We are frequently asked by families what the best option is to establish a limited liability entity while also consolidating family investments or business assets.
The answer is, it depends. However, it’s essential to assess the details and comprehend the impact of each structure.
When families want to create an entity for the consolidation of publicly traded securities, real estate, family business interests, and other family assets, they generally consider Family Limited Partnerships (FLPs) and Limited Liability Companies (LLCs).
There are notable differences between the two. FLPs have general partners who oversee and control the partnership, along with limited partners who hold an economic interest in the partnership. LLCs, on the other hand, have one or more managing members who govern the business and members who own shares of the LLC. Assets are transferred to the entity in exchange for an interest in the general or limited partner of an FLP or an LLC interest. A limited partnership agreement or operating agreement manages the operation and management of the FLP or LLC, respectively.
The interest owned by the family member or individual can be gifted or sold outright to a trust, potentially at a discounted value. The entity must serve a business purpose, a common objective. For instance, when the senior generation and their children contribute assets to the entity, it results in a larger pool of assets, ultimately creating investment opportunities that may not be available to the senior generation or children individually. To clarify, establishing an FLP or LLC solely to reduce transfer taxes, with no other business purpose, may cause the entity to fail, and any generational planning efforts could be denied by the Internal Revenue Service.
Before deciding whether an FLP or an LLC is suitable for you and your assets, below are some pros and cons to aid in the decision-making process: Advantages of an FLP or LLC
- Consolidation of family assets under one entity. Families often have marketable securities, real estate, and other business interests held in different names, entities, or trusts. Creating a single entity allows for asset consolidation, potentially resulting in greater scale for certain investments and easier management oversight of various assets.
- General Partner/Managing Member retains control. FLP general partners or LLC managing members control the assets held in the entity and determine if, and when, distributions are made. While not obligatory, distributions should be made pro rata to the underlying owners of the entity to help avoid complexities arising from non-pro-rata distributions in partnership accounting. Guaranteed payments may be an alternative to distributions, especially when the entity experiences losses and cannot make distributions.
- Asset protection. FLP and LLC structures can provide asset protection by keeping personal and business assets separate. Consequently, a claim against the entity does not grant a creditor the right to seize personal assets to settle a judgment, lien, or financial debt.
- Income tax benefits. If structured correctly, there is generally no tax on the formation and funding of the entity. Generally, the entities are disregarded for federal income tax purposes, and the entity owners pay taxes on their share of business profits, whether distributed or not. Individual tax implications depend on each owner’s basis in the FLP or LLC. Entity owners may also opt to be treated as S- or C-Corporations if specific requirements are met, which could offer additional tax advantages.
- Gift and estate tax benefits. Gifting ownership interests in an FLP or LLC can yield gift and estate tax advantages through valuation discounts. Lower valuations result from a lack of control, lack of marketability, and/or a minority interest or share discount. These discounts effectively reduce the amount of gift and estate tax exemption applied to the transfer of an ownership interest. Consequently, the transferor can gift more assets out of their estate for significantly less cost. Any future appreciation of the transferred assets accrues to the new owner, further reducing the transferor’s estate and potential estate tax liability.
- It’s worth noting that similar discounts can also apply when selling assets to determine the seller’s note amount, allowing the seller to dispose of the discounted value from their estate.
Disadvantages of an FLP or LLC - Lack of control. Assets held in the entity are controlled by FLP general partners or LLC managing members, who are responsible for all decisions regarding business management. FLP limited partners and LLC non-voting members do not possess decision-making authority.
- Liability. FLP general partners are personally liable for all partnership obligations, whereas limited partners have limited liability equal to their FLP investment. In the case of an LLC, managing or non-managing members are not personally responsible for the LLC’s debts and obligations.
- Ongoing costs and complexity. In addition to the expenses associated with establishing the entity, ongoing complexities, such as gifting, may require input and advice from legal counsel and/or a CPA.
- Tax filing. With multiple FLP partners or LLC members, the entity will need to file an informational return each year (Form 1065) and prepare Schedule K-1 for each partner or member. Tax income (or losses), deductions, credits, etc., will be allocated among all owners in proportion to their ownership.
- Stepped-Up Cost Basis. The rules regarding cost basis when gifting ownership interests do not allow for a stepped-up calculation. Instead, the cost basis “carries over” from the transferor to the transferee. A buyer will have a cost basis and inherit the seller’s capital account, which may result in a disparity between what the buyer paid (outside basis) and the buyer’s allocation of the seller’s capital account (inside basis). To rectify this issue, the buyer can make a §754 election to make a special cost basis adjustment to the inside basis.
When used correctly, an FLP or LLC can be a valuable tool for consolidating family assets, protecting them from potential creditors, and transferring them tax-efficiently to named beneficiaries.