We all know the merits of Family Limited Partnerships (FLPs). In this post, we examine the family limited partnership vs LLC. There are pros and cons of each structure.
Choice of entity is one of the most crucial planning decisions when a client is considering a family-limited partnership. And yet, sound professional advice is often glossed over, usually not made at all, or made with inadequate information.
Our discussion will fall into two separate areas:
- Comparing the general legal and income tax differences among the different entities available.
- Focussing more specifically on how the differences between the partnership and the LLC can impact the desired estate and gift tax treatment, that is, how this choice can affect the valuation discount.
Table of contents
Partnerships, LLPs, and LLCs
These all generally share the same income tax characteristics. The biggest plus for these is the absence of the negatives that other entities have. In addition to having the most tax characteristics in common, they’re also very similar to each other with regard to practical consideration.
Generally, all must be registered with a state recording agency, although a general partnership often doesn’t need to be registered.
Exceptions to Common Characteristics
Anything you can accomplish with one you can achieve with another, with some particular exceptions:
- There may be state law restrictions on one of the entities.
- The partnership form, either the general or a limited partnership, still requires that someone have unlimited liability.
- Although it is possible to have all the general partners corporations or LLCs, there’s no need to have this second entity when only one is needed for protection from liability.
- The liability issue is, of course, not necessary if the only asset in the entity is marketable securities.
Factors Favoring the LLC
Whether a partnership (or a limited liability partnership) is superior to an LLC for purposes of FLP planning depends on a few items.
Some advisors favor the limited partnership over the LLC because it has more history. The laws have been around longer. There are more judicial decisions related to them, and there’s overall more certainty as to the legal consequences of a limited partnership than an LLC.
Unfortunately, this sounds a little like “it’s the way we’ve always done it” and often warrants more scrutiny than it’s being given. For instance, the LLC provides all the owners with limited liability without setting up the second tier of entities.
Overview of Family Limited Partnerships and Related Concepts
This affects entities with operating businesses, with less of an effect on entities holding solely marketable securities. An individual may lose the limited liability afforded to limited partners if he materially participates in the limited partnership. This restriction on material participation may, in turn, make the limited partner unable to take some passive losses.
This affects FLP arrangements involving children old enough to participate in the management and some FLPs with passive losses from managed real estate.
Factors Favoring the Limited Partnership
For purposes of self-employment tax, limited partner distributions are not self-employment income. This means that if a person is a 1% general partner and 50% limited partner, the portion of their distributions allocable to the limited partner interest won’t be subject to the tax. There is no analog to this with the LLC, and it may be modified by regulations currently on hold.
This primarily affects entities with service income but has a more negligible effect on passive investments. A general partner of a limited partnership has more absolute power than the managing member of an LLC.
This affects donors who are adamant about retaining control over the entity by retaining general partner shares. As you can see, it’s not a matter of one vehicle being better than another. Instead, it’s a matter of determining an individual client’s needs and choosing the entity that most closely conforms with those needs.
Impact of State Law
It is a “truism” that state law determines rights, and federal tax law taxes according to rights. Accordingly, the federal tax law could have a different impact on the identical facts in two different states since the states’ laws might be different.
In the context of family-limited partnerships, correct planning relies heavily on your understanding of what state law says about partners’ rights in partnerships and members of LLCs. At a minimum, you should be familiar with the laws of your state.
Suppose you don’t have access to your state’s statutes regarding limited partnerships, limited liability companies, and limited liability partnerships, along with some way to get updated information. In that case, you are limited in your ability to advise clients on FLP planning. It is also helpful to have information on nearby states that may be more tax-favorable to partnerships, LLCs, or both.
Think back to the elements of control that were important when determining that a lack of control discount might be appropriate. What does your state law have to say about these? Most important are the default laws related to liquidation. That is, in the absence of an agreement, how difficult would it be for a partner or member to liquidate their interest or the entity?
Simply stated, the easier it is for the entity to dissolve, and the easier it is for a partner or member to cash out his interest, the smaller the valuation discount will be.
In many states, it’s harder for a partner to liquidate a partnership than for a member to liquidate an LLC, but this is not universally so. In Connecticut, for instance, an LLC member doesn’t have the power to liquidate, but a partner does.
In that case, the LLC will generally be superior to the limited partnership for FLP purposes; elsewhere, the result might be different.
Family Limited Partnership vs LLC
As you can see, examining the family limited partnership vs llc can be tricky. Make sure that you discuss the issue with your CPA and estate attorney to make the best option in your situation.