Some of the hardest decisions a family can make are how to handle money, property and other family investments. An answer to these difficult questions, especially for families with considerable real estate holdings, is establishing a Family Limited Partnership (FLP). When used properly, an FLP can be very profitable and save families thousands of dollars in gift and estate taxes. FLPs provide both protection from creditors and flexibility not found in other trusts, as it can be amended or changed.

What is an FLP?

An FLP is a limited partnership controlled by members of a family; like other limited partnerships, an FLP consists of two types of partners: general and limited. General partners control all management and investment decisions and bear 100% of the liability. Limited partners cannot participate in the management of the FLP and have limited liability. The partnership itself isn't taxable – instead, the owners of a partnership report the partnership's income and deductions on their personal tax return, in proportion to their interests.

In an FLP, generally, the senior family members (parents or grandparents) contribute assets in exchange for a small general partner interest and a large limited partner interest. They can then give all or a portion of the limited partner interest to their children and grandchildren. This interest can go to the heirs directly, or be set aside in a trust.

Benefits of an FLP

Transferring limited partnership interests to family members reduces the taxable estate of senior family members. The senior family members transfer the value of the asset to their children, removing it from their estates for federal estate tax purposes, while retaining control over the decisions and distributions of the investment. Since the limited partners cannot control investments or distributions, they may be eligible for valuation discounts at the time of transfer.

Transfers of limited partnership interests are also eligible for the annual gift tax exclusion, a powerful tool for reducing income, gift and estate taxes. According to law, the value of limited partnership shares can be discounted when transferred to family members. In addition, because of an FLP's flexibility, the family members who are owners can usually amend the partnership agreement as family circumstances change.

An FLP also protects assets from claims of future creditors and spouses of failed marriages. Creditors may not force cash distributions, vote, or own the interest of a limited partner without the consent of the general partners. And in the event of a divorce, where a limited partner ceases to be a family member, the partnership documents can require a transfer back to the family for fair market value, keeping the asset within the family structure.

By combining investments together into an FLP, a family's investment fees are significantly reduced. Instead of maintaining separate brokerage accounts or trusts for each child, the partnership can hold one brokerage account, and the children or trusts for children can own partnership interests.

How Do I Begin?

An FLP must be structured with both the present and future owners in mind, protecting the generations of today as well as generations to come. To begin the FLP process, a written limited partnership agreement must be prepared. After the agreement is prepared, assets may be transferred, such as real estate, corporate stock, or cash. FLPs are not designed for the transfer of an individual's home, life insurance, or retirement plans.

The general partnership interests are retained by the senior partners for their lifetime, while the limited partnership interests are given as gifts over time to the limited partners.

Be Careful With FLPs

Care should be taken both when creating the FLP and in observing the formalities of operating the FLP as a family business. Be sure to investigate state laws and the rights and obligations associated with transferred property, and always discuss any of these decisions with professional appraisers.