Family Limited Partnerships & Limited Liability Limited Partnerships
FLP Background & History
“Family Limited Partnership” (FLP) is actually a slang term. State statutes and the IRS code never actually refer to an entity as an FLP. What the term “Family Limited Partnership” actually refers to is a limited partnership (LP) that is formed to hold the family business or investments.
LP’s are essentially a predecessor to the LLC. Some form of LP has existed since Roman times, but modern American LP’s became commonly used the 1970’s and 1980’s. The idea was that investors would put money into the LP and would be “silent partners” meaning that they had no voice in managing the LP. They just receive a portion of the income. The person who ran the LP and had all of the authority (and all the liability) was the general partner.
Estate planners developed ingenious ways to use the LP to reduce a client’s estate tax liability by having clients will gift their limited partnership interests to their children over time. Because the interests in the limited partnership are not liquid, and have a very limited resale market, they are eligible for some kind of valuation discounts and used for federal gift and estate tax planning purposes.
Family Limited Partnerships also have some attraction as asset protection vehicles, primarily because properly structured limited partnerships are generally afforded “charging order protection.”
Limited Liability Limited Partnerships (LLLP)
The limited liability limited partnership (LLLP) is a relatively new modification of the limited partnership, a form of business entity recognized under U.S. Commercial Law. An LLLP is a limited partnership and as such consists of one or more general partners and one or more limited partners. The general partners manage the LLLP, while typically the limited partners only have a financial interest.
The difference between an LLLP and a traditional LP is with respect to the general partner’s liability for the debts and obligations of the limited partnership. In a traditional limited partnership the general partners are jointly and severally liable for the debts and obligations of the limited partnership; limited partners are not liable for those debts and obligations beyond the amount of their respective capital contributions.
In an LLLP, by having the limited partnership make an election under state law, the general partners are afforded limited liability for the debts and obligations of the limited partnership that arise during the period that the LLLP election is in place. Certain LLLP elections take the form of the limited partnership electing to be a limited liability partnership (this is the format used in, for example, Delaware) while in other states the election is made in the certificate of limited partnership. Most states require that an LLLP identify itself in its name, but those requirements are not universal.
Because the LLLP is so new, its use is not widespread. Not all states have adopted statutes that allow for the formation of LLLPs.
Common “Pitfalls” in Limited Partnership structures
FLPs/LLLPs are widely marketed by a variety of attorneys, and other planners. The reason is the potential federal gift and estate tax benefits along with the potential asset protection benefits. The unfortunate truth is, FLPs/LLLPs are also marketed by countless promoters who sell “boiler plate” or “one size fits all” FLP/LLLP structures. Some promoters even sell kits so clients have a “do-it-yourself” approach to FLP/LLLP planning.
FLPs/LLLPs can be a very powerful estate planning and asset protection planning tool when properly set up and utilized. Unfortunately FLPs/LLLPs are almost never set up or utilized correctly, and often fail to produce their desired benefits. Below is a list of common pitfalls.
Failure to Fund – People will go to great lengths to have their FLP formed and many pay large fees to a planner to do so, but if property is never transferred and retitled to the FLP/LLLP, the entire structure is entirely worthless. An FLP/LLLP can only benefit protect property it owns!
Failure to Maintain the LP – As a Limited Partnership registered with the Secretary of State, annual fees are required to be paid. The failure to pay these fees can mean that the entity will eventually go into default or even be revoked.
Failure to Follow Formalities – While FLP/LLLPs do not require the same rigid formality as a corporation they need to be run like actual businesses. In order for the FLP/LLLP to be respected (by the courts and the IRS) as an actual business (and receive all of these benefits), the owners themselves need to treat it as an actual business.
This means that the FLP/LLLP must have a limited partnership agreement and that agreement needs to be followed. Big businesses like Microsoft record major decisions in meeting minutes, small FLP/LLLP’s need to do the same thing. Big businesses keep clear accounting records, FLP/LLLP’s need to as well. Big businesses keep their assets separated from the owners and employees, FLP/LLLP’s need to enforce this separation as well.
Non-Business Assets or Activities – In keeping with the FLP/LLLP as a business theme, a person can’t simply put non-business assets into an FLP/LLLP and assume it’s protected from liability or excluded from their estate. There needs to be a business purpose to the FLP/LLLP and to its assets.
Parent as General Partner – While having a parent as a general partner may be appealing to the parent who wishes to gift ownership to their children, to truly remove assets from their estate, the parent would need to surrender control over the FLP/LLLP. In other words, as long as the parent remains in control, their estate cannot benefit from a gifting program.
Parent as both General Partner and only Limited Partner – This arrangement makes absolutely no sense, except maybe as an initial transition phase, before making any gifts or transfers of LP interests. The word “partner” implies there’s at least 2 people doing the partnering. (Really, when’s the last time you partnered with yourself?) Legally speaking, without 2 distinct partners, the LP collapses and affords no actual value.
