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The Family Limited Partnership
Although it's been around, and used for the purposes discussed, for a
long time, this technique is getting increased attention. It's a way to
reduce gift and estate taxes while maintaining overall control, and to
protect your assets from the claims of creditors as well.
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Basics of Limited Partnerships
The Discount Partnership
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Asset Protection
Conclusion
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Basics of Limited Partnerships
In a usual partnership, all partners are general partners.
Each is responsible for the debts of the business -- totally. One
person, who may have a 1% stake in the business, could be sued by
creditors if the business went bust. They could recover all the
debts from him personally. He'd have a right of contribution from
his partners -- but if they couldn't be found, or were themselves
bankrupt -- tooooooooo bad. Furthermore, from an outsider's
standpoint, every partner has apparent authority to enter into
contracts and bind the partnership. This can make the key partner
-- the manager -- nervous.
Enter the limited partnership. Like the corporation, it is a
creature of statute because it's an exception to the general
rule, and the rules must be complied with. If it's done right --
X can put in $10,000 -- and be limited in his loss. If the
business goes bad, he may lose everything he's put in -- he may
even lose more if he's voluntarily signed notes, etc. -- but he
knows the extent of his risk. He cannot lose more than he's
agreed to put in. The rest of his assets are safe.
In exchange for this safety, he's given up the right to have any
say in the business, and the right to apparently represent the
business. He is strictly an investor. The actual running of the
business is done by one or more general partners. They are the
ones responsible for business debts. For them, the normal
partnership rules apply. It has served as a way to raise money
for their activities (running a grocery, operating real estate,
having a stock portfolio, etc.) while retaining control.
The partnership agreement will spell out the respective rights of
the parties, including their respective interests in profits and
in liquidation. It may say that the limited partners put in 99%
of the money and get 95% of the profits, and 98% of the proceeds
on liquidation. It usually restricts the ability to transfer
interests.
The partnership may show a profit -- but that doesn't put money
in the partners' pockets. The general partner can usually decide
how much to distribute, or how much to hold back for the needs of
the business.
From a tax standpoint, the partnership is a conduit. Each partner
is taxed on his share of the income, whether or not he received
it.
A family limited partnership has no special legal nature. It is
simply a partnership whose members happen to be family members.
It is governed by the same rules as other limited partnerships.
In the past, it might have been used to give kids a stake in the
farm, or in investments, without letting them interfere in the
management.
With that background, let's look at two uses that have gotten
current popularity.
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The Discount Partnership
John comes to you with a great offer. A limited partnership has
been formed. His cousin Harry is the general partner. Several
family members have put in contributions. The partnership has
$1,000,000 of cash. Not land. Not stock. Not even bank accounts.
$1,000,000 of green paper. John has a 5% partnership interest.
But he got carried away when he put in so much -- he really needs
the money for other needs. Would you buy a 1% interest for
$10,000? You think about it -- a 1% interest in $1,000,000 of
cash. That's certainly worth $10,000.
But you discuss it with your lawyer who points out:
You have no way of getting at that cash unless the partnership is
dissolved, and you can't force a dissolution. That cash might be
invested in Arizona swampland next week -- you have no say over
what is going to happen.
Even if it's invested in a good operation and makes money -- you
may not see the profit if the general partner decides to hold on
to it. But you'll be taxed on it.
If you want to re-sell your interest, the partnership agreement
restricts your right to transfer or sell to outsiders.
Does it still look like such a reasonable deal? Are you still
interested in paying $10,000 for that 1% interest in $1,000,000
cash? Or, if you're interested at all, would you offer a lot less
to reflect the risks and problems?
This, simply put, is the heart of the interest in limited
partnerships -- that no willing buyer would in fact pay a
percentage of the underlying value without getting a sharp
discount. And so if John dies owning that partnership interest,
or makes a gift of it, its value for tax purposes would be
sharply reduced. A good estimate would be 20-50% discount from
underlying asset value. And this discount is not a trick -- it's
for real problems. John's asset is simply worth less than it
appears.
