By Dr. James M. Dahle, WCI Founder
The vast majority of good information out there about FLPs is written by those who are paid to create them (asset protection and estate planning attorneys) so as you might imagine it tends to focus on the upsides, without focusing on the downsides. Like with anything that is generally sold, not bought, there are significant downsides to consider prior to purchase. First, let's talk about how a family limited partnership works, and why someone might want to use one.
What Is a Family Limited Partnership?
A Family Limited Partnership (FLP) is a business structure with some estate planning and asset protection benefits. Note that the FLP must have a real business purpose; it will be disregarded if the IRS or the state finds it was formed just to avoid taxes. Any partnership can have up to two types of partners: general partners and limited partners. A general partner has both control of and financial responsibility for the actions of the business. A limited partner has neither control nor financial responsibility. Both types of partners have their pluses and minuses. For example, a limited partner cannot lose more money than they have invested in the partnership. However, a general partner is personally responsible for all of the liabilities of the partnership.
In a FLP, all of the members of the partnership are related. Otherwise, it functions just like any other limited partnership, with one or more general partners and one or more limited partners. In a typical family limited partnership, members of the senior generation are the general partners and members of the younger generation(s) are the limited partners. This allows the older folks to have control of the business until they die, while also providing a convenient and tax-efficient way to pass the assets of the business on to the next generation(s).
Family Limited Partnership Asset Protection Benefits
The main reason physicians buy (are sold) FLPs is as an asset protection device. Of course, the best asset protection isn't asset protection, so you have to have a non-asset protection reason to establish one. With FLPs, those reasons are usually estate planning and tax minimization. Of course, you have to have the FLP established and funded long before getting sued in order to avoid being nailed for a fraudulent transfer.
But if you do have an FLP in place, this is how it works. Let's say you are successfully sued and the judgment is above your malpractice limits. At that point, it is theoretically possible (even if exceedingly rare) that the creditor will come after your personal assets. However, if you don't actually own any assets (because the FLP does) then they can't take them. That makes the creditor (and his attorney) much more likely to accept a settlement for policy limits or less.
A non-malpractice suit runs into the same issue. For example, if someone slips on your rental property, they wouldn't be able to collect from you personally since the rental property is owned by the FLP. So the most they could get would be the equity in the property (minus sales costs). And if they decided to name you anyway, you wouldn't actually own anything, since everything else you “own” (that isn't protected by your state, like retirement accounts or cash value life insurance) is actually owned by other FLPs.
How Does a Charging Order Impact Your FLP?
In most states, however, the creditor could place a charging order on an FLP. That means that when the FLP makes distributions, the creditor can take your share of them. Of course, as the general partner in the FLP, you get to decide when to make distributions, and you could just decide NEVER to do so. The other really fun thing about charging orders, is the phantom income issue. When the FLP makes money, taxes must be paid on it, whether that money is distributed or not. And if a creditor has a charging order entitling him to a share of the income, he gets to pay a share of the taxes, whether he gets the income or not. So you could REALLY stick it to the creditor by making him pay taxes despite never collecting anything. Kind of fun, huh? This is all supposed to make it easier to settle any suits against you and discourage plaintiffs' attorneys from proceeding.
Using a Family Limited Partnership for Estate Planning
Even if the main reason you're really implementing an FLP is for asset protection, you don't tell the court that. You tell them it is for estate planning. So how is an FLP useful for estate planning? Well, like a revocable trust any assets inside the FLP pass to your heirs (the limited partners) without passing through probate. There is also an opportunity to reduce potential estate taxes (which most doctors' estates will never have to pay anyway given the relatively high exemptions, at least on federal estate taxes).
The first principle is the gifting of shares. You give limited partnership shares away to your heirs. Since you and your spouse can give $16,000 each to each heir without any gift/estate tax implications, this is a great way to reduce the size of your estate, hopefully all the way down to below the exemption level (in 2022 $12.06 million [$24.12 million married] and indexed to inflation). So every year you give a few more shares away, reducing the estate and thus the estate tax due on that estate. There are basically two principles to saving estate taxes with an FLP.
