Among the biggest long-term concerns of many business owners is succession planning. How can owners smoothly and safely transfer ownership and control of the company to the next generation? From a tax perspective, the optimal time to start this process is long before the owner is ready to give up control. A family limited partnership (FLP) can help you enjoy the tax benefits. An FLP helps you gradually transfer ownership while you continue to run the business.
To establish a family limited partnership, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children or other beneficiaries.
You retain the general partnership interest, which may be as little as 1% of the assets. However, as general partner, you still run day-to-day operations and make business decisions.
As you transfer the family limited partnership interests, you will remove their value from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.
Because your children hold limited partnership interests in the family owned business, they have no control over the FLP. Thus, they have no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.
The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount. So greater portions of the business can be transferred before triggering gift tax. For example, let’s say the discount is 25%. That means, in 2022, you could gift an FLP interest equal to as much as $21,333 (on a controlling basis) tax-free. This is because the discounted value wouldn’t exceed the $16,000 annual gift tax exclusion.
There also may be income partnership taxation benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket. This potentially reduces the amount of income tax paid overall by the family.
Perhaps the biggest downside is how the IRS scrutinizes the structuring of a family limited partnership. If it determines that discounts are excessive or that your FLP has no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.
The IRS also pays close attention to the administration of FLPs. Lack of attention to partnership tax rules or formalities, for instance, can indicate that an FLP was set up solely as a tax-avoidance strategy.
A family limited partnership can be an effective succession and estate planning tool. However, as noted, it’s far from risk free. Our accounting firm can help you determine whether one is right for you and advise you on other ways to develop a sound succession plan.