Among the biggest long-term concerns of many business owners is succession planning — how to smoothly and safely transfer ownership and control of the company to the next generation.
From a tax perspective, the optimal time to start this process is long before the owner is ready to give up control. A family limited partnership (FLP) can help you enjoy the tax benefits of gradually transferring ownership while you continue to run the business.
How it works
To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children or other beneficiaries.
You retain the general partnership interest, which may be as little as 1% of the assets. However, as general partner, you still run day-to-day operations and make business decisions.
As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.
Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.
The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, let’s say the discount is 25%. That means, in 2022, you could gift an FLP interest equal to as much as $21,333 (on a controlling basis) tax-free because the discounted value wouldn’t exceed the $16,000 annual gift tax exclusion.
There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.
Perhaps the biggest downside is that the IRS tends to scrutinize how FLPs are structured. If it determines that discounts are excessive or that your FLP has no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.
The IRS also pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for instance, can indicate that an FLP was set up solely as a tax-avoidance strategy.
Not for everyone
An FLP can be an effective succession and estate planning tool but, as noted, it’s far from risk free. We can help you determine whether one is right for you and advise you on other ways to develop a sound succession plan. Contact us for assistance with your business succession plans.