Client’s Living Trust as the Partner – Depending on who is the other partner, a living trust as a partner can present major issues. One common (and flawed strategy) is to have a person serve as general partner and their living trust as limited partner. While this arrangement may work avoiding probate, it offers no estate planning benefit, and absolutely useless asset protection. Since a living trust is revocable, a creditor may obtain a court order revoking the living trust. Once the trust is revoked, we have a situation where the person is partnered with themselves. The FLP/LLLP collapses and the creditor can attach the FLP/LLLP’s assets.
Failure to Diversify/One Big FLP/LLLP – Try to protect all assets in one entity and you end up protecting none. Using one FLP/LLLP (or any one entity for that matter), creates a presumption that the FLP/LLLP is used for personal purposes, not for a business purpose. A person should have assets outside of the FLP/LLLP which pays for personal expenses like utilities and living expenses. Multiple FLP/LLLP’s also provide a back up—if one entity is dissolved, the others can continue operations. Of course, much of this depends on the net worth of the individual, which is why it is important to analyze each person’s particular circumstances.
Fraudulent Transfer – Fraudulent transfer law is very complex, and there is a state law version and a federal law version. The idea is fairly simple—a person can’t give away assets with the intent of hiding them from creditors. It gets complicated, however, when we start asking, when and how do we prove “intent to hide from creditors?” If a person transfers assets into an FLP/LLLP 20 years before he is ever sued, was there an intent back then to hide from future creditors? What if the transfer was made 20 days before the lawsuit? One thing is clear: a person can’t set up an FLP/LLLP just before liability hits and have any hope of protecting his assets.
Failure to Make Gifts of the LP Interests – If the FLP/LLLP is established for estate planning and gifting, it provides no benefit if those yearly gifts aren’t actually made. The plan must be implemented, year after year in order to be effective.
Failure to Obtain Valuations – A gifting plan is based on the annual gift exclusion of $12,000. In other words, a person can give away $12,000 each year to any person without any gift tax liability or using up their lifetime exemption. So how do we make sure that the gifts from parent to child do not exceed $12,000? We need proper valuations—appraisals conducted by qualified, licensed appraisers.
Excessive Discount – Because a limited partnership interest lacks management control, voting power, and an open market to resell the partnership interest, the value of a partnership interest deserves a discounted value when it comes to gifting. But what’s a reasonable discount percentage? Empirically, the IRS has accepted 30% discount valuations—but some planners are aggressive and take discounts of 40%, 50%, 60%, etc… There’s a great saying… “Pigs get fed, hogs get slaughtered.”
Gifting Limited Partnership Interests Directly to Children – Although gifting to children accomplishes the estate planning goal of decreasing estate tax liability, there’s a much better way to do it. Gifting the limited partnership interest to a spendthrift trust for the children can prevent the limited partnership interest from being included in the children’s estate when they die, and the trust can protect the limited partnership interest from the children’s creditors or future ex-spouses. These spendthrift trusts can be used both for adult children, and for minor children.
Guidelines for Property Using FLP/LLLP Structures
Limited Partnerships can provide solid benefit in the areas of estate planning and creditor liability minimization, but it’s very situational. Here are some important considerations when using an FLP/LLLPs structure:
Don’t Overuse – Some assets should simply not be in the FLP/LLLP, such as personal vehicles, watercraft, a person’s primary residence. Make sure that there are not other options that meet a client’s needs more—maybe all a particular person needs is a revocable living trust, or a spendthrift trust, or a family LLC. FLP/LLLP’s can sometimes require a great deal of administrative effort—there should be a enough assets to justify the added administration.
Treat the FLP/LLLP as a Business Entity not a Family Trust –.The assets in the FLP/LLLP should have a business purpose and should transact business and investment. When it generates income, it should make quarterly distributions of profit to the limited partners. The limited partnership should never make direct payments for partner’s personal expenses. The FLP/LLLP is not a big checking account for the owners to use. That would be tantamount to commingling personal and business assets.
Have a Good Limited Partnership Agreement –.The limited partnership agreement should be well drafted defining the rights of the limited partner and restricting sale and transfer of partnership interests. These limitations reinforce the reasons for market value discounting. A properly drafted limited partnership will also reinforce charging order protection, preventing a partner’s creditor from being able to liquidate the limited partnership.
Control at the GP Level is Critically Important – The general partner manages all aspects of the FLP/LLLP. The general partner selects investments, makes cash distributions, loans, etc.
Maximize Transfers – Transfers of assets by parents to the FLP/LLLP should be made immediately, and annual gifts of the LP interests should be religiously made to the children’s spendthrift trusts.
Hired General Partners/Managers – Sometimes it makes sense to hire a truly independent third-party to act as the General Partner of a family limited partnership. So long as appropriate safeguards are in place to assure that the third-party will not abscond with the partnership assets, such an arrangement provides substantially greater asset protection and estate planning benefits for only slightly higher costs.
The single biggest problem in the marketing and use of FLP/LLLP’s is misuse. By “misuse” we mean that the FLP/LLLP is being used for the wrong client. Many asset protection planners, the FLP/LLLP is all they know—when all you have is a hammer, every problem looks like a nail.
Some planners unfortunately have FLP/LLLPs as their only tools, and those planners solve every client problem with an FLP/LLLP.