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Flip Over FLPs: Part 1

With Democrats having taken over Congress in the midterm elections, things are looking bad for those who supported repealing the estate tax. After failing to pass a bill that would have permanently eliminated federal estate taxation earlier this year, it's now likely that any compromise will retain the estate tax for at least some estates.

Therefore, it's time to dust off some of the estate planning techniques that financial planners and estate attorneys have been holding in reserve. After all, if you succeed in getting great returns from premium blue-chip stocks like Costco (Nasdaq: COST  ) and Disney (NYSE: DIS  ) , you want to make sure your family gets to keep that money after you're gone. Although it won't be possible to optimize estate planning strategies until all of the uncertainties raised by the estate tax relief provisions enacted in 2001 are addressed, it's probably a safe bet that active management of passing assets down to future generations will help prosperous families minimize their estate tax liability. One method that is commonly used for managing gifts between family members involves creating a business entity, often known as a family limited partnership or FLP (pronounced "flip"). When used correctly, a FLP can enable you to make gifts to future generations more efficiently, while retaining substantial control over the investment and distribution of partnership assets.

How the FLP works
Setting up a family limited partnership involves many of the same tasks as setting up a new business. Many operating businesses use the limited partnership entity as a way to manage liability for investors. A limited partnership usually includes one or more general partners, along with a number of limited partners. In the context of a for-profit enterprise, the general partners are those who take active responsibility for managing the business and making decisions on behalf of the limited partnership as a whole. They usually have broad authority to run the business as they wish, subject only to whatever limitations are set out in a partnership agreement. Along with this power and responsibility comes risk; general partners bear potentially unlimited personal liability for anything the limited partnership does.

Limited partners, on the other hand, have little or no authority to conduct business on behalf of the limited partnership. Usually, the contribution that limited partners make to the overall business is solely financial. As passive investors, limited partners are subject to the business decisions made by the general partners; the partnership agreement governs the rights that limited partners have. For the most part, limited partners invest in limited partnerships in the hope of receiving distributions of profits and capital gains that exceed what they could earn as shareholders of public companies.

When used for family estate planning purposes, limited partnerships have somewhat different characteristics. Even though most families don't operate their own businesses, there isn't any requirement that a family limited partnership involve a business in which you're actively involved. In most cases, the typical strategy involves performing the necessary steps to create the legal entity and then funding the limited partnership with cash, securities, real estate, and other valuable property.

How to set up a FLP
The first step in setting up a family limited partnership is to establish a legally recognized business entity. In order to do this, you will generally need to obtain the necessary forms from the Secretary of State or another similar state official that has responsibility over business filings. The forms will require you to choose a name for the FLP; typically, people choose a name like "the John Smith Family Limited Partnership" for simplicity. The forms in most states require only basic information, including the name and address of the general partners. Once you complete the forms, your state will instruct you on how to file them and what fees are required.

Although creating a legal entity is a task that you could do on your own, the more important part of setting up a family limited partnership is drafting the partnership agreement. As the second part of this article discusses in greater detail, there are a number of benefits that using a FLP provides to facilitate gifts of assets among family members. In order to get the full value of these benefits, however, it is absolutely essential that the partnership agreement include several complicated provisions that define certain characteristics of the limited partnership. Because the use of family limited partnerships often results in substantially reduced tax liability, the IRS is likely to scrutinize your partnership agreement; if it finds mistakes or other troublesome provisions, it may challenge your ability to use your FLP in its intended manner. In order to make sure the FLP fits in with the other components of your estate planning, it's generally a good idea to enlist the aid of your estate planning attorney to draft an appropriate partnership agreement.

Once the legal entity and partnership agreement are in place, then you can start to fund the limited partnership with assets. FLPs can usually hold any type of valuable asset, including cash, investment securities, real estate, and tangible property such as art or precious metals. For investment and bank accounts, funding your FLP may be as easy as changing the name on your account from your individual name to the name you chose for the FLP. Because the FLP is a business entity, some financial institutions will require a different type of account application in order to transfer your account into the name of the FLP. For real estate, your attorney will generally need to draft a real estate deed to transfer the property.

After the initial funding is complete, then you will be the FLP's sole general partner and hold 100% of the ownership interest in the limited partnership. Where the real benefits of the family limited partnership become evident is in the next stage, when you begin making gifts of limited partnership interests to your children, grandchildren, and other heirs. The second part of this article discusses these benefits in detail.

Related Articles:

The Motley Fool has several good sources for estate planning information. Rule Your Retirement is a comprehensive retirement service that helps you assess all aspects of your financial future, from savings to estate planning to asset allocation. Try it out for 30 days with no risk.

Disney and Costco are Motley Fool Stock Advisor picks.

Fool contributor Dan Caplinger fondly remembers the hundreds of pages of partnership documents he drafted as an associate attorney. He doesn't own shares of the companies mentioned in this article. The Fool's disclosure policy will have you turning somersaults.


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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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