The basic operation of Family Limited Partnerships is discussed in “Asset Protection: Concepts and Theory” in Chapters 19 and 20.
Common Defects in Family Limited Partnership Structures
The term “Family Limited Partnership” (FLP) is a slang term used by planners. There is no statute anywhere that uses the term, nor does the Internal Revenue Code use it. What “Family Limited Partnership” refers to is a limited partnership formed to hold the family business or investments, with the idea that the parents will make gifts of their limited partnership interests to their children. Because the limited partnership interests are illiquid, so the theory goes, they should be subject to substantial discounts for federal gift and estate tax planning purposes.
Family Limited Partnerships also have some attraction as asset protection vehicles, primarily because the limited partnership interests may be subject to “charging order protection” in some states. See charging orders for more on this topic.
Because of the potential federal gift and estate tax benefits and potential asset protection benefits, FLPs are widely marketed by a variety of attorneys, CPAs, CFPs, and other planners. Unfortunately, FLPs are also marketed by numerous promoters who shamelessly sell one-size-fits-all cookie-cutter FLP structures and even sometimes also sell kits allowing clients to engage in do-it-yourself FLP planning.
When utilized correctly, FLPs can be very powerful estate planning and asset protection planning tools. The problem is: FLPs are almost never correctly utilized, and because of this they often fail to produce their promised benefits. The following is a list of common defects in FLP structures, not in any particular order and certainly not exhaustive:
Failure to Fund the FLP – Many people will go to great lengths to form their FLP and pay substantial fees to a planner to do so, but then never transfer any significant assets to it. Obviously, to the extent that assets are not contributed to the FLP those assets are not afforded either the tax benefits or asset protection benefits of the arrangement.
Failure to Maintain the FLP – Limited partnership require the payment of annual fees, and the failure to pay these fees can mean that the entity will eventually be stricken by whatever governmental entity formed it in the first place. If the entity is stricken, it ceases to exist as far as the state and IRS is concerned.
Failure to Follow Formalities – Although they do not have nearly the level of formalities as do corporations, limited partnerships are required to have Operating Agreements which must be followed, and the failure to have an Operating Agreement or to follow it can mean that the FLP could be disregarded by a court and treated as it never existed.
Non-Business Assets or Activities – Notwithstanding the use of the term “Family” in FLP, these are still limited partnerships, which are fundamentally business entities and are not meant for personal use. The family residence should not, for instance, be placed into a FLP, nor should normal family expenses (utilities, clothing, educational expenses, etc.) be paid from the FLP. The use of the FLP for personal purposes could result in the entity being disregarded for tax and asset protection purposes.
Parent as General Partner – From an asset protection viewpoint (and arguably an estate planning viewpoint as well) making the Parent the General Partner (GP) of the FLP is the single most common mistake in FLP structuring. The reason is that charging order protection relies on the GP to not make distributions to a limited partner’s interest for the benefit of a creditor. However, if the Parent gets sued, the creditor could probably persuade the court to enter an order compelling the Parent to make a distribution to the Parent’s LP interest, thus totally subverting the charging order protection.
Parent as both General Partner and only Limited Partner – If the Parent is both the General Partner and the only Limited Partner (LP), then a court may deem that since the Parent owns all the interests, there is no partnership and the Parent simply owns the FLPs assets outright (thus negating the charging order protection and any hoped-for tax benefits). As dumb as making the Parent both the GP and LP seems, there are actually promoters who sell cookie-cutter structures that make exactly this mistake.
Parent’s Living Trust as the GP – A variation of the foregoing has the Parent form a revocable grantor trust (a/k/a “Living Trust”) that acts as the General Partner. The problem here is that a savvy creditor of the Parent will go to the court and ask for an order compelling the Parent to revoke his or her Living Trust, thus making the Parent the direct GP of the FLP with all the problems that entails. The same problem exists for structures that make the GP a corporation or LLC which is wholly-owned by the Parent’s living trust, since revocation of the living trust will put the creditor in control of those entities, and thus in control of the FLP.
Individual as General Partner – If an individual dies, or is sued, the management of the FLP may be thrown into disarray and the potential exists for an heir or creditor to take control of the FLP’s assets. Thus, it is a very bad practice to make an individual the GP of a FLP.
