One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. In many cases, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.

A family limited partnership, or FLP, can help owners gradually transfer ownership while still retaining control. An FLP can also provide protection from creditors.

Creating the FLP

As the name suggests, an FLP is a limited partnership in which most or all partners belong to a single family group. Creating an FLP generally involves several steps. At the outset, the family business owner transfers his or her ownership interests to a partnership in exchange for both general and limited partnership interests.

The owner retains the general partnership interest, which may amount to as little as 1% of the assets. However, as the general partner, the owner can still run day-to-day operations and make business decisions. In other words, the owner can control the FLP assets, even though he or she owns just a tiny sliver of them.

Moving Interests to the FLP

Once the FLP is established, the owner can transfer some or all of the limited partnership interests to his or her children or other family members, either by gift or by sale. These transfers can occur all at once or over a period of time. As they occur, the value of the FLP interests is removed from the owner’s estate for federal estate tax purposes. What’s more, the business’s future income and asset appreciation moves to the next generation.

The children, as holders of limited partnership interests, have no control over the FLP, and thus no control over the business. The children also can’t sell their interests without the general partner’s consent or force the liquidation of the FLP.

Because the limited FLP interests are noncontrolling interests, they generally can be valued at a discount. A discount can also be applied to reflect the fact that no outside market for the FLP interests typically exists.

Because of the discounts, greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 30%, in 2012 you could gift an FLP interest equal to as much as $18,571 tax-free because the discounted value doesn’t exceed the $13,000 annual gift tax exclusion.

If you want to transfer interests in excess of the annual exclusion amount, you can apply your lifetime gift tax exemption.

There also may be income tax benefits. The income earned by the FLP will flow through to the partners for income tax purposes. In many cases, the children will be in a lower tax bracket, potentially lowering the amount of income tax paid overall by the family.

Protecting Assets

An added benefit of an FLP is that the FLP’s assets typically are protected from creditors, because they aren’t owned by the individual partners. However, a creditor may be able to receive future distributions made by the FLP. Yet even this benefit is limited, because the general partner can decide not to make any future distributions.

If the family owns several businesses — say, a small manufacturing company and an apartment building — each can be placed in a separate FLP, which protects each entity from exposure to lawsuits against the other entities.

Additional FLPs can be structured to provide even greater protection from creditors. For instance, an FLP’s assets can consist primarily of business equipment, which then can be rented to the family business. As a result, the business would have little income that creditors could reach.

In cases of divorce, if one limited partner no longer is a family member, the partnership agreement can stipulate that his or her interest return to the FLP. This helps keep the FLP within the family.

A Flexible Planning Tool

Because an FLP can be amended or liquidated before its term expires — though usually only with the consent of all partners — it also can offer more flexibility than other estate planning tools, such as an irrevocable trust. The FLP agreement also can provide a mechanism for resolving disputes.

An FLP can be an effective family-business succession and estate planning tool. But, an FLP isn’t without some downsides — see the sidebar listed below.  Your accounting advisor can help you determine whether an FLP should be part of your succession plan.

 Sidebar: Be Aware of Potential FLP Risks

Perhaps the biggest downside of FLPs is that the IRS commonly scrutinizes them. If the IRS determines that the discounts applied when the partnership interests were transferred were excessive or that the FLP had no valid business reason for existing other than to minimize taxes, it could trigger additional taxes, as well as interest and penalties.

The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.

Similarly, if a creditor can show that an FLP was established solely to evade a legitimate claim that existed before the FLP’s formation, the transfers to and from the FLP may be determined to be fraudulent, and the creditors could be given access to the assets. Again, check with your tax advisor to determine if an FLP is the right vehicle for you.