Maybe you've experienced the joys and challenges of running a family business. There are financial, legacy, and family decisions intertwined in a great many choices that you have to make on a regular basis.
Thinking longer term, how should a family business be structured to help manage future business operations, potentially reduce estate taxes, and help protect the family from creditors?
In the following article, we discuss 2 business entity structures that, given the right circumstances, can be appropriate for a family business: family limited partnerships (FLPs) and limited liability companies (LLCs). We will explore the common attributes of both structures and examine how they differ from other entities such as C-corporations and S-corporations. Lastly, we'll look at how families might leverage them in estate planning strategies to potentially transfer wealth to the next generation.
What is a family limited partnership?
A family limited partnership refers to a partnership between 2 or more family members that is generally established for the purpose of operating a family business, managing real estate holdings, or to act as a holding company for marketable securities and other investment types. An FLP is a separate legal entity with its own management structure and tax reporting requirements.
"Unlike a traditional limited liability partnership, the partnership agreement establishing an FLP restricts ownership of the partnership units to family members. This limitation can play an important part in estate planning and discounting strategies," says Nicholas Beis, vice president, advanced planning at Fidelity.
When establishing an FLP, 2 types of partnership interests will be created: general partnership interests and limited partnership interests.
- General partnership interests. The general partners are responsible for making managerial decisions for the partnership. When the partnership is first established, it is common for parents or grandparents to act as the general partners either individually or through a separate corporate or limited liability entity to avoid the partnership being dissolved upon the death of the sole remaining general partner.
- Limited partnership interests. Limited partners have no managerial responsibility. In many cases, the initial limited partners will be descendants of the general partners. By creating 2 classes of owners, the FLP structure allows a family to transfer wealth to a younger generation, while select family members, typically parents or grandparents, retain control.
A further distinction: exposure to personal liability for the affairs of the partnership. General partners are exposed to unlimited liability for affairs of the FLP, whereas the liability of limited partners is limited to the partner's individual ownership interest. In contrast, an S-corporation or LLC, generally provides limited liability protection to all owners of the business no matter what their level of managerial control.
Pass throughs and federal income taxation
Like other partnerships, an FLP will be treated as a "pass-through" entity for income tax purposes. The partnership itself is not subject to federal income taxation. Instead, the partners are liable for income tax on his or her distributive share, which is the portion of profits to which a partner is entitled under the partnership agreement. Although individual income tax rates can be higher than corporate tax rates paid by C-corporations, pass-through taxation can result in a net benefit for family members.1
Another advantage of partnership tax treatment is the ability to make a "special allocation" of the distributive share. By following strict IRS guidelines, a family may draft a partnership agreement that allocates distributive share on a basis other than percentage ownership. This may allow a family to shift the tax burden of the partnership's profits from family members in higher tax brackets to those in lower brackets.
Despite the potential benefits of pass-through treatment, caution must be exercised. Beis adds, "Partners will be subject to income tax on their distributive share whether they receive a distribution from the partnership or not. This is the case when family members feel the need to leave profits in the business to fund expansion or future expenses." On the other hand, shareholders of a C-corporation will only be taxed individually on the profits actually distributed to the shareholder.
Pass-through treatment can also pose a problem for family members that are actively involved in operating the partnership. The IRS requires these family members to pay self-employment taxes, including contributions to the Social Security and Medicare programs, in addition to income taxes on their distributive share.
What is a family limited liability company?
Like an FLP, a family limited liability company is a separate legal entity that can be established for the purpose of operating a family business, managing real estate holdings, or to act as a holding company for marketable securities and other investment types. Also similar to an FLP, which limits ownership of the entity to family members, the operating agreement of a family LLC will restrict ownership and transfer rights to keep ownership of the entity within a family.
Despite their similar purposes and shared attributes, the 2 entity types vary in several important ways including management structure, which family members are afforded liability protection, and tax treatment options.
A family LLC can be established in 2 ways: as either a member-managed LLC or a manager-managed LLC.
- A member-managed LLC provides that the individual owners, known as members, will share managerial control of the company.
- A manager-managed LLC will designate a manager who has control over the day-to-day operations and management of the company. In a manager-managed LLC, the members retain control over strategic decisions of the company (e.g., selling the entity) and will have the authority to replace the manager. This differs significantly from an FLP where the limited partners can exert no control over the operation of the business.