Formation in a Bad Jurisdiction – Some jurisdictions do not limit the creditor’s remedy to a charging order, thus allowing a judgment creditor to attempt a wide variety of possible remedies to get at the FLP assets to satisfy its judgment. These jurisdictions should be avoided.
Holding Assets in a Bad Jurisdiction – Even if the FLP is formed in a jurisdiction that limits creditors’ remedies to a charging order, that doesn’t mean that if the FLP has assets in a state that doesn’t limit the creditors’ remedies that charging order protection will apply. Indeed, a smart creditor will attempt to “forum shop” its collection efforts by locating the FLPs assets in jurisdictions that do not limit the creditor’s remedy to a charging order. The upshot of all this is that a FLP should restrict the physical domicile of its assets to states that do affirmatively limit creditors’ remedies to a charging order.
Failure to Limit Remedies – Amazingly, many FLP operating agreements are drafting in a way that they do not limit creditors’ remedies to a charging order, thus creating opportunities for creditors to pursue alternative strategies to get at the FLP assets.
Avoid the Hammer-Nail Approach – There is an old saying that “when the only tool in your toolbox is a hammer, everything looks like a nail.” Some planners have FLPs (or FLP/FAPT combo platters) as their only tool, and thus of course those planners solve every client problem with a FLP whether the FLP is the best solution for that problem or not. Contrary to what some promoters claim, not every estate planning or asset protection problem should be solved with Family Limited Partnerships. Other methods and structures will be better for some situations, and for particular problems within the family estate.
Failure to Diversify/One Big FLP – The second most common error in FLP structuring is to place all of the client’s significant assets into a single FLP, thus creating a large, single target for creditors to relentlessly attack. As with most other asset protection methods, an FLP will be more effective if it is just one of several diverse methods used to protect assets.
Combined with Foreign Asset Protection Trust – Called the “Combo Platter”, the idea is that the limited partnership interests will be owned by an offshore trust, and when a creditor comes along the partnership will simply be liquidated and all the assets transferred offshore to the trust. Among the many problems with this structure is that it has been so heavily overmarketed that it is readily identified as a blatant asset protection structure. Probably a worse problem is that offshore trust component only “works” if the client is willing to flee the jurisdiction of U.S. courts. See Foreign Asset Protection Trusts. Promoters of this structure will not, of course, share these little tidbits of knowledge with their customers for fear of losing a sale. If you bought an asset protection plan prior to 2000, the Combo Platter is probably what you ended up with. It needs to be fixed immediately.
Fraudulent Transfer – Charging order protection only works for assets that are already in the FLP structure. If the initial transfer to the FLP was a fraudulent transfer, however, the court can simply void the transaction to the FLP as if it never existed. Promoters make a variety of representations about transfers of assets to FLP as being “for value” and thus ipso facto not a fraudulent transfer. However, whether a transfer is for value is not dispositive and a court can set aside a transfer whether or not it is for value if the transfer was made in defraud of creditors. The court can make such a determination based on, for example, statements in the promoter’s marketing materials that one of the advantages of an FLP is to avoid creditors. Another reason to avoid promoters who heavily market FLPs as an asset protection tool.
Failure to Make Gifts of the LP Interests – Some people will go to great trouble to fund their FLPs, but never get around to actually gifting the LP interests to the children. This results in wasted opportunities to take advantage of the annual unified exclusion, and ultimately in higher estate taxes paid by the parents’ estate. It also unnecessarily exposes the LP interests to the parents’ creditors during the interim.
Failure to Obtain Valuations – If the FLP will be used to avoid estate taxes by way of discounting the limited partnership interests that are gifted, it is critically important that the limited partnership interests be the subject of a valuation by a qualified appraiser. If no appraisal is conducted, the odds of the discounting standing up to IRS scrutiny are very low.
Excessive Discount – Some promoters to induce a sale will promise clients that the limited partnership interests can be significantly discounted, sometimes in excess of 50%. While there is no certain number that will pass IRS scrutiny, discounts in the 20% or less range are much more conservative and less likely to draw attention. The old adage “Pigs get fat, and hogs get slaughtered” applies to discounting LP interests.