Of course, one might say that it's illusory because he's not
really at the risk of the general partner. Suppose John himself
were the general partner? The problem really wouldn't exist. And
no discount would be allowed -- in his estate. But if he gave
some away -- the recipient of the gift doesn't have that control,
so a discount would be available for gift tax purposes on that
interest. Suppose the partners were John and his wife? Already,
the degree of control is slipping. And while family members may
feel absolute trust in each other and not worry about the risks
-- the buyer of that interest isn't a family member and can't
count on the love of the general partner.
Okay, how do we use it?
You form a limited partnership to own most of your investment
assets. With many variations, the General Partners can be you and
your living trust, or you and your spouse, both, etc. The general
partners may own perhaps a 2% interest in the partnership. 1% is
owned by an unrelated trusted outsider (who has the power to
prevent liquidation -- therefore you and your family cannot
liquidate and remove the restrictions). The balance is owned by
you (or you and spouse, etc.) as limited partners.
Now, if you give away those limited partnership interests, they
are valued at a discount.
For estate tax purposes, you should have at least one other
General Partner (e.g. your spouse) to make a case for a discount
on your limited partnership interests.
In recent years, Congress has taken at least one step against
this. 2704(b)(2) of the Internal Revenue Code now provides that,
in valuing interests, I. R. S. may disregard restrictions on
liquidation which may be removed by the family. And so it is
desirable to have a non-family member whose consent is required
for dissolving the partnership. Furthermore, some recent
proposals would change these rules.
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Asset Protection
Suppose, before John is able to sell his limited partnership
interest, a creditor sues him, gets a judgment and starts to
collect. He levies on John's bank account and gets that turned
over to him. He levies on John's stock, gets that turned over to
him, and sells it to raise cash. He levies on John's limited
partnership interest -- and that's when problems start. Even if
he could get the partnership interest turned over to him, he'd
have a heck of a time selling it for cash (see above). But he
can't even get that far. Under the terms of the Uniform Limited
Partnership Act, the only remedy of a creditor of a limited
partner is a charging order. This is a right to receive
distributions if, as, and when the general partner makes them.
The creditor may not see any distributions. Neither might John if
the creditor hadn't acted. But John would have been taxable on
his share of partnership profits, even if he didn't receive them.
Once the creditor gets his charging order, he stands in John's
shoes tax-wise. He may receive taxable income without
distributions.
Now suppose the same thing happens to Harry, the general partner.
The creditor doesn't focus on the limited partnership interest --
he focuses on the general partnership interest. By getting that,
he creates possible distributions. And so the bulk of the
documentation is designed to protect from levy on the general
partnership interest. We use a corporate general partner to bring
in more dilution. We spread the stock around. We have a buy-sell
agreement that's triggered by creditor action. And even if the
creditor were somehow to get ownership of the stock -- he'd find
that there's a shareholder voting agreement requiring him to vote
for you and your spouse as directors, to elect one of you as
president. In control of the corporation, you can get some money
out as payment to the corporation for management, then out to you
as salary (subject to 15%wage deduction, which isn't as bad as
asset levying).
The key is to understand that this is a tool, not a cure-all. It
depends on your not needing the money in the partnership, so you
can outwait the creditor. I talked one lottery winner out of such
a partnership -- he needed the distributions. It wouldn't provide
much protection. But as long as they are assets which are there
for security -- which you don't personally need in the near
future -- you can afford to not distribute. And therefore the
creditor ultimately says "can we talk?" and is open to
settlement.
Weaknesses? To some people, it's just a "gimmick" which may get
changed. But it's not that unusual. Realize there are some states
with unlimited homestead exemptions -- people have been known to
pour their assets into a million dollar house just before
declaring bankruptcy. The "gimmick" works. Similarly, homes may
be in tenancy by the entirety which are protected from levy of
the creditor of one spouse.
There is a potential attack. The Fraudulent Conveyances Act
enables the undoing of transfers designed to hinder creditors.
While I'd be willing to defend on that if necessary (this isn't a
transfer, it's a change of investment), you're far better off to
avoid it. And the best way to avoid it is to have a balance sheet
which shows that when you did it, you were fully solvent and had
no outstanding claims.
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Conclusion
Conclusion
Both of these uses (discounts for estate tax reduction and asset
protection from creditors) require major professional planning
and implementation. Don't blow a major step by getting
unqualified help.
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