However, you don't need an FLP to give stuff away. You could just give them cash and do the same thing. The reason the FLP is helpful is the second principle, the discounting of the shares. Since your heirs have no controlling interest in the asset, and have to deal with serious liquidity issues (there's no ready market for FLP shares), it isn't worth as much as cash on the barrelhead. You may be able to discount these shares as much as 50%. So you can really give twice as much without digging into the estate tax exemption.
Tax Minimization Benefits of a Family Limited Partnership
Aside from the reduction of possible estate taxes, there is also the possibility of reducing your tax burden now using an FLP. You do this by shifting income from you to someone in a lower tax bracket, i.e. your kids. So if you own a quarter of an FLP, and your three kids each own a quarter, then 3/4 of that income isn't taxable to you. If your kids are in their 20s or 30s and working, they might be in the 15%-25% bracket. If you're in the 28%-39.6% bracket, there is some real savings there. If your kids are minors, of course, you run into kiddie tax issues for investment income. That means in 2022 the first $1,150 is exempt from tax, the next $1,150 is taxed at the child's tax rate, and beyond that, it's all taxed at your rate.
The FLP, like any business, could also hire your family members to work for it. That salary, of course, is not subject to your tax brackets, but you'll probably have to pay their payroll taxes on it. The family members could, however, take that earned income and put it into retirement accounts.
Family Limited Partnership Disadvantages, What Your Attorney Might Not Tell You
So now that you know the benefits of an FLP, you're ready to run out and get one, right? Not so fast. It is important that you understand the significant downsides first.
The first disadvantage if an FLP is that attorneys don't work for free. It isn't free to set-up an FLP, maintain it, or fund it. It will likely cost you thousands of dollars to do so.
The second downside is that you will probably never need the asset protection benefits. Although I suppose you could think of it as an “insurance cost” you're probably throwing away both the money and the time spent on doing this. You still need to purchase malpractice and umbrella insurance. And it is still exceedingly unlikely that you will end up having a judgment exceeding your limits. And it isn't as if there aren't other ways to protect assets—like retirement accounts, cheaper LLCs, and properly titling your home. Besides, your biggest asset protection risk is your spouse, not your patients or tenants.
The third downside is that you probably won't have to pay estate taxes anyway. If you and your spouse are planning to retire on $2M-$5M, chances of you dying with more than $24.12M, indexed to inflation, seems pretty unlikely. This stuff made a lot more sense for physicians when there was a $1 Million federal estate tax exemption. At $5M+, it just doesn't make much sense. That doesn't mean Congress can't change the rules, but it seems silly to establish an FLP just in case they do. Now, if you have a huge net worth, different story. But most docs don't and won't.
The fourth downside is that the tax minimization is probably pretty low. If you've got three kids you're planning on giving $2K a piece to to reduce your taxes, you'll owe $300 for them on that $6K. If you were in the 33% bracket and didn't do the FLP, you'd owe $2K. So there's a $1700 savings. It isn't nothing, but it certainly isn't on the order of maxing out a profit-sharing plan, that might save 10 times that much in taxes. And hiring your kids? So now instead of you paying taxes on 33%, they're paying taxes at 15%+15.3% payroll taxes. Is there savings there? Sure, but not that much.
For the right person, an FLP can have some huge benefits. For the typical doctor, the costs probably outweigh the benefits, especially if you have to establish multiple FLPs.
What do you think? Do you have or have you considered an FLP? Why or why not? Have you found it useful in an asset protection situation? Comment below!
[This updated post was ofiginally published in 2014.]
Hurrah! A very precise and complete summary of FLPs. It could not have been said better.
I initiated an FLP for my mother-in-law in the early 90’s. At the time, the threshold for estate taxes was $525K, if I remember correctly. She had already established a family trust since Dad was a raging alcoholic and to protect what was then a $1.5M estate, this effectively kept him out of the loop if she passed. We made the trust the General Partner with the five children limited partners. All assets not already in the trust were moved to the FLP.
