A family limited partnership is a highly customizable vehicle for generational wealth transfer. The FLP and its close cousin, the family limited liability company, are entities that may be used in trust and estate planning to transfer family wealth efficiently across generations; to protect family assets; and to consolidate assets to achieve economies of scale related to administrative costs. A FLP, as its name implies, is a limited partnership in which all partners are family members (or trusts for their benefit). Typically, the patriarch or matriarch of the family is the general partner (GP) and contributes most or all of the assets.
FLPs Ideal for Today’s Planning Environment
Enhanced Internal Revenue Service enforcement is making it harder for successful families to execute estate planning and wealth transfer strategies at a time when the lifetime exemption amount will be dramatically reduced after 2025. Fortunately, there’s still time for your clients to address these challenges.
I know what you’re thinking: FLPs are just for the ultrawealthy. That’s a common misconception. Even clients with $10 million in net worth can use FLPs to protect their assets and transfer wealth in a tax-advantaged way. Also, you might be surprised to learn that FLPs and FLLCs aren’t overly expensive to establish and maintain. The average cost to set up a FLP is between $10,000 and $20,000, with annual ongoing costs typically even less. Finally, FLPs aren’t just for real estate. They can hold marketable securities, interests in private equity, venture capital, hedge funds or even entire operating businesses.
The primary benefit of an FLP is that it produces a tax-advantaged valuation of its assets. The key to this valuation is fair market value (FMV), that is, the price at which a willing buyer and a willing seller would transact, and the inherent layered structure. When executed properly (I’ll get to this in a minute), the FLP creates a business interest and the advantages that come with it (see Transferring Business Interests to Optimize Estate Taxes) out of assets that are inefficient for estate planning. The key is to move these assets out of one’s taxable estate in an efficient manner. Notably, a FLP creates a barrier to control and marketability that would be available to the holder of the underlying assets.
To adjust for these conditions we include minority discounts, discount for lack of control (DLOC) and discount for lack of marketability (DLOM), in the computation of FMV. In aggregate, these discounts can be in the range of 30% to 40%, which is largely driven by DLOM. For more on DLOM, see my recent article.
Every few years, fear mongers warn that the IRS is (finally) going to eliminate FLP discounts. This is laughable to anyone with an understanding of how to establish FLPs and minority discounts properly. DLOC and DLOM aren’t prescribed by the IRS but are based on economic reality that’s provable in theory and supported by voluminous empirical evidence. For more evidence, see Pierson M. Grieve v. Commissioner, T.C. Memo 2020-28 (March 2, 2020).
Real World Example
John Doe and his wife, Jane, fund a FLP with $20 million worth of interests he has in private equity, marketable securities, real estate and some cash. Let’s say Doe has five trusts for five kids, so that’s $4 million apiece. Because he’s funded those trusts through this tax-advantaged structure, each $4 million trust conservatively becomes $3 million on a minority interest basis due to the DLOC and DLOM.
Preparing for Sunsetting of Exclusion in 2026
For the past five years, taxpayers have benefited from the historically high gift and estate tax exemptions introduced under P.L. 115-97 (formerly known as the Tax Cuts and Jobs Act of 2017). In 2023, the estate and gift tax exemption increased to $12.92 million per person ($25.84 million for married couples). This generous exemption has given tremendous flexibility to many individuals and families because their estates are often under the $25.84 million estate tax filing threshold. For example, a married couple may gift up to $25.84 million in 2023, either during life or at death, without incurring any federal gift or estate tax. Assets gifted in excess of the exemption amount are generally taxed at a 40% rate.
However, unless Congress takes additional action, the double exemption provisions of the P.L. 115-97 will “sunset” on Dec. 31, 2025, and the estate and gift tax exemption will essentially be cut in half. This results in an exemption for 2026 somewhere between $6 million and $7 million, depending on inflation (roughly $13 million for married couples). Suddenly John Doe’s $20 million taxable estate would be looking at a $7 million tax exposure starting in 2026, even though he has no tax exposure today. At the 40% federal tax rate, that’s a $2.8 million tax hit at the federal level alone. In states such as New York, the owner could be looking at an additional 16% tax on an estate of this size.
With a FLP, the Doe Family could eliminate upwards of $3 million in estate tax, after spending less than $100,000 lifetime on estate planning fees to establish and maintain the structure. That’s a pretty good return on investment, wouldn’t you say?
What if the Adult Kids Aren’t Ready?
In succession planning, the next generation’s readiness must align with the older generation when it comes to managing the family’s wealth. However, with a FLP, the older generation can maintain control and make decisions through the GP interest even if holding as little as 1% of the value. Then, when a successor is ultimately ready for the responsibility, the GP interest can be transferred. Through this process, we can protect a family’s wealth from mismanagement or immaturity while still advancing estate planning strategy.
Structuring An FLP That Won’t Be Challenged By the IRS
A FLP’s ability to withstand potential scrutiny is proportional to the quality of the story that you craft for it. You can’t just say: “I want to pay less in taxes,” wave your hands, and say “FLIP” three times fast. You need to construct a real company with a true purpose. This is where prudent advisors come into play. If the FLP is a genuine business partnership, it needs to operate like one.
Here are some tips to suggest to your client:
- Have one or more substantial nontax purposes for creating the FLP (this is a requirement for a valid FLP);
- Keep good records;
- Have regular meetings of partners to discuss operations;
- Create the FLP while you're still in good health;
- Observe all legal formalities when creating the FLP and while operating the business;
- Hire an independent appraiser to value assets going into the FLP;
- Transfer legal title of assets going into the FLP;
- Only put business assets into the FLP;
- If your client does put personal assets into the FLP, such as their home, they should pay fair market rental;
- Don’t commingle FLP assets and personal assets—keep them separate;
- Never use FLP assets for personal purposes;
- Keep enough assets outside the FLP to pay for personal expenses; and
- Distribute income to partners pro rata.