The pros and cons of family limited partnerships

That’s because a big reduction is planned in the amount of an estate that can be shielded from federal estate taxes. For 2022, estates valued at up to $12.06 million are exempt from federal estate taxes. But on Jan. 1, 2026, unless there is action by Congress, the exemption is set to plunge to somewhere closer to $6 million, adjusted for inflation.

Wealthy Americans are re-evaluating their estate plans as a result, says Ronald Fatoullah, an elder-law attorney in New York. Many are transferring assets into family limited partnerships, or FLPs, as a tax-saving strategy.

An FLP can be tailored to suit your legacy plans, says David Born, a financial adviser at Private Financial Management LLC in San Francisco. “They can be set to wind down upon your death, at a specific date in the future, or operate in perpetuity,” he says.

Individuals don’t have to be ultrawealthy for family limited partnerships to make sense, says Andrew J. Sherman, partner, Seyfarth Shaw LLP in Washington, D.C. “These can make sense for upper-middle-class families that own small businesses, or who have inherited real estate, or valuable collectibles they are not ready to sell,” he says.

There can be downsides. The cost to set one up generally ranges from $8,000 to $15,000, but can go much higher depending on what state you live in and the complexity of the partnership. In addition, there are annual operating costs, tax filings and appraisal fees.

There is also the danger of a challenge from the Internal Revenue Service.

“The IRS scrutinizes FLPs closely since it believes they are subject to abuse,” says Gabriel Kaplan, a financial planner and CPA in Scarsdale, N.Y. “The agency wants to make sure they have a legitimate business purpose.” The threat of audits could increase next year now that the IRS has $80 billion in funding from Congress to beef up enforcement and improve operations, financial advisers say.

Here’s a closer look at how FLPs work.

All in the family

The first step is to draft a formal FLP agreement, something typically done by an estate-planning attorney in consultation with a client’s accountant and financial adviser.

What makes one of these partnerships different from a traditional limited partnership is mainly the fact that all of the partners are family members. There are two kinds of partners: general and limited. Usually, parents or grandparents are the general partners and contribute the bulk of the assets, such as a business, a stock portfolio or real estate. Children are typically limited partners, with interests in the partnership.

General partners control all of the investment and management decisions and bear the partnership liability, even though their ownership of the assets can be reduced to as little as 1% or 2%. They make the day-to-day business decisions, including how to allocate funds and distribute income.

The ability of general partners to maintain control of the transferred assets is one of an FLP’s biggest advantages. “It can be a win-win for wealth creators, reducing their taxable estate through gifting while maintaining control of the business and assets,” says Brian Littlejohn, founder of Sherwood Wealth Management, a private wealth advisory firm in Basalt, Colo.

For this reason, an FLP can be part of a succession plan, allowing a general partner to groom his or her heirs while securing their economic interests. You also don’t have to choose your successors right away. You can wait until a future date to decide to whom you want to transfer your general interest.

“This gives you flexibility when trying to forge your legacy plan,” says Mr. Littlejohn.

Asset transfer

Once the legal entity is created, assets may be transferred to the FLP immediately or over time, depending on the family’s wishes and the amount of planning involved.

“Getting most of the property out of the general partner’s taxable estate is the end goal,” says Tom O’Saben, director of tax content and government relations for the National Association of Tax Professionals. The assets in the FLP are divided and gifted to the limited partners—often to trusts for the limited partners who are the owner’s descendants. The trusts ensure that the gifts to the descendants remain out of their personal estates, too.

These gifts are tax-free, up to the annual gift-tax exclusion amount. For 2022, the exclusion amount is $16,000 a person or $32,000 a couple. That means grandparents with three children and seven grandchildren could transfer $320,000 of limited interest shares to their family each year with no tax liability. Spouses of children and grandchildren aren’t usually made limited partners in an FLP.

Asset interests in an FLP also may be valued at a discount because partnership interests are illiquid and considered less marketable for sale. Such a discount can potentially help a family reduce its estate and gift-tax burden. “The discount is typically 30% or more,” Mr. Littlejohn says.

When a donor who is general partner dies, the interests previously gifted to the limited partners aren’t subject to estate and inheritance taxes. The deceased general partner’s interests and control of assets pass to the designated limited partners, or typically to trusts set up in each person’s name as designated in his or her estate plan. Most often the FLP remains an operational family business and another family member is named general partner.

FLPs can be structured for many life contingencies to ensure assets are kept within the family. “Restrictions can be imposed on the transfer of partnership interests in the event of divorce, bankruptcy or death,” says Mr. Kaplan.

These vehicles also ease the transfer of assets to heirs by gift or other ways, since they receive partnership interests rather than fractional interests in real estate or specific shares of stock.

Plenty of caveats

To avoid problems with the IRS, the partnership must be conducted as a business entity. Meetings must be held with formal minutes taken; general partners must be compensated for their services; and limited partners must pay taxes on their share of the income from the partnership.

Keep in mind these complex vehicles require constant professional attention by your team of advisers to remain compliant with IRS rules, Mr. Kaplan notes.

“Know there are risks with FLPs,” says James I. Dougherty, an estate-planning attorney at Dungey Dougherty PLLC in Greenwich, Conn. “The IRS has challenged these partnerships. It wants to confirm that there were legitimate nontax reasons for establishing the FLP as opposed to the taxpayer setting up one simply to artificially lower the value of the assets for tax purposes.”

There are additional caveats as well.

“It is difficult to back out of once you’ve created an FLP and transferred assets into it,” says Jim Evans, vice president of TTG Financial Inc., a financial-planning firm in Canton, Ohio. “You will face legal and accounting consequences. And If you have a falling-out with one of the limited partners and it gets acrimonious, they could sue you.” Unlike corporations and trusts, general partners aren’t insulated from potential lawsuits, judgments or creditor seizures.

That is why some estate planning attorneys advise clients to set up family limited liability companies instead, notes Ryan Shain, an estate planning attorney and partner of Schinner & Shain LLP, in Malibu, Calif. These can be set up to operate much like FLPs but also protect all partners from liability—including the general partners.

“These partnerships are not for everyone,” says Mr. Born, the adviser in San Francisco. “It all depends on the size of your estate, your tax situation and financial goals.”