Gifting Limited Partnership Interests Directly to Children – By gifting limited partnership interests directly to a child, the possibility arises of creditors or an ex-spouse of the child getting possession of (or at least a charging order agaisnt) the limited partnership interest. By placing the parents gifting the limited partnership interest to a spendthrift trust instead, claims against the limited partnership interest by the child’s creditors and ex-spouses are avoided.
Guidelines for Property Using FLP Structures
Family Limited Partnerships can and should play a role in the family’s estate and asset protection planning within their limitations. The following are not any hard rules to follow, but are simply some “Rules of Thumb” about using FLPs correctly:
Control at the GP Level is Critically Important – Usually whether a FLP “works” or not when challenged by creditors is determined by whether the GP can avoid collateral attacks by creditors. At the same time, if the GP is not structured correctly, control of the FLP can be lost. Thus, it is very important that the GP be structured correctly, which is the real art of asset protection and estate planning.
Don't Overuse -- The Family Limited Partnership is just one of many available techniques, and it should not be overused or made into a single large target. Thus, the percentage of the client's total assets that go into a FLP structure should ideally be 25% or less, and not more than 40% except in unusual circumstances (or a very small estate). Avoid promoters who will try to stick nearly everything into the FLP.
Diversify – It is better to have several smaller FLPs than to have one oversized one. A good Rule of Thumb is to create a new FLP for every $2 million to $5 million in assets. This keeps the profile of each FLP lower for both creditors and for any IRS audits.
Treat the FLP as a Business Entity not a Family Trust – The FLP must be treated as a business entity, and should not be used as a family trust. All the investment holdings of the FLP should be for business or investment purposes, and all payments made by the FLP should facilitate those purposes. The FLP should absolutely not be used for personal family purposes, such as to hold the family home or fund college educations. If the family requires money from the FLP, then it should either be borrowed from the FLP at current interest rates or (much better) distributed from the FLP to the various trusts holding the interests, and from there given to family members.
Have a Good Operating Agreement and Good Law – A major key to the success of an FLP is having a very good operating agreement that is custom-tailored to the family business (an unmodified standard form Operating Agreement is often worthless, or worse). It is also very important that the FLP be formed in a jurisdiction that limits the creditor’s remedy to a charging order, and does not easily allow liquidation of the partnership interests to satisfy creditors.
Have Trusts Own the Children’s LP Interests – With slightly more work, the FLP can provide substantially more asset protection if the LP interests are conveyed to spendthrift trusts formed for the children and the not the children outright.
Maximize Transfers – Transfers of assets by parents to the FLP should be made immediately, and annual gifts of the LP interests should be religiously made to the children’s spendthrift trusts.
Avoid the Offshore Urge – To generate higher fees, some promoters will encourage that the LP interests be held in an offshore trust. They will not tell you, however, that for this arrangement to work you will probably have to flee the country to avoid being thrown in jail for contempt of court. They also will not tell you that the case law establishes absolutely no advantage to having the LP interests foreign asset protection trusts as opposed to an arrangement of well thought-out, structured and drafted domestic trusts.
Avoid Kits and Promoters – If you have enough in assets to justify having an FLP, then you should spend the time to go to a licensed tax attorney in your jurisdiction who has experience in structuring these entities the right way, and assisting you with transfers to the FLP. The kits and one-size-fits-all promoters invariably cause more problems than they solve, meaning that there will later by additional costs to both remediate the past problems and finally do it right.
Hired General Partners/Managers
Sometimes it makes sense to hire a truly independent third-party to act as the General Partner of a family limited partnership. So long as appropriate safeguards are in place to assure that the third-party will not abscond with the partnership assets, such an arrangement provides substantially greater asset protection and estate planning benefits for only slightly higher costs.
Family Limited Liability Company (FLLC)
There is absolutely no reason to believe that Limited Liability Companies provide any less estate planning or asset protection benefits than limited partnerships. However, the foregoing warnings and suggestions apply with equal weight to FLLCs. For a variety of reasons, the FLLC should never be “member managed” and the same concerns that go into selection and structuring of the GP should apply to the manager of the FLLC.
Xtreme LLC (XLLC)
An Xtreme LLC uses the Delaware Series LLC to create a very strong asset protection structure that can be used as the Family LLC. The XLLC represents the cutting-edge of asset protection planning in relation to FLPs and FLLCs as it is known today.
The Series LLC Center -- http://www.assetprotectionbook.com/seriesLLC_center.htm