The Family Limited Partnership: A Controlled Business Transfer
A family limited partnership is different from any other partnership, because only family members can hold “limited” partnership interests. A limited partner is one who has an ownership interest in a business, but has no formal control over its operation. Limited partners may, as a matter of practice, be engaged in the day-to-day affairs of the business, even serving in management positions, but when it comes to the “last word,” the general partner(s) has exclusive control.
- A family limited partnership can be an ideal way to make an orderly, progressive transfer of a business from one generation to the next. Here’s how it works:
- A limited partnership is formed, with Dad and/or Mom, (and maybe Uncle Harry and Aunt Sue), as general partners, but the general partners’ ownership share is usually only 1% or 2% of the entire partnership. The balance of the business is allocated to limited partnership shares, which are, at first also owned by the general partners.
- The general partner may be an individual(s) or a corporation, but the general partnership is designed and directed by the business owner. Typically, a general partnership should be put into proper legal form, and in most cases, it should be assigned to the general partner’s revocable living trust.
- The goal is a systematic transfer of the limited partnership interests to the successor generation, which is accomplished by making “gifts” of the limited partnerships, at a rate and a valued amount to be determined. Two things should be noted: the transfer is not of the assets of the business, goodwill of the business, or any other “thing” that is part of the business. The transfer is a transfer of a limited partnership interest, and it is the legal entity of the partnership which owns the assets, not the persons who happen to be partners, in an individual capacity.
- Since a family limited partnership will be set up so that only family members can own partnership interests (whether general or limited), the transferability (salability) of those interests is extremely limited, since there is virtually no market for a non-controlling interest in a family business. Because, as a rule, such interests are only marketable to other family members, they are worth far less than typical corporate equity shares or public partnerships. Furthermore, because the limited partnership interests constitute a minority interest in the business, the combination of lack of marketability and minority status allow the assignment of reduced valuation, for purposes of calculating applicable gift exclusion eligibility and/or gift taxation. This is true even when the transfer of the minority interest will eventually cause the recipient(s) to have a majority interest. This reduction in valuation is called discounting.*
Let’s suppose that you have a $300,000 retail facility. You (or your corporation) are the owner of it, and you set up a family limited partnership , transferring title of your business to your new “FLP.” Now, even though the FLP owns the business, you, as general partner, continue to control and manage the business, which is the asset owned by the partnership.
To the extent that you, as general partner, fail to divest yourself of limited partnership interests, they will be included in your estate at your death. Assuming the partnership is not liquidated to satisfy the debts and taxes of your estate, it is likely that your remaining limited partnership interests will be valued at a discount. Notwithstanding this potential estate tax valuation discount, the family limited partnership should be undertaken with the intention of achieving a complete generational transfer.
Here’s a typical scenario, using the $300,000 retail business as a case study:
If you and your spouse decide to give tax-free gifts to each of your three children, as permitted by law, you may each make a gift of $10,000 to each child, per year (for a total of $20,000 per child). Of course, greater amounts may be given, but are subject to the federal gift tax.
If you simply gave each child $20,000 worth of the ownership of your retail business, it would take five years before your children achieved full ownership of the business, assuming the market value of the business did not increase in the meantime.
If, as an alternative, you gave each child $20,000 worth of the limited partnership, the children would not own a portion of the retail business. You still own it. What your children own, instead, is a portion of a partnership, in an amount that is increasing every year. And remember that $20,000 “worth” of a limited partnership may well be an amount far greater than $20,000 “worth” of a retail operation, because of valuation discounts.
Even if you gave away 99% of the partnership, as long as you are the general partner, you would retain the right of control over 100% of the partnership.
What this means, in practical terms, is that you can accomplish a business transfer, with significant valuation discounts, without ceding control to your limited partners, no matter how large their interest. As general partner, you may choose to delegate any of your responsibilities anytime you want to, as a way of training or including the successor generation, but you do not have to do so. Then, when you are ready to retire or leave the business, you can give away or sell your remaining interest in the partnership, which may be as little as 1%.
Remember that under normal gifting restrictions, it would take you five years to transfer the entire $300,000 business to your three children, and “control issues” might arise, as are typical among multiple “owners.” If you transfer, instead, shares of the family limited partnership , the discounted value of the partnership is less than the market value of the retail business itself, and thus the transfer may be accomplished more quickly. Additionally, like it or not, limited partners cannot override the business decisions of general partners.
Gifts even larger than the tax-free $10,000 may be made, to hasten or unequally apportion the transfer, if you are willing to assume federal gift tax liability. This is not altogether a bad idea, since the gift tax liability will be based on the discounted valuation of your gift.
If no family limited partnership or other business succession transfer is in place, your business interest will be included in your taxable estate. If it passes to your heirs by inheritance, estate tax will be assessed on the appraised market value of the business, (which would be its value if sold to a stranger or a competitor), without the family limited partnership valuation discount!
A family limited partnership is ideal where a business owner desires that a business continue beyond his/her retirement or death, and where there is a least one other family member (usually of the younger generation) who is willing and able to become active in the business, with actual ownership occurring gradually.
* Valuation discounts must be made by qualified appraisers, and are subject to IRS review and approval. Typical discounts may range as high as 35-55% or more.