As she got older, we (my wife) discovered indiscriminate co-mingling of cash, purchases, etc between herself as a real estate agent, as trustee of the trust itself, and as GP for the FLP.
She passed in 2006, but not before I encouraged her, in her capacity as trustee, to resign as the GP, and replace herself as the GP as herself. This way when she died, the five children individually and as successor trustees of the Trust, which waa now a limited partner, could decide what to do.
But since the estate tax issue was no longer relevant, and the five kids live in four different states, the presence of an FLP owning real estate and other assets simply became a pain in the ass. But had she died in 1996 with a $2M estate, it would have saved a lot of taxes. It has to be seen in context and the reasons for having an FLP today are severely limited. The discounting of FLP units is still valid, but the IRS is increasingly challenging this. If you have a large estate and attempt to discount asset values by more than 10 – 15%, you are likely to lose.
We have an LLC for office equipment for my husband’s practice. His practice is an S Corp. The kids are minority shareholders in the LLC. We use the proceeds from the rental income to pay for 529’s, college, family vacations, etc. Couldn’t you just add the kids to your LLC which you already have set up and get the same tax benefits as an FLP?
If you’re going to jack up the rent that the practice pays, you are either paying a low rent at the moment or you will be much higher than the current market. Which one is it? At the end of the day, your rent has to be a market rent. There is usually a range for the type of building, square footage, location, etc. If you’re in Kansas, you shouldn’t be paying a rent more applicable for Manhattan!
While the current $5,000,000 per-spouse exemption amount, indexed for inflation, is “permanent” (for ~15 years anyway), Congress is very fickle. Just a handful of years ago, that number was more like $1,000,000 per-spouse, and a few years before that, it was under a million dollars. Even if the exemption amount remains in place, most MD’s who are smart with their money could easily approach the exclusion amount by the time they die. A particular investment over ten or twenty years could surge in value, or even the appreciation of a family home over that time could cause a decedent to have an estate tax problem.
Strategies that involve the use of annual exclusion gifts hinge on year-after-year donations being made to total up to a significant amount. If the estate exclusion amount changes when grandma and grandpa are 75, the amount of annual exclusion gifts they can make at that point is severely diminished simply because they don’t have enough years left.
First, it’s not $5M. It’s $5.34M since it’s indexed to inflation. And it’s doubled if you’re married. At 3% inflation, by the time I hit my life expectancy in 45 years, that amount will be $20.2M ($40.4M). Sure, some doctors could have an issue, but it seems to me that most won’t if the law doesn’t change. It just seems unlikely to me that I’ll die with 4 or 5 (or ten) times the amount I retired with. I’m confident I’m better at spending and giving money away than that.
State exemption amounts may be lower, of course.
Second, remember that worst case scenario here is that you pay more estate taxes than you otherwise would. It’s not like anyone is eating Alpo in retirement or doesn’t get an inheritance if you screw this up.
If you want to do estate planning purely in case estate tax law changes, it’s a free country. Doesn’t seem very wise to me though for the majority of docs. (Your situation may be completely different, or course.) Let’s be realistic. What does it take to get a $10 Million portfolio in 30 years. Let’s just use real numbers for this. A 5% real return and we’ll leave the $10.7M number static. You need to be putting away $145K a year, just for retirement. The average physician salary is somewhere in the $200-250K range. Look around you. How many average physicians are putting away 60-75% of their gross income? I’m not saying there aren’t any docs who will have estate tax issues, but it certainly won’t be even a large minority of us, especially given our spending and investing habits. If you’re in that small minority, then you’ll need to pay more attention to this issue.
Correct, it is $5M indexed for inflation, or $5.34 per spouse in 2014. Already many consider $5M to be extravagant, and when it eventually becomes $10M it would not be surprising to see it revisited.