Another key difference is the liability protection afforded to the members of the family LLC. "All members, no matter their level of managerial control, are shielded from personal liability for activities of the business. This approach is in contrast with an FLP in which the general partners are subject to unlimited personal liability for affairs of the partnership," says Beis.
Tax planning considerations
Family LLCs offer families flexibility in tax planning by allowing the LLC's members to select how the family LLC will be treated for tax purposes. By default, a family LLC will be treated as a partnership and will "pass-through" profits and losses to its members like an FLP. This includes the ability to reallocate the distributive share in the company's operating agreement.
C-corporation. Members of the family LLC may elect to be taxed as a C-corporation because of:
- The ability to retain profits within the company and reinvest in the business2
- The opportunity to help avoid personal income tax liability in years when profits are not distributed as dividends
- The ability to provide family members who are actively engaged in the operation of the company with employee benefits such as health and disability insurance
- The opportunity to deduct the cost of employee benefits if they are provided to at least 70% of the LLC's employees
S-corporation. Members of the family LLC may elect to be taxed as a S-corporation because:
- The entity will be treated as a pass-through entity and avoid the double taxation at both the entity and individual levels similar to a partnership.
- The IRS requires that members who actively participate in operating the LLC must be paid a 'reasonable wage' that meets industry standards and are deducted as a business expense.
- The cost of contributing to Social Security and Medicare for employee-members is shared by the member and the LLC which can result in significant savings over the self-employment tax imposed on partners in the FLP who play a similarly active role.
Piercing the corporate veil: A note on liability protection
Although FLPs and family LLCs provide limited liability protection for some or all owners, those protections may be lost or waived under certain circumstances. Care should be taken to preserve these protections and an attorney should be consulted when engaging in activities that might undermine the status of the entity, exceed the scope of an owner's managerial authority, or result in an assumption of personal liability for debts of the business.
Piercing or lifting the corporate veil is a term used to describe a court holding members of an LLC personally liable for the debts of the LLC. A court may pierce the corporate veil when the creditor of the company can prove:
- That the members of the company failed to maintain a meaningful separation between themselves and the company. This might take the form of the members using company assets to satisfy personal liabilities.
- That the company's actions were fraudulent because the members borrowed money or incurred expenses that they knowingly could not repay using assets of the company.
- That the company's creditors suffered a financial loss.
Similarly, limited partners of an FLP can also be held personally liable for the debts of the partnership under certain circumstances. This most commonly happens when the limited liability partners exercise managerial control over the FLP. Under these circumstances, a court may rule that a limited partner is in fact a general partner despite the terms of the partnership agreement and hold the limited partner liable for the affairs of the partnership.3
Estate planning and discounting opportunities
In addition to liability protections and the potential for more advantageous tax treatment, the management structure and ownership restrictions of FLPs and LLCs offer estate planning opportunities. Families that wish for a closely held business or other assets to remain under the ownership and control of their fellow family members see an estate planning advantage in being able to use an FLP or a family LLC to transfer ownership within the family at a reduced or "discounted rate" while also restricting who may exert managerial control and who may be a recipient of transferred interest.
Lifetime gifting is one of the estate planning strategies that can benefit from the use of an FLP or family LLC. Gifts made during one's lifetime may reduce the value of an estate at death by transferring not only the value of the asset itself but also any potential future appreciation on the transferred asset as well. This discounting method allows certain family members to retain control while gifting the value of the business.
"This is important because the federal government, 12 states, and the District of Columbia, impose a tax on an individual's 'taxable estate' at death if that taxable estate exceeds the current applicable estate tax exclusion amount4," says Beis. "In general, when gifting assets during a lifetime5, the goal is to transfer as much wealth from a taxable estate while using as little of a lifetime exclusion as possible."
To help achieve the goal of making use of as little exclusion as possible for lifetime gifts, attorneys and tax advisors may advise their clients to utilize a "discounting" strategy whereby the appraised value of the units of the FLP or family LLC are reduced to account for a lack of control and/or marketability.
Restrictions on who may make managerial decisions, limiting the number of ownership units, and restricting who can receive ownership units may lead a professional appraiser to determine that a family has reduced the fair market value of the ownership interest in their FLP or family LLC. The discounted appraised fair market value can then be used to assign a value to lifetime gifts and thus impact how much of an individual's lifetime exclusion is used for the transfer.6
However, transferring assets during the original business owner's lifetime will result in the loss of an important benefit known as the "step-up" of cost basis. The step-up is the adjustment of the value of an appreciated asset for tax purposes when those assets are transferred to beneficiaries at the original owner's death. The step-up can significantly reduce the capital gains tax liability when the beneficiary eventually sells the inherited asset.
