What is FLP valuation (Family Limited Partnership Valuation): Understand the Tax implications of FLP

Family-owned businesses passed down from generation to generation need extra care in management. Why? Because they need convenient transactions and precise records. An FLP business acts as an ally here. This is a great financial structure for protecting money from outsiders and conveniently passing family assets to the next generation.

Now, how should we value the Family Limited Partnership?

It requires careful assessment of various factors, including family relationships and their assets. While well-established businesses can utilize income and cash flow as financial indicators to determine their worth, FLP valuation sometimes works with numerous asset portfolios, including:

• Stocks, 
• Enterprises and 
• Real Estate

All of these issues make determining the FLP value difficult. You should consult a competent valuer to know how much your business is worth. This article will help you learn more about FLP valuation, its benefits, and obstacles and give you a good picture of where you stand and what you should do next.

Family Limited Partnership Valuation (FLP Valuation)

Valuation experts often need help assessing ownership interests in Family Limited Partnerships that lack control and are not easily saleable in the market. This typically happens when valuing FLPs for estate and gift tax purposes.

FLP valuation often uses a discount rate when assessing which requires more control. Valuers can base these discounts on either the market method or the income approach. The reason for these discounts is the limitations they have, which can affect the overall value of an estate.

What is FLP or Family Limited Partnership?

An FLP is a nontaxable entity established and regulated by statute. Partners (both general and limited) and assignees primarily comprise family members. A limited partnership is founded under and managed by the state’s Revised Uniform Limited Partnership Act (RULPA). 

Many concerns raised in FLP appraisals are legal interpretations of the partnership agreement rather than “pure” valuation issues. Suppose the valuation analyst doubts the nature of the assignment or the conditions of the partnership agreement. In that case, the client’s attorney should clarify them to the valuation analyst, not vice versa.

In a family limited partnership, the parents or grandparents contribute and take general ownership of the assets. The other family members will usually have a limited partnership on the assets. While dissolving the FLP typically after the second parent dies, the children will divide the assets among themselves as partners.

Benefits of FLP valuation

The following are some benefits of a Family Limited partnership:

• Tax Benefits: the owner’s interest, which they gain over time, is easily transferable to other individuals without paying taxes. By doing this, the business owner can reduce their estate size, eventually decreasing the tax liability. Typically, family members want to transfer ownership interest to their children using an annual gift tax deduction. Currently, the fee is $15,000 per person. Therefore, investing in a family-limited partnership allows business owners to gradually pass the tax burden to their children while avoiding inheritance taxes.
• Valuation Discounts: One of the main benefits of FLPs is the flexibility to apply valuation discounts to limited partner interests. Valuers base these reductions on the idea that limited partners have limited rights and control.
• Control and Flexibility: The FLP business has increased control over its family assets. The partnership arrangement allows the family to maintain centralized control, with one or more general partners making decisions. Limited partners, generally family members, engage in the partnership but have little control, which can be an effective measure for protecting family wealth and reducing conflicts. Furthermore, because the partnership agreement is subject to revision, the firm maintains a certain level of independence for the general partners.
• Asset Protection: The family maintains control over the assets of a family limited partnership because they consider them partnership property. As a result, any outside investors who wish to become engaged in the business will be unable to do so. If a limited partner quits the family, such as by divorce, they must return the shares to the firm. This ensures that the business remains under family ownership and management.
• Estate Planning: Family limited partnerships  have become increasingly popular as an estate planning tool for lowering transfer tax values. Typically, a tax practitioner will consult with a valuation expert to assess the tax worth of FLP interests. The valuation expert also creates a report that outlines the valuation approach utilized in the analysis, the reason for choosing the method, and the calculation behind the valuation results.

How to do FLP valuation?

There are three approaches to calculating FLP valuation. They are:

Income Approach:

Determine the available cash flow to partners and adjust the income approach of FLP valuation by capitalizing or discounting as needed. The valuer could look at the asset sales price as a starting point for the terminal value calculation.

There will also be a reduction in value discount due to a lack of marketability (DLOM). The minority owner’s access to the capitalized or discounted cash flow determines their minority value; hence, there is no need to discount due to a lack of control.

Example for FLP Valuations Income approach:

Suppose a Family Limited Partnership owns a portfolio of rental properties generating rental income. For simplicity, let’s consider one rental property owned by the FLP.

• The FLP owns a rental property, which generates an annual net rental income of $100,000.
• Let’s assume a capitalization rate of 8%.

Valuation:

• Determine the Net Operating Income (NOI) of the property.
  • NOI = Annual Rental Income – Operating Expenses
  • Assuming operating expenses are $30,000 annually, NOI = $100,000 – $30,000 = $70,000.
• Apply the Capitalization Rate to the Net Operating Income.
  • Value = NOI / Cap Rate
  • Value = $70,000 / 0.08 = $875,000

So, using the Income Approach, the estimated value of the rental property within the Family Limited Partnership is $875,000.

Asset Approach

A typical way to determine the value of FLP ownership is using the asset-based approach, including the asset accumulation technique. As part of this process, the valuer revises the book values of assets and liabilities to reflect their current market worth. The valuer will deduct the asset’s fair market value from the liability’s FMV to get the value.

Taking an asset-based approach implies being able to control and sell your ownership stake. So, it assumes that the owner may realize the asset’s full value when sold.

