One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. So when is the best time to do this? Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.

A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.

How an FLP Works

To establish an FLP, the owner transfers their ownership interests to a partnership in exchange for both general and limited partnership interests. The owner then transfers limited partnership interests to their children.

The owner retains the general partnership interest, which may be as little as 1 percent of the assets. But as general partner, the owner can still run day-to-day operations and make business decisions.

Tax Benefits of an FLP

As the owner transfers the FLP interests, their value is removed from their taxable estate. The future business income and asset appreciation associated with those interests move to the next generation.

Because the children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without the owner’s consent or force the FLP’s liquidation.

The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25 percent, in 2018 the owner could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.

To transfer interests in excess of the annual exclusion, the owner can apply their lifetime gift tax exemption.  Because of the Tax Cuts and Jobs Act, 2018 may be a particularly good year to do so because it was raised to a record-high $11.18 million, . The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.

There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. The children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.

The IRS and FLPs 

Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.

The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.

Is an FLP Right for Your Business?

An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact one of our tax advisors for help determining whether an FLP is right for you.