2 hypothetical examples of how families with different planning priorities selected a business entity structure
FLP planning example – retail apparel stores
Virginia and George started a successful retail apparel business with one store in their hometown. Over the past thirty years, Virginia and George developed the business and established several additional locations. Virginia and George had operated the business as a sole proprietorship which provided pass through tax treatment of business profits but left them exposed to personal liability for the affairs of the business. Virginia and George have 5 children, 2 of whom, Carol and Sam, are actively engaged in the day-to-day operation of the business. Their business goals were to:
- Keep the business in the family, while recognizing that only Carol and Sam have the necessary experience to continue operations.
- Retain control of managerial decisions while slowly transitioning the ownership and equity of the business to their children.
- Protect the business from any personal liabilities their children may have.
- Shield their 3 children who are not actively engaged in the business from personal liability for the affairs of the partnership.
Virginia and George met with an attorney who suggested that the couple consider an FLP. The couple liked the advantages that the FLP offered in terms of tax treatment and control. In addition to the FLP, Virginia and George established an LLC to act as general partner to ensure that the partnership is not dissolved if both Virginia and George die.
By retaining ownership of the general partner LLC, Virginia and George were able to retain control over both the day-to-day and strategic management of their retail business during their lifetimes. By adopting an appropriate partnership agreement, Virginia and George were able to prevent the children from selling their ownership to non-family members. Here's how the process unfolded:
- After the FLP was established, Virginia and George obtained a professional appraisal of the business and the value of the limited partnership interest in the FLP.
- The appraiser provided a discounted valuation for the limited partnership interests because Virginia and George retained all managerial control as the general partners through their ownership of the company holding the general partnership interests.
- The appraiser also believed that a discounted value is appropriate based on the limited market available to transact ownership units if any child made the decision to sell their interest.
- Based on the discounted appraised fair market value, Virginia and George began to gift limited partnership interests to their children. They used less of their lifetime exclusion due to the discount.
When Virginia and George retire, they plan to transfer the shares of the company acting as general partner to Carol and Sam. Carol and Sam will maintain managerial control as the siblings with the most knowledge and expertise. Meanwhile, Carol and Sam's siblings will continue to enjoy the profits of the business while being shielded from liability should the FLP be unable to meet its financial obligations.
Family LLC planning example – commercial real estate
Andrea and Peter started a new business venture, managing commercial real estate, with their 3 adult married children. Andrea, Peter, and all 3 children have relevant professional experience and contributed capital to the new business. Since everyone contributed to the business, the family members agreed that managerial control should be shared. Here's how it happened:
- The family also agreed that they do not want to be in business with non-family members.
- On the advice of their attorney, the family adopted an operating agreement that restricts ownership and transfer of LLC membership units to family members.
- The family members then decided to enter into a buy-sell agreement that provides a mechanism for the company to purchase the ownership units of an owner who dies for a predetermined price.
- The family next consulted with the company's insurance agent to procure the appropriate level of insurance on each member to provide liquidity to fund the potential future purchase of their units.
After 5 years of operating the business, one of the children, William, died leaving a spouse and 2 children of his own. The terms of the buy-sell agreement allowed the LLC to purchase William's ownership units using the proceeds from the life insurance policy. This ensured that William's family received the benefit of his hard work and financial contributions to the company while managerial control remained with the family members that started the business.
Over the next 20 years, Andrea and Peter gifted a portion of their equity in the company to their 2 surviving children. After consulting with their attorney, Andrea and Peter decided on a conservative discounting strategy for the business interests transferred because, while the children have managerial control of the business, the market of available purchasers has been limited to immediate family by the operating agreement.
When Andrea and Peter decided to retire, their 2 children decided to purchase the small amount of equity they retained in the company. Due to changes in the scope of the business both in operations and geography, the children decided that it would be best to dissolve the LLC and start 2 separate companies that better reflect the activities of the business. Since the surviving children shared managerial control, they unanimously voted to dissolve the company and distributed the assets of the business to themselves as the remaining members.
Family limited partnerships and limited liability companies each provide different benefits for individuals planning for a family business, and these are only 2 possible structures that should be considered. The selection of the right entity can be complex. Working with a professional team including an estate planning attorney and tax advisor is key when a family is deciding what form their business will take initially, and later on, particularly when engaging in more advanced strategies such as discounting.