What Is A Family Limited Partnership?

dan • Aug 21, 2022

Families that own and run successful businesses together often face several challenges. The successful transfer of a business is one of the most notoriously difficult problems in estate planning.
Many times, the generation that created the business wants to transfer that business to future generations – eventually. In the meantime, they want to maintain control. So the first problem is how to both maintain control while transferring management, knowledge, and eventual ownership to the next generation.
The other common problem is that, usually, different family members have different levels of interest and participation in the family business. The family members who have high levels of participation and interest might feel as though they deserve a larger share, or even the whole thing, when the founding generation eventually moves on, given the amount of time and effort they have contributed over the years. The less interested family members may not necessarily want the business, but that doesn’t usually mean they are okay with being disinherited. The more interested family members may feel resentful of less interested family members receiving the same ownership interest as they have. The less interested family members may feel resentful about the more interested family members having been handed a career.
And then, of course, one of the biggest threats to the longevity of family businesses is outsides becoming involved, especially if it happens involuntarily via divorce or creditor problems.

Many of these issues can be addressed with business entities designed specifically for the purpose. One flexible and powerful arrangement is a family limited partnership.


What is a family limited partnership?

A family limited partnership is a business partnership formed under state law, with two more family members controlling the day-to-day operation of the business as its “general partners.” The partnership is “limited” because, unlike traditional partnerships, these are arranged under state laws specifically allowing certain people to be given partnership interests without taking on liability for the partnership.
The non-controlling partners are “limited partners.” Limited partners are entitled to share in the business’s profits, but they do not have a right to participate in its day-to-day management. The benefit of not having the right to participate in the business’s day-to-day management is that limit on liability for the business’s debts and liabilities.
The characteristic that separates a family partnership from other types of partnerships is the restrictions on to whom ownership can be transferred. Typically, transfer options are tightly limited to other family members. 

Advantages of a family limited partnership

A family limited partnership:
  1. Allows the founding generation to remain in control of the business while establishing a structure through which to transfer ownership in the business to future generations.
  2. Gives the founding generation a way to transfer ownership of the business to family members in a manner that reflects their interest and involvement in the business. As described above, it is very common, in families that own businesses, for some members to be more interested or involved in the business than others.
  3. Limits who can become a member of the business. Perhaps the biggest risk that family business face is that ex-in-laws will gain ownership interests through divorce.
  4. Provides asset protection. The only members of a limited partnership that potentially have personal liability are the “general partners.” Limited partners do not. We further limit the potential for a partner’s creditors to get to partnership assets by, for example, requiring a super majority for certain actions or requiring unanimous agreement among the partners to liquidate the partnership’s assets or dissolve the partnership. Further protection can be built in by including layers of protection, such as LLCs, within the partnership.
  5. Can minimize taxes. Often the value of the assets inside of a family partnership exceed the value of the partnership itself. How can that be? Because the limits on control over the business or who can it be transferred to diminish its value. Would you pay $5 million for a business that had $5 million of assets if you knew you would never have any right to control or direct how those assets were used?
  6. Allows for flexibility. Unlike trusts, a family limited partnership can provide asset protection and tax minimization while still allowing the founders to change the entity’s governing terms.

Words of caution

To the extent you do end up using your family partnership to avoid debts or minimize taxes, you better be prepared for the possibility that a court or the IRS are going to closely scrutinize it. As a society, we don’t want to make debt or tax avoidance easy.
What will they be looking for? The following scenarios can result in a loss of the benefits a family partnership is supposed to provide:
  1. Commingling the partnership’s assets with your personal assets. The partnership should be limited to holding business and income-producing assets. Trying to extend the protection to your personal life by putting your house or cars in the trust blurs the line between the two.
  2. Using the partnership’s bank account to pay your personal expenses. If you need money to pay your personal expenses, you should go through the hassle of making a profit distribution and then using the funds that you received to pay those expenses. Using the partnership bank account or credit card to buy your groceries, for example, is another form of comingling.
  3. Receiving income that was produced by a partnership asset directly. Sometimes people will put rental properties into their partnership, and then have the rent paid directly to them. Again, the income should go to the partnership first and then be distributed as a profit.
  4. Living in a property that is owned by the partnership, rent free. No true business would allow someone to live in its properties for free. If you are living in a property that is owned by the family partnership, you not only need to pay rent, but fair market rent.
  5. Transferring all your assets to the partnership. Sometimes, people get excited about the asset protection potential a partnership provides and try to transfer everything into it. A critical part of asset protection, however, is not to make yourself insolvent. You need to keep enough assets in your name to cover your expected personal expenses and liabilities.
  6. Having no reason to set up the partnership other than tax minimization. The IRS requires that these types of entities have a purpose beyond just tax avoidance. That additional purpose can include consolidation and organization, asset protection, and other typical business purposes.

Conclusion

If you own a business that you are interested in keeping in your family while also achieving tax and asset protection benefits, you should consider adding a family partnership to your estate plan. 

What next? 

If you think it might be time to think through your estate plan, you can: 
  1. Give us a call at 720-821-7604 to schedule a "Discovery Session" at which we can determine whether our firm would be a good fit for your needs. Or fill out our contact form to have us call you.
  2. Visit our estate planning page to learn more about how proactively thinking through your estate plan can protect you and your family, minimize hassle, lower the chance of family discord, and minimize or eliminate taxes.
  3. Learn more by reading our blog or watching our videos .

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