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FLPs and LLCs

Look at estate planning issues when choosing a family business entity

Family business owners usually choose a business entity -- proprietorship, partnership, corporation or limited liability company (LLC) -- to take advantage of what the entity offers in capitalization, income tax and management structure.

But an often-overlooked consideration in selecting a business entity is how to transfer ownership to your children or other family members either during your lifetime or at your death.

Two entities are excellent choices for transferring ownership to family members: family limited partnerships (FLPs) and LLCs.

Similarities And Differences
FLPs and LLCs share these advantages:

• Both let you transfer shares while you retain control of the business.
• Transferring shares qualifies for the gift tax annual exclusion and the lifetime estate and gift tax exemption.
• Transferring shares reduces your estate's value and thus your federal estate tax.
• For income tax purposes, business income and deductions pass through to individual owners -- as in a partnership, proprietorship or S corporation.
• Both entities offer some protection of assets from creditors.

Although FLPs and LLCs are similar in many respects, deciding which one is best for your business requires a better understanding of their differences. (See "Estate Planning Advantages of FLPs vs. LLCs" on page 4.)

The choice between an FLP and an LLC depends partly on the state in which you live. All 50 states have statutes governing these entities. Each state's law may vary slightly, though the main features are quite similar.

What Is an FLP?
An FLP is simply a limited partnership in which partners are usually members of the same family or related entities. All limited partnerships have one or more general partners and one or more limited partners.

General partners are solely responsible for managing the business and bear unlimited liability for business debts. Limited partners are passive investors: They can't participate in managing the business, and their liability is limited to their respective investment amounts. An FLP can hold a family business or separate business assets leased to the business. (You can also use an FLP to pool a family's resources and invest in securities or hold life insurance.) But to protect an FLP's tax benefits, the entity must have a valid business purpose. For example, the IRS would likely challenge an FLP formed shortly before the general partner's death on the ground that the FLP was formed primarily to reduce estate tax.

In a typical scenario, a married couple owning a family business sets up an FLP with the general partnership's interest totaling 10% of the company's value and the limited partnership's interests totaling 90%. Every year or so, each parent gives each child limited-partnership shares with a market value not exceeding the gift tax annual exclusion amount -- currently $11,000. In this way, the parents gradually transfer business ownership to their children without incurring estate or gift taxes. Even if the limited partners together own 99% of the company, the general partner retains all control and is the only partner with unlimited liability.

What Is an LLC?
LLCs have been around only since the late 1970s. They combine a corporation's limited liability advantages with a partnership's pass-through taxation. In most states, LLC owners are called members. You can restrict LLC membership to family members if you like. Or you can create two classes of membership -- voting and nonvoting.

By law, the founding members decide who will be eligible to participate in managing the company. Founding members may:

• Restrict management to one or both parents,
• Open management to any or all members, or
• Reserve the right to hire outside managers.

All LLC members enjoy limited liability protection, whether or not they participate in company management.

Typically, a couple who owns a family business will form an LLC that assigns, for example, a 50% interest to each parent. Then they give ownership interests each year to their children, with most of the same (but not necessarily all) tax advantages that the FLP offers.

Liability Protection
An important difference between FLPs and LLCs is their level of liability protection. In general, LLCs do a better job because they protect all members. The FLP protects only limited partners -- not general partners.

To help overcome liability concerns, a family might create a corporation to act as the general partner, but this structure can be cumbersome and expensive.

Discounts
The FLP's unusual tax-saving prowess lets you discount the value of limited partnership shares you transfer, as well as the value of the limited partnership shares remaining in your estate when you die.

This discount can range from 20% to 50% and allows you to give larger tax-exempt gifts to your children -- via the FLP -- than you otherwise could.
For example, let's say you own a printing shop with an appraised value of $1.5 million. You can reasonably expect an outside buyer to pay you close to $1.5 million for it. But an outsider is unlikely to pay $15,000 for a 1% business share giving the buyer no operational control and no control over distributing shop-generated income. The market value of that 1% limited partnership share would be substantially less than $15,000, which is why the IRS allows a discount for purposes of gift and estate taxes.

So, for example, a 35% discount would bring the "minority interest" value of a 1% share in the shop to $9,750, thereby bringing the gift's value within the $11,000 annual exclusion amount. And, if other issues don't preclude doing so, you could give a greater percentage and use some of your lifetime exemption amount. Can you apply similar discounts to LLC interests that you give your children?

Yes, in some cases, depending on your state's LLC statute, how you structure your LLC and how you manage your LLC. Discuss this issue with your attorney before you transfer LLC shares to your children.

Other Differences
Liability protection and discounts are the most important differences between FLPs and LLCs. Less important ones include:

Management participation. If FLP limited partners participate in managing the business (or any assets the FLP holds), they would probably lose their liability protection and possibly some tax advantages. But LLC members may be managers, without sacrificing any advantages, depending on how the LLC is set up.

Passive loss. Because they are passive investors, FLP limited partners ordinarily can't deduct partnership losses against earned income or investment income. LLC members and general partners of FLPs who actively participate in the business can probably deduct their share of any losses, but this area of tax law is especially complicated. Legal precedent. Because LLC statutes are relatively new, the courts have issued few legal guidelines to help interpret them. FLPs, by contrast, have a longer history and more case law for guidance.

Not an Easy Choice
As you can see, the choice between an FLP and a LLC -- or between those entities and all the other options -- isn't clear-cut. We would be happy to evaluate your situation and help you determine the best choice.

Although FLPs and LLCs are similar in many respects, deciding which one is best for your business requires a better understanding of their differences. Estate-Planning Advantages Of FLPs vs. LLCs