What is a Family Partnership? Is a Family Partnership right for my family?
A family partnership or a family limited partnership (FLP) is a legal entity created to consolidate a family’s holdings of businesses, real estate, publicly traded securities and other assets. It can take the form of partnership or a limited liability company. Family partnerships are often created for tax and wealth transfer purposes. However, a real business purpose must be established for the entity to receive full recognition from the IRS.
How is a family partnership created?
Generally, the family member that created a business or substantial set of other assets, like real estate, contributes their holdings to the newly established partnership in exchange for a share in the new entity. In other words, the asset owner then owns shares in the family partnership, which owns the business or assets. The contributing family member is often the general partner (GP) of the family partnership. This means they retain 100% of the decision-making authority and control of the family assets, regardless of how additional shares are distributed. The general partner can then gift limited partnership (LP) interests to family members without losing control over the operations of the business. Creating LP shares provides an effective way to split up assets among multiple generations of a family. As many shares as needed can be created and distributed without changing the underlying control of the family business. The owners of limited partner shares are entitled to dividends and income from the partnership, but like an investor in a fund, have no decision-making authority over the assets and usually cannot sell their LP shares outside the family.
What are the tax benefits of a family partnership?
The most used tax benefits are known as discounts for “lack of control” and “lack of marketability.” The limited partners (LP) do not have the right to make decisions about the underlying business assets, i.e., a “lack of control.” Limited partners also cannot sell their interests outside the family, i.e., a “lack of marketability.” Control and marketability are common attributes used in valuing assets and the lack of both attributes is generally assumed to reduce the value of the asset by 10% - 30%. This “discount” means that 10% to 30% more of the business can be transferred to the next generation without estate taxes.
In addition to discounts, family partnership shares can be gifted each year. Instead of giving cash, parents can give their children and grandchildren interests in the partnership. Those interests will likely continue to appreciate over time, resulting in a significant wealth transfer opportunity at a low valuation.
Family partnerships are a great wealth transfer tool!
How do you decide who gets which piece of property? What about different businesses? How do you start educating your children and grandchildren about the family business? Family partnerships provide a straightforward way to transfer illiquid assets among family members based on the total financial value of the assets. Instead of dividing up assets illogically to accomplish “fair” wealth transfer, parents can simply gift shares in the total asset pool to their heirs.
In addition to being a practical tool, family partnerships can be a great training ground for the next generation. Partnerships are required to function as businesses, with board meetings, minutes and rational decision making. Next generation family members can participate in meetings, ask questions, and take notes. Eventually, they may even make suggestions to the general partners on how to best manage the partnership for the family’s benefit. If utilized properly, when an actual change in leadership and control occurs, it will be a formality because the next generation has been practically involved in family business discussions for years.
What can go wrong with a family partnership?
Wrong structure: If set up improperly, the legal entity may not qualify for the control and marketability discounts, which may be a key reason for establishing the entity.
Not treated as a business: If the family does not treat the partnership like a real business by holding meetings, keeping records, and taking notes, the IRS may invalidate the partnership for tax purposes.
Lack of “Family Building Effort”: It takes time and energy to teach the next generation about family business. Simply having a partnership and holding meetings won’t suffice. It requires ongoing discussions, time and attention from the current generation of family leaders.
Family fallouts down the line: Once the family entity is created, it is very difficult to go backwards to change the structure if the relationships inside the family change.
How to Set-Up a Family Partnership?
As we mentioned above, receiving the proper legal guidance on a family entity is critical to success. Because of their complexity, family entities usually cost at least $10,000 to set up and the cost can be much higher if the underlying assets are complex. Each year the partnership will have accounting and administrative fees as well. The first step is ensuring that the benefits are worth the costs and overhead. If you think a partnership might be a good fit for your family, start a conversation with your financial or estate planning advisors. They can help connect you to the right legal counsel that would ultimately draft the documents to formally establish the partnership.
If you have questions or would like to discuss family partnerships with us, please schedule a call here.