Family Limited Partnerships – the double edged sword (Part 1)
A limited partnership is a legal tool sometimes used in planning for farm families. When used in a family business context, it is often called a “family limited partnerships” or “FLP.” What is this creature and why use it?
What is it?
A limited partnership is a business entity, not entirely unlike a corporation. An FLP is formed when two or more family members agree to share ownership of assets and they file appropriate papers with the secretary of state to obtain recognition of the limited partnership as a new, separate legal entity. While a simple partnership can arise by two or more people merely combining their efforts and resources and doing business together—even without any written agreement—a limited partnership cannot arise without approval from the state.
The FLP has two classes of ownership interests: general and limited. A fair comparison would be to a corporation with voting and non-voting stock. The partners own the partnership like stockholders own the corporation. One person can own both voting and non-voting stock in a corporation; in the limited partnership, one person can own both general partner interests and limited partner interests.
An FLP typically has a very small percentage of general interests, say two percent; the remaining ninety eight percent of the ownership would be limited interests. The general partner interests carry practically all control of the FLP. All investment and management decisions are made by whoever holds the general partner interests. The general partner can be a virtual dictator!
Why use an FLP?
Bill and Mary establish an FLP. They transfer $5,000,000 in land to the FLP. They owned real estate; now they own FLP interests. Mary and Bill each holds 1% general interest and 49% limited interests. The entity (the FLP) now owns the real estate.
Farm owners establishing an FLP typically want to retain control while giving away some ownership. Here, Bill and Mary can start giving limited partner interests to their children. Because of the nature of an FLP, they can do so without giving up any control of the farm. They could give away more than 50% of the partnership—even as much as 98%—but still retain control of everything by keeping their two, 1% general partner interest.
Why make such gifts? To reduce their taxable estate. If they have five children and give one-half of 1% to each child each year for ten years, that is 25%. Upon Bill and Mary’s deaths those interests will not be part of their estate for calculating estate taxes. If the FLP balance sheet shows that it owns $5,000,000 in real estate, the FLP is arguably worth $5,000,000. But they will only own 75% of it to be included in their estate.
Leveraged Gifting
Another advantage of the FLP is this: each limited partner interest is discounted from its pro rata value. We might say the sum of the parts is less than the whole. If you own 1% of a $5,000,000 tract of land, one could say that share is worth $50,000. But 1% of the FLP is not. Remember how much control is held by the general partner?
Imagine Fred Neighbor asks to buy 1% of your limited partnership. He would not pay $50,000. The limited partner interests come with too many “strings attached.” Fred will have to pay income tax on 1% of the FLP income each year; the general partner might not give him that 1%, but could reinvest it inside the FLP (but he will still pay income tax on it!); Fred has no voice in investment of the FLP assets—general partner could sell all land and reinvest in CDs; he cannot voice his opinion about what crops are planted; he cannot decide how high to set the rent (if the ground is rented); he cannot sell his 1% without the consent of all other partners; he cannot decide he wants out and get his money back.
The result of these strings is that 1% of this FLP might be worth only $30,000 to $40,000. Bill and Mary can give a larger percentage to their children each year without incurring gift tax. The interests they still have at death—say 75%—will be valued at less than that fraction of the real estate.
Next month we will take a look at some more implications, both pro and con, of using a limited partnership to help protect your farm and transfer it to your heirs.
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Article authored by Curt W. Ferguson and originally published in the Prairie Farmer magazine, May 2006 issue
