A Family Limited Partnership (FLP) is a legal entity designed to manage and transfer family wealth and business interests across generations. This framework allows a family to consolidate various assets, such as real estate, investment portfolios, or a closely-held business, into a single, cohesive structure. The primary objective is to facilitate the orderly transfer of wealth to heirs while allowing the senior generation to retain management authority over the assets. The FLP is a sophisticated estate planning tool that requires proper formation and disciplined, ongoing operation.
Understanding the Family Partnership Structure
The mechanics of an FLP rely on a clear division of roles between two classes of owners: the General Partner (GP) and the Limited Partners (LPs). The General Partner, typically the parent or founding family member, holds the exclusive authority to manage the partnership’s assets and make all operational and investment decisions. The GP assumes unlimited personal liability for the partnership’s debts, which often leads to using an entity like an LLC as the GP to mitigate this exposure.
Limited Partners, usually the children or grandchildren, contribute capital or receive their interests through gifts. They possess no management rights or control over the partnership’s operations. This lack of control grants them limited liability, shielding their personal assets from the partnership’s obligations. This separation of asset control from asset ownership is the foundational element of the FLP. By transferring the majority of the partnership’s economic value to the LPs, the senior generation shifts wealth out of their taxable estate while remaining the sole decision-maker.
The Core Purpose: Wealth Transfer and Control
Families choose an FLP primarily for non-tax objectives centered on generational control and asset preservation. The structure ensures a single, unified strategy governs the management of consolidated family assets, simplifying administration and preventing property fragmentation across multiple heirs. Centralized control allows the senior generation to maintain direction over the assets during their lifetime, safeguarding them from potential mismanagement.
The FLP also protects family assets from external threats, such as personal creditors or division of property during a limited partner’s divorce. Furthermore, the structure serves as a mechanism for family governance, educating younger generations about responsible wealth management. By restricting a limited partner’s ability to sell or transfer their interest outside the family, the FLP helps ensure the long-term continuity of family ownership and business succession.
Key Benefits: Valuation Discounts and Asset Protection
A primary motivation for establishing an FLP is the use of valuation discounts to reduce the taxable value of gifted interests. When the General Partner transfers a Limited Partner interest, its value for gift or estate tax purposes is not based on a proportionate share of the underlying assets. Instead, the valuation is reduced by two factors: the Discount for Lack of Marketability (DLOM) and the Discount for Lack of Control (DLOC).
The DLOM reflects that a limited partnership interest is difficult to sell quickly because there is no public trading market for the asset. The DLOC applies because a Limited Partner cannot force distributions, influence management decisions, or compel asset liquidation. These combined discounts allow the senior generation to gift a larger actual value of assets to heirs while consuming a smaller amount of their lifetime gift tax exemption.
The FLP also provides protection against the personal creditors of a limited partner. If a partner is sued, a creditor’s sole remedy is limited to a Charging Order against that partner’s interest. This order does not grant the creditor voting rights or control over the partnership assets. It only entitles the creditor to receive income distributions the General Partner decides to make to the debtor partner. Since the General Partner can withhold distributions indefinitely, the Charging Order serves as a deterrent against claims.
Necessary Steps for Formation and Operation
Drafting the Partnership Agreement
The formation process begins with drafting a comprehensive partnership agreement, the foundational legal document of the FLP. This agreement must clearly define the management powers of the General Partner and the passive nature of the Limited Partner interests. The document also codifies restrictions on transferability, preventing a partner from selling their interest to non-family members without the GP’s consent.
Funding the Partnership
Once the agreement is in place, assets intended for the FLP must be formally transferred into the partnership’s name, such as through new deeds or updated account registrations. Suitable assets include income-producing real estate, marketable securities, and interests in operating businesses. Personal assets, such as a primary residence or personal checking accounts, should be avoided, as their inclusion can undermine the FLP’s legal standing with the Internal Revenue Service (IRS).
Naming General and Limited Partners
The partnership must identify at least one General Partner, who holds a small percentage of the economic interest but retains all control. The majority of the equity is designated as Limited Partner interests. These interests are typically transferred to the younger generation through a series of annual gifts, leveraging the valuation discounts to efficiently move wealth out of the senior generation’s taxable estate over time.
Maintaining Formalities
For the FLP to be respected as a legitimate entity, all partners must adhere to strict operational formalities after its creation. This includes maintaining separate bank accounts and never commingling personal and partnership funds. Furthermore, the partnership must hold regular meetings, keep detailed minutes and financial records, and file its own tax returns, treating the FLP as a true business enterprise separate from the partners’ personal affairs.
Risks, Drawbacks, and Avoiding IRS Challenges
The complexity and administrative demands of an FLP result in significant setup and maintenance costs, requiring ongoing services from legal and accounting professionals. The most substantial risk is intense scrutiny from the IRS, which frequently challenges FLPs. The IRS often asserts that the partnership lacks a “legitimate non-tax business purpose” and was created solely to avoid transfer taxes.
Taxpayers lose the intended benefits if the partnership is deemed a sham entity. Common pitfalls include the General Partner using partnership funds for personal expenses or failing to completely transfer legal title to the assets. The IRS also scrutinizes cases where the senior generation contributes substantially all assets to the FLP without retaining enough outside funds for personal living expenses, suggesting an implied agreement to retain control.
When a Family Partnership Might Not Be Right
An FLP is a sophisticated structure generally appropriate only for families with a substantial net worth, typically exceeding the federal estate tax exemption threshold. The high cost of professional fees for formation, valuation, and ongoing compliance is difficult to justify for smaller estates. Families must also be committed to the long-term, disciplined management required to maintain the entity’s legal and tax validity. For families with more modest estates, simpler estate planning tools, such as trusts, are often a more cost-effective and practical way to manage and transfer assets.