As Seen in Headnotes: Why You Should Consult a Family Lawyer When Forming an FLP

Family limited partnerships (FLPs) and trusts can be the workhorses of high-net-worth estate planning. Used well, they move wealth to the next generation at a discount, keep the family business in the family, and shield assets from creditors. They can be brilliant. And when the couple who created them decides to divorce, that same brilliance can turn into a very expensive puzzle.

The reason is simple. These vehicles are designed to lock assets down, restrict who can touch them, and depress their reported value. Every one of those features is a gift at the estate tax audit. Every one of them becomes an obstacle when a court is trying to divide property fairly. The estate planner and the corporate lawyer are thinking about the IRS. The family lawyer is thinking about the day the marriage ends. Both belong in the room when the structure is built, not just when it needs to be unraveled.

Here is what happens when a divorce meets an FLP.

Partnership property is not divisible. Once assets are contributed to a partnership, they belong to the partnership, not to the partners. A divorce court cannot reach into the entity and hand specific assets to the non-partner spouse, and, unlike a corporation, a partnership generally cannot be “pierced.” What the court can characterize and divide is the partnership interest itself—the right to profits and distributions—not the ranch, the building, or the brokerage account inside it. A spouse can end up “awarded” an illiquid minority interest in an entity the other spouse controls.

Contributions can quietly change character. An interest acquired before marriage, or by gift or inheritance, is separate property. An interest acquired during the marriage is presumptively community unless it can be traced. The trap is in the funding. Separate property poured into a partnership can inadvertently become property of a community property FLP, and distributions of partnership profits are presumed to be community even when the underlying interest is separate. Mineral interests are especially treacherous because separate-property royalties and bonus payments that flow through the partnership and back out as distributions can come out the other side as community property.

Valuation cuts both ways. The lack-of-control and lack-of-marketability discounts that make gifting so efficient become a battleground in divorce. The non-owning spouse, watching those discounts shrink their share, has every incentive to fight them, and the dispute usually requires dueling appraisals. Which can be an expensive battle.

Control is its own fight. The one percent general partner or managing LLC interest holds the power. Under Texas law, a membership interest may be community property, but the right to manage is not. The result is that the spouse named as manager keeps running the show, while the other spouse is left with an assignee’s interest, meaning he or she is entitled to distributions, but is shut out of governance. Whoever holds the controls holds the leverage.

Trusts raise parallel problems. Whether trust assets are reachable often turns on whether the beneficiary spouse has a present possessory interest or merely an expectancy; undistributed income of a properly run trust generally stays separate. Once a partnership interest is owned by a trust, it is no longer community property, and control passes to the trustee, who is often one spouse rather than the other. Creative solutions do exist, such as a buyout, staged liquidating distributions, a built-in swap power, or decanting, but they usually work without a headache only if someone thought about divorce when the trust was drafted.

Unwinding is not free. Dissolving an FLP to simplify a divorce can trigger real tax consequences and can forfeit the valuation discounts the family worked years to establish. Further, interests that were partitioned into each spouse’s separate property, or gifted away to children, may be entirely beyond the court’s power to divide.

This is not intended as an argument against family limited partnerships or trusts; rather, it is an argument for building them with all the right advisors at the table. A family lawyer consulted at formation can flag the characterization traps, the control issues, and liquidity problems while the plan is still moldable and relatively inexpensive to revise through thoughtful drafting with an eye on a potential divorce. The alternative is discovering them in the middle of a divorce.