While an estate tax problem doesn’t cause any problems for the decedent (they’re dead), a 40% or 80% tax can devastate a family business, farm, property, etc. Also, many wealthy individuals are very upset when they think of the IRS taking 40% to 80% of what they earned, despite the fact that they’ll be dead.
I agree, looking at it simply from a salary, retirement saving and reasonable rate of return standpoint, there is probably no need for setting something up like a FLP for estate tax purposes, because there is no estate tax problem. However, when a physician (or anyone) has other rapidly appreciating investments such as medical patents, oil & gas interests, etc., these can quickly outpace the inflation on the estate exemption amount. I have served many physician clients who have found themselves facing such an estate tax problem.
I agree many doctors will have an estate tax problem. There’s a million of us. Even if just 5% of us have an estate tax problem that’s still 50,000 of us. There are plenty of clients there for you. But the majority? Seems unlikely.
I’m not so sure that a reasonable amount of docs won’t be hit by estate taxes, even at current levels. If you look at the Cooley Table, that is part of the Trinity study, you see that the median result for someone with a 75:25 portfolio, who has a withdrawal rate of 3% for 30 years is 12.7. That means that someone who retires with $5M in invested assets, who lives on $150K (inflation adjusted) will average having $63.5M after 30 years. That could snare some of us.
Bob Koenitzer DDS
Sure, and if you have a withdrawal rate of 1%, you’ll leave even more.
Again, spend some money, give some away as you go along. If your portfolio starts doing awesome, spend even more and give even more away. I mean, if you’re getting much above the exemption, well, do something about it. That doesn’t mean you have to do something about it just in case 30 years early.
Unfortunately, I live in a state where a charging order is not the *exclusive* remedy for a creditor of someone who owns an interest in an FLP or LLC – in my state, such a creditor can foreclose on an FLP/LLC membership interest. I remain very interested in methods of asset protection that do not involve insurance products or expensive legal products (that produce year over year drains on investment performance). My state does have a fairly robust domestic asset protection trust law – but I worry that this will be an expensive and inconvenient way to obtain peace of mind (and perhaps it would be false peace of mind). I have read Asset Protection for Physicians and High Risk Business Owners by Robert J. Mintz (2010) & Asset Protection by Jay Adkisson (2004). The question remains: how best to protect the taxable account?
The best way to protect it is to have it owned by someone else. 🙂 You can also keep it as small as possible by using other accounts whenever available, doing Roth conversions, using it for your charitable donations etc etc. But it’s very hard to protect a taxable account from creditors once a judgment against you has taken place.
Although people promoting asset protection plans often assert that the creditor holding a non-forecloseable charging order would be subject to tax liability on “phantom” income even if nothing is distributed, this is very likely NOT accurate under current interpretations of federal tax laws. The charging order merely results in the creditor having a lien on distributions that are payable – and being a lien-holder is not enough to cause him or her to be treated as a partner for tax purposes. In fact, instead of the creditor being “KO’d by the K-1” as these salesmen like to say, the current owner remains liable for tax on the entity’s earnings even if distributions aren’t made. The creditor often has much more leverage than many people assume. Here’s a link to an article written by a knowledgeable attorney practicing in this area.
http://www.forbes.com/sites/jayadkisson/2011/07/31/charging-orders-and-k-o-d-by-the-k-1-not/
Thanks for the link. Love Jay’s work. Issues with LLCs and LPs and charging orders are constantly changing and are state specific.
I can say that with both myself and my wife in highly litigious fields, it gives me great piece of mind to have the protection of an FLP even if the charging order protection potentially had some holes. It gives another layer of protection for malpractice and umbrella insurance while letting us still have control over the assets. The issue of how it helps with estate taxes shouldn’t be undervalued. Giving annual gifts to multiple heirs over several years can have its own complications on family relations over time. I mentioned the book: THE CYCLE OF THE GIFT in another post. The book describes these problems and suggests careful and perhaps more sophisticated planning than these annual exclusion gifts. Thanks for the discussion!