Learn what a family limited partnership is and how families use it to finance a business endeavor or manage their wealth and investments.
Definition of a Family Limited Partnership
A family limited partnership is a legitimate business structure used by families to pool their resources for business and investing purposes. Each family member involved in the partnership becomes a shareholder and has specific powers and authority based on the partner role the charter or operating agreement grants them. Acronym: FLP
How Does an FLP Work?
In a family limited partnership, family members can pool their money and undertake a project, such as building rental properties or investing in real estate, which might not be possible individually. A typical family limited partnership has two types of partners: general and limited.
General Partners
When one or more family members are named as general partners, each partner is responsible for the day-to-day management of the family limited partnership. This includes overseeing or conducting any of the necessary functions of running the business or managing the financial assets within the partnership. General partners are paid (if there is payment agreed upon) according to the partnership operating agreement. Some general partners receive a cut of profits, while others get a fixed annual salary. They also have unlimited liability. If any of the projects fail, creditors can go after their assets to cover business debts and liabilities.
Limited Partners
A limited partner is a family member who contributes money in exchange for ownership in a project but has no day-to-day management responsibilities. They can also not be involved in executive functions or risk losing their protected limited partner status. Limited partners vote on the partnership agreement, which establishes the rules governing the family limited partnership, and collect dividends, interest, and profits. As a general rule, limited partners cannot lose more than they have invested in the partnership unless they begin taking on general partner responsibilities.
FLP Taxes
Taxes become complicated when FLPs are used for investments or passing on money to successive generations. In general, significant assets can be passed on to future generations using an FLP without triggering estate or inheritance taxes. The FLP, as a business structure, does not pay taxes. Taxes are passed through to the partners to report on their income taxes. Taxes are reported through the FLP to the Internal Revenue Service depending on each partner’s interest share in the FLP. Gifts given through the FLP to partners are not taxed up to the exclusion amount for the year the gift was given.
FLP Units/Shares
Family limited partnerships usually issue units (similar to shares) to each partner to know how much of the company they own. In most FLP agreements, shares cannot be sold until a specific period has passed. If any of these units are sold, they are subject to regulation by the Securities and Exchange Commission. Care should be taken by partners who look to sell their shares in a family limited partnership because these types of transactions must meet requirements set under the Securities Act of 1933.
A Business/Investment Example
As an example of establishing an FLP for business purposes, imagine Robbie wants to build a row of upscale townhouses. Costs are projected to be $1.2 million, including working capital, and it should generate $200,000 in earnings before income taxes, depreciation, and amortization. He wants a down payment of at least 50%, so he calls his family for help, and they decide to form a family limited partnership. They settle on the following structure:
The family limited partnership will issue 6,000 limited partnership units, or shares, at $100 each to raise the required $600,000 in starting capital. These units cannot be sold for at least five years, and the partnership will pay out 70% of cash earnings in the form of dividends.Robbie will buy 600 of these shares by contributing $60,000 to the family limited partnership, giving him 10% ownership of the project. He will be named general partner, and he will receive the first 5% of pre-tax profits as a management fee for handling the day-to-day operations.Other members of Robbie’s family buy the remaining 5,400 shares, each representing fractional ownership in the family limited partnership.
Robbie controls the family limited partnership with $600,000 cash. He goes to a local bank and gets a first mortgage loan for the remaining $600,000, giving him the $1.2 million he needs to fund the project. The partnership builds the townhouses, leases them to tenants, and begins to collect rental income. The FLP distributes earnings throughout the family, and the mortgage is paid down. Once it’s paid off, payments can be redirected to building maintenance, and distributions can either increase, be reinvested into the business, or both. Capital can be used to purchase investments to help the partnership increase its assets or build new structures to generate rental income. In this way, Robbie and his family have pooled resources and increased their net worth while establishing a business that is passed on through generations.
Do I Need a Family Limited Partnership?
While no one but a qualified lawyer and tax accountant can help you answer this question, there are some considerations to factor into your decision. Think about whether pooling your money will allow you to undertake projects that otherwise would not be possible. If so, do these projects offer above-average rates of return? You also don’t want to find yourself in a situation where pooling your money causes you to take on too much risk and become financially vulnerable using your family’s money. If you’re a limited partner, trusting the general partner is essential because they will have unrestricted access to cash deposits and business assets. If you have any questions about their integrity or business acumen, you may want to avoid the investment. Good management often makes the difference between investment losses and significant gains. If you trust your family partners, find out if the family limited partnership will be formed for a single investment opportunity or as an ongoing investment vehicle that will continue to create or acquire assets. Issuing limited partnership units is like issuing stock in many respects and is subject to laws and regulations. Be sure the limited partnership project is big enough to justify the expense of having a lawyer review securities laws so that you don’t attract attention from the authorities.
