Several years ago, when I was just learning the ropes of the U.S. asset protection system the idea of using Limited Partnerships for families was hot. People loved them for three major reasons:
(a) Absolute General Partner control was firmly established by caselaw
(b) Tax-saving advantages
(c) Easy transfer of assets to the next generation
There was also a massive marketing push towards getting people into “family” limited partnerships. But a lot of things have changed since then. Is an FLP still a good choice?
First, some housekeeping. FLPs are no different from a regular limited partnership legally – you won’t find a Certificate of Family Limited Partnership form on any Secretary of State websites (at least that I’m aware of). What makes them stand apart from a regular LP is the language of the Limited Partnership Agreement. In a FLP this language has been modified for family use and contains provisions dealing with death, disability and divorce of family members, all with an eye towards keeping things “in the family.”
An FLP is typically set up with Mom and Dad as the General Partners, controlling the assets and investment decisions. Mom and Dad also start off as the majority owners of the FLP, and bring the kids in as minority members. This allows for a revenue stream to be directed to the kids, who will pay taxes at their lower rate. Over time Mom and Dad transfer more and more of their ownership to the kids, often by maximizing their tax-free gifting allowance each year, until at the end of the day the kids wind up as majority owners, and Mom and Dad are left with a fractional interest, which transfers upon their death. By depleting their personally asset base during their lifetime Mom and Dad have potentially avoided most (if not all) estate taxes. And, as General Partners Mom and Dad still stay in control of the assets because the FLP Agreement was written in such a way that they can’t be removed.
But there are pros and cons to every asset protection and estate planning strategy. Here are a couple of things to keep in mind when considering an FLP for your family:
General Partner Liability. In partnership law, the General Partner (GP) has total control over the partnership’s daily operations, investment decisions, and so on. But this control comes with a price. The GP is also liable for the acts and debts of the partnership, and can stay liable even after resigning. But in an FLP, remember, the FLP Agreement has been written in such a way that Mom and Dad can’t be removed as GPs, and often can’t resign, either. So if Mom and Dad are personally liable for the acts and debts of the FLP, and are also owners of the FLP, you’ve just created a big hole in your liability protection planning.
The way around this issue is to make sure that Mom and Dad carry out their GP duties through a protected business structure, like an LLC or a corporation. Because these other structures do provide protection from the acts and debts of the business, Mom and Dad can stay in control and stay safe. It’s best to set this up at the time the FLP is set up. Again, the language of the FLP Agreement may make it impossible to do at a later date.
Extra Cost. In many states it costs more to form a partnership than it does to form an LLC, or it will cost more to maintain. Also if you put a second business structure in place to act as the GP vehicle, you’ve got to consider all the costs associated with forming and maintaining that second business: a second set of filing fees, second set of books and records, second tax return, and so on. If you were to use an LLC as your family asset vehicle, you could potentially avoid this – the Managers of an LLC are NOT liable for the acts and debts of the LLC in the same fashion that general partners are.
Kiddie Tax. The third factor to think about, kiddie tax has become a major issue in the last few years (as Diane can attest to)! Say you have an asset generating $1k/month in passive income, and you’re at the 35% tax bracket. It could look awfully attractive to transfer that asset to your kids, who are only in a 10% tax bracket. You see immediate tax savings of 25% and you may even get out of paying them an allowance.
This was an immensely popular tax and estate planning strategy up until recently, when the government took a look at the amount of wealth transferring from one generation to another through tax-advantaged structures like an FLP and said, “Hey, wait a minute!” Their answer was to get aggressive with the application of kiddie tax, which basically says that if you transfer an income-producing asset to kids who are 18 and under, those kids will pay tax t the same rate you would, if you hadn’t transferred the asset.
Even with extra maintenance costs and the impact of kiddie tax, I still like FLPs in many situations. Say you’ve got 15 assets set up in 15 different LLCs. Each year you want to transfer a piece of ownership in each LLC to your kids. That’s a lot of paperwork, and there’s a very real possibility you’ll forget someone here and there. If all of the LLCs were collectively owned by the FLP, you would have a convenient and centralized way to administer that – instead of transferring ownership in 15 LLCs each year, you would make a single transfer of FLP interests. The liability protection is very strong – between the LLCs and the FLP it would be difficult for a creditor to get hold of family assets. And as parents, you maintain firm control over the assets you’ve worked so hard to accumulate. But you need to be smart – protect yourself by using a corporate structure as GP!