Family Limited Partnerships: Estate Tax Benefits and More

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Family limited partnerships have long been a valuable tool of the estate planner. Although historically recognized as providing estate tax planning benefits through the discounted value of assets, these limited partnerships can also implement succession planning goals for the closely-held or family-run business, including the transition of management/leadership for the business.

Limited partnerships provide three key benefits to the business owner:

  1. a limited partnership is not subject to income tax – it is a “flow-through” entity for income tax purposes;
  2. in organizing the partnership, the business owner has more flexibility in providing for control, restrictions on transferability and other similar matters;
  3. the limited partners should receive the protections of limited liability shielding them from the risks of the business enterprise.

Note: For purposes of this blog, we will assume that a limited partnership is the best legal entity to achieve the goals discussed. Other choices may be Subchapter S corporation (S Corporation) or a limited liability company (LLC) which can be either member-managed or manager-managed. The advantages and disadvantages of each of these entities will be addressed in following posts.

To form a family limited partnership, the entity is typically formed through filings with the state Secretary of State’s Office.  The owner then contributes assets to the limited partnership.   Real estate and buildings are transferred by deed, and non-real estate assets are typically transferred through a “Bill of Sale”.  As a limited partnership, the entity typically has two classes of owners: the general partner, who is responsible for the day-to-day operation of the partnership, and the limited partners, who have significantly less control over the use or disposition of assets held by the partnership. Each of the partners, both general and limited, may share equally in distributions or appreciation of assets, or special allocations of income may be used.

Once formed, the owner, who may hold both the initial general and limited partnership interests in the partnership, may transfer by gift some or all of the limited partnership interests to others, including family members, and may retain the general partnership interest to manage the affairs of the partnership.

A family limited partnership is an effective estate tax-planning tool because the fair market value of the limited partnership interests transferred as gifts may be significantly less than the fair market value of the underlying assets owned by the limited partnership.  This difference is attributable to the valuation standard used to determine the fair market value of the partnership’s assets for tax purposes, and certain discounts to the value of the gifted limited partnership interests which are recognized by the Internal Revenue Service and the courts.

A properly drafted family limited partnership agreement can provide a clear path of leadership transition for a business at the death or disability of the founder. The family limited partnership can be especially attractive if the business/assets under consideration require ongoing active management such as a farming operation, a real estate development, or even a family store, where day-to-day management is required. The family limited partnership can also provide more flexibility than, say, a trust arrangement where the business may require additional capital from outside sources (such as  investors), and family limited partnership may be used to provide key employees with a stake in the business.   The family limited partnership is often a better alternative than a trust arrangement, and clearly superior to no transition plan at all.

The family limited partnership can provide centralized management and day-to-day operational control for the business, and can also provide some voice in affairs for the limited partners. To protect the limited liability status of limited partners, however, the limited partners should not participate in regular management of the business, although limited partners may participate in major decisions affecting the business. These  decisions can include the sale of substantially all of the assets of the business, merger or consolidation, appointment of a new/successor general partner, and other significant matters.

In summary, family limited partnerships can be a useful tool to provide transition of leadership in the event of death or disability of the founder and centralized management for a business. This is particularly true in the context of a closely-held or family-run business, where continuing control and ownership of the business within a smaller group or a family represents a goal independent of the estate tax savings.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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