Family-owned businesses are a pillar of American culture and enterprise. They produce billions of dollars in goods and provide many services in all industries and sectors. 

For business purposes, they take different structures, depending on the needs and goals of their operations. Two popular structures, or entities, are the Family Limited Liability Company (FLLC) and the Family Limited Partnership (FLP). Both designations offer extensive personal liability protections while allowing families to protect family assets across generations—but they also require owners to sometimes proceed with caution. 

Ten mistakes that owners of family limited partnerships and limited liability companies should avoid

Because of these—among other advantages—the entities are becoming increasingly popular as an option for preserving family wealth. However, if you want to use this business structure to grow a family business, here are some common mistakes to avoid. 

1. Neglecting formalities

FLPs and FLLCs are not “set it and forget it” entities. Owners must go through certain business formalities, such as conducting regular meetings, documenting all transactions, and maintaining separate bank accounts. Failure to do so can lead to negative consequences, such as the partnership being disregarded and significant tax and personal liabilities. 

For instance, if you fail to maintain separate bank accounts, a court may determine that the liability protections typically provided by LLCs do not apply in your case. If this occurs, you could be personally liable in a lawsuit against your FLLC or FLP.  

A business lawyer can help you understand the rules and laws that guide these entities and avoid problems.

2. Inappropriate asset transfer

As a member of an FLLC, you must be careful with improper asset transfers, such as primary residences, to your FLLC or FLP. For example, it would likely be considered improper for a senior family member to transfer their primary residence to the FLLC and continue living there without paying fair-market rent. 

3. Overuse of discounts

Many financial planners believe you should take advantage of valuation discounts when transferring property. Whether or not this is true, you should always beware of overdoing it. Overusing discounts can bring regulatory scrutiny, resulting in unfavorable consequences, such as fines and disregard of status.  

For example, consider a senior family member who wants to transfer $250,000 of assets to one of their children. If they then claim that the asset is worth only $125,000 (a 50% discount), the IRS would likely take action. To avoid this, the senior family member may want to reduce the discount significantly.

4. Retaining personal control

Often, senior family members transfer assets to the FLLC or FLP but retain too much control over them. When this occurs, the IRS may consider the assets taxable as part of these senior family members’ estates. 

5. Ignoring proportional distributions

The FLLC or FLP must make distributions according to each member’s ownership proportion. Failure to do so may cause issues with the IRS. 

For example, a family member who owns 10% of the FLLC should only receive 10% of the distribution. When reviewing tax documents, the IRS considers improper distributions worthy of scrutiny. 

6. Inadequate capitalization

Your FLLC or FLP must have sufficient capital in the coffers to accomplish its business objectives and goals and cover its financial obligations. Without adequate capital, the IRS or a court may disregard your company for estate tax purposes.

An example of inadequate capitalization would be an FLLC that goes bankrupt after the owners invest $250,000 as startup capital. An analysis of the business indicates that proper capitalization should have been at least $750,000. Hence, the FLLC lacked at least $500,000 in capital when it opened for business.

7. Lack of business purpose

Your FLLC must have an explicit and legitimate business purpose. Without one, the courts, the IRS, and other agencies will consider your status as an FLLC or FLP illegitimate. For example, distributing family wealth is not a legitimate business purpose according to FLLC and FLP eligibility requirements. 

8. Funding personal expenses from a partnership account

FLP and FLLC funds should be in separate accounts from your personal bank accounts and those of your family. And these funds should never be used to pay for owners’ personal expenditures and expenses. 

Owners, for instance, cannot use the partnership or company account to pay for vacations, personal property, personal bills, and anything else unrelated to the business. This activity may lead to taxation and business problems if noticed by the IRS. 

9. Late formation

If you delay forming an FLP or FLLC, you and your family may be unable to benefit from the tax advantages associated with doing so. Waiting until a family member is sick or dying exposes you to the risk of scrutiny by the IRS, which could view the transfers as simply a way of avoiding estate taxes. 

For example, suppose an older family member enters hospice care and then decides to form an FLLC or FLP. In that case, the IRS might investigate whether the move was an attempt to avoid taxation when the individual dies. 

10. Poor record keeping

There are many problems inherent in poor record keeping. For one, it can lead to the mishandling and even misappropriation of FLLC assets. Poor record keeping also causes problems with the IRS and other agencies.

An FLLC or FLP with poor record keeping might find it challenging or impossible to produce essential documentation, including records of each partner’s contribution to the business or profit and loss statements.

Let our team help you protect your FLP or FLLC

Mistakes regarding FLPs and FLLCs are common, and many can lead to significant problems, including overwhelming tax and personal liabilities.

Any family business interested in exploring FLLC and FLP entities should contact an experienced business and estate planning attorney for an affordable consultation. The team at Shann M. Chaudhry, Esq., can help you navigate the process of establishing and managing your FLP or FLLC. 

If you’re ready to get started, contact us today.