fax at (913) 362-9667.
Your suggestions for improving this web site are most welcome.
Sponsored by Offshore Press, Inc., Copyright, 2001. All rights reserved. Offshore Press, Inc., Box 8194, Prairie Village, KS 66208. (913) 362-9667. Email to email@example.com.