Entity Structure in Family Business Succession Planning
Business Entity Structure
In order for a family business succession plan to be successful, it must plan for the transfer of assets and authority to the future owners, while at the same time reducing the business’ estate tax liability. One effective way to accomplish all these things is to establish a business entity structure. While there are a great many kinds of entities a business can use to accomplish its goals, we will focus our discussion on family limited partnerships (FLPs) and limited liability companies (LLCs).
How do FLPs and LLCs work together?
An FLP structure manages and holds business assets for a family as a limited partnership interest. Then these interests and other assets are held by the FLP’s general partner, usually an LLC. In this instance, the LLC owns 1% general partner interest and is capitalized with liquid assets.
What is the role of the LLC as a general partner in the FLP?
The LLC managers (the family business owners) are in charge of the FLP’s daily operations, making all key decisions regarding the FLP’s business assets.
How are an FLP and LLC structured?
Family business owners contribute cash to the LLC, which in turn purchases 1% general partnership interest in the FLP. Family business owners would own equal shares of the LLC’s membership interest, entitling the owners to make key business decisions. The owners would also convey their business and its assets to the FLP and would own equal shares of the remaining 99% interest in the FLP. This entitles the owners to any cash distributions. Next generation leaders could then be made limited partners in the FLP, but not the LLC, which protects these heirs from liability.
What happens when the business is passed to the next generation?
With an FLP/LLC arrangement, the owners can gift or sell the business interests to the next generation, or the transfer will occur upon the death of the owners.
What are the transfer restrictions?
Owners should specify whether the transfer to the next generation gives the heirs the right to make business decisions on behalf of the family business or to merely benefit financially from the business. The owners can also specify only certain family members to whom they wish the business to be later sold, should the FLP partners wish to sell at a later time.
Additionally, when an FLP interest is transferred, it is transferred only as an assignee interest, rather than as a full partnership interest. The assignee can later be admitted as a limited partner under the terms of the FLP. This structure governs the course of the business while allowing the owners to gradually transition authority and assets to the next generation as they see fit.
How can an FLP/LLC structure reduce a family business’ tax burden?
The answer is only with very careful documentation and maintenance, at a minimum, of:
- Annual meetings and minutes
- Annual documentation recording all matters of business
- Annual election of officers and managers
- The entity’s registered agent for service of process
- Tax returns being filed and made available for review by limited partners
- Bank accounts used solely as business accounts
- Company and partnership names being filed with the secretary of state
With these measures in place, an FLP/LLC structure can create some tax benefits for a family business. First, an interest that is gifted to an heir has the same cost basis that it had to the giver at the time of transfer. This can also reduce the giver’s estate for tax purposes. The structure also divides business interests, creating valuation discounts.
How does an FLP/LLC structure protect the family business partners?
In this structure, the limited partners are not personally liable for the FLP’s expenses or obligations. Instead, the LLC is. This has the effect of separating ownership from personal liability.
How can an FLP/LLC structure work with other structures?
The entity can work in conjunction with a variety of trusts to help the owners hand down the family business gradually:
- For example, an intentionally defective grantor trust can dictate that the assets be held and moved down a generation. This allows the business to grow without the burden of estate tax or the generation skipping tax. The skipped generation, however, is gifted money from the trust, which they can use to purchase assignee FLP interests. This trust is owned by the grantor only for income tax purposes, but not estate tax purposes.
- Family business owners can use spendthrift trusts for each heir. These trusts are protected from creditors until distributions are made and grow free of estate tax at both the grantor’s death and the heir’s death. This trust also ensures the heir does not overspend the income from the family interest.
Why is an FLP a good choice?
An FLP can help streamline management issues by holding business assets or interests, thereby avoiding divided ownership interest.
In establishing an entity structure for your family business, you are advised to seek the professional assistance of your attorney and a certified public accountant who specializes in estate tax.
This article is for informational purposes only and is not a substitute for professional advice. Consult your tax advisor. Contributing Sources: Entrepreneurship.com, “BUSINESS SUCCESSION PLANNING: Death, Disability, and Gifting” by Ami D. Desai and Nicole Erickson, State Bar of Texas REPRESENTING SMALL BUSINESS 2009