Example for FLP Valuations Asset approach:

A Family Limited Partnership holds real estate assets. Consider a single commercial property, such as an office building valued at $1,000,000, owned by the FLP.

Discounts Applied:

• Lack of Marketability Discount: 20%
• Lack of Control Discount: 15%

Valuation:

• Determine the fair market value of the property without considering any discounts.
  • Fair Market Value (FMV) = $1,000,000
• Apply discounts:
  • Lack of Marketability Discount: $1,000,000 * 20% = $200,000
  • Lack of Control Discount: $800,000 (FMV after Lack of Marketability Discount) * 15% = $120,000
• Calculate the Adjusted Net Asset Value (ANAV):
  • ANAV = FMV – Total Discount
  • ANAV = $1,000,000 – ($200,000 + $120,000) = $680,000

So, the Adjusted Net Asset Value (ANAV) of the commercial property within the Family Limited Partnership, after applying discounts for lack of marketability and control, is $680,000. 

Market Approach

Looking for similar publicly listed interests might help you figure out valuation multiples. One way to determine the right multiple is to look at the net asset value (NAV) after weighing the risks of the particular valuation assignment. The result is a minority value since these facts depend on transactions involving minority interests. 

Example for FLP Valuations Market approach:

The Market Approach for FLP valuation can be trickier than Asset or Income approaches because finding directly comparable FLPs is rare. 

Find similar FLPs that recently sold:

• FLP 1: Owned office buildings, sold for $1,200,000 with a total Net Asset Value (NAV) of $1,000,000. (Price-to-NAV Ratio = 1.2)
• FLP 2: Owned rental properties, sold for $800,000 with a NAV of $600,000. (Price-to-NAV Ratio = 1.33)
• FLP 3: Owned a mix of assets, sold for $750,000 with a NAV of $500,000. (Price-to-NAV Ratio = 1.5)

FLP: FLP has a total NAV of $900,000.

Market Approach Estimation:

• Calculate Average Price-to-NAV Ratio:
• Average Ratio = (1.2 + 1.33 + 1.5) / 3
• Average Ratio = 1.34

Apply Average Ratio to Your FLP’s NAV:

• Estimated Market Value = NAV x Average Ratio
• Estimated Market Value = $900,000 x 1.34
• Estimated Market Value = $1,206,000

Tax implications of FLP

Family-limited partnerships have tax consequences based on structure, purpose, & Activities. The following are some of the key tax implications;

• Income Tax: The Family Limited Partnership can transfer funds from parents with income tax rates as high as 35% to children with income tax rates as low as 15% or 25%. A proportional amount of the partnership’s earnings is taxable at the limited partners’ rate. If the child is under 19, the parent’s rate taxes the income from the gifted limited partnership stake.
• Gift and Estate Tax: Because limited partners do not participate in management, they cannot force partnership distributions or liquidation to gain partnership assets. Their ability to sell their interests is often limited; parents may severely reduce the value of limited partnership interests gifted to their children. These include reductions for low marketability and minority interest. These savings can be highly significant, ranging from 30% to 60%, depending on how the FLP is designed and structured. These discounts enable parents to benefit from annual gift tax exclusions, unified credits, and generation-skipping tax advantages.
• State Tax Consideration: The tax status will differ by state. Some may charge high Family limited partnership taxes or have differing income, estate, and gift tax laws.
• IRS scrutiny: The Internal Revenue Service (IRS) will thoroughly evaluate, particularly for gift and estate tax savings. 

Risks and Challenges in FLP Valuation

Although the FLP valuation has many advantages, it has some dangers and limitations. They are:

• IRS Scrutiny: The IRS closely evaluates FLP valuations to ensure they are not used to undervalue assets for tax purposes. If they suspect undervaluation or improper valuation methods, they may have audits, penalties, and legal action if necessary.
• Valuation Discounts: A major advantage of having a Family limited partnership valuation is the ability to apply valuation discounts for lack of control and marketability when transferring assets to family members. However, determining the correct discount level can be subjective and is often inspected by the IRS. If the discounts are applied more than the actual, it may lead to potential challenges from the IRS.  
• Complexity in Valuation: FLP valuation involves assessing several factors, including:
  • The underlying assets
  • The partnership agreement
  • Market conditions and
  • Any specific situation of the partners.

Considering all these factors, arriving at a precise valuation acceptable to all stakeholders can be complicated.

• Legal Interpretations: Because family-limited partnership valuation differs from other types of firms, performing an FLP valuation can be difficult. Legal interpretations of partnership agreements, state laws, and regulations can further complicate FLP valuations.

Different jurisdictions can have varying laws and regulations for FLP valuations, and legal nuances can impact the valuation process.

Make your Valuation Services Easy with Eqvista!

An FLP valuation, or a valuation in general, helps the owners in several ways. They can know their company’s worth and take action in areas of improvement. A business valuation helps determine the fair market value of the business.

At Eqvista, we help to get your business valuation done on time and ensure accuracy. We also provide cap table management services through which you can create and maintain records regarding the company’s ownership and what all others hold in the company. 

Are you looking for a professional valuer to do your business valuation? We have an expert team who can help you precisely accomplish all your business valuation needs. Want to know more? Contact us today!