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Introduction

A Family Limited Partnership is an effective tool for preserving family wealth by transferring assets to younger generations, while preserving control in the transferor.  The Family Limited Partnership may be utilized to transfer assets of all types, including real estate, stocks, bonds, and interests in closely held businesses.  If properly utilized, the Family Limited Partnership can be not only a useful economic tool, but also a catalyst for family unity. 

            A limited partnership is a uniquely appropriate vehicle for the transfer of wealth and retention of control, because the general partner of a limited partnership is, as a matter of law, empowered to manage the limited partnership.  Limited partners have no managerial powers or responsibilities, so control resides solely in the general partner.

            The mechanics of using a Family Limited Partnership are simple.  A limited partnership is created by the donor who contributes the assets to be held by that entity, be it real estate, stocks, bonds, or interests in a closely held business.  In return for this contribution, the donor receives a general partnership interest, as well as limited partnership interests in the Family Limited Partnership.  The limited partnership interests can then be transferred to wife, children and/or grandchildren.  This is a simple mechanical task, as only a single page assignment form need be completed for each transfer.

            The limited partnership interests assigned each year can be equivalent to the annual gift tax exclusion, or $10,000 per donee.  Accordingly, each year husband and wife can transfer $20,000 of limited partnership interests in a Family Limited Partnership to each of their children.

            There is another significant benefit to utilizing a Family Limited Partnership for wealth transfer, and that is the availability of discounts for lack of control.   By its very nature, a limited partnership is controlled by the general partner.  Accordingly, limited partnership interests have no control and are therefore valued at less than their pro rata share of the assets of the partnership.  For example, if $1,000,000 of stocks were used to fund a Family Limited Partnership, each 1% of limited partnership interest would, without discount for lack of control, have a value of $10,000.  However, if a 33-1/3% discount were applied, each 1% limited partnership interest would have a value of $6,667.  Notwithstanding this, in the event that the limited partnership were liquidated, the limited partner would receive $10,000 of assets.  This type of discount would give the donor the ability to, in effect, transfer $15,000 of wealth while only using the annual exclusion of $10,000.  The discount may also be utilized to value for estate tax purposes any limited partnership interests owned by the donor at the time of the donor’s death.

            To properly document the discount, a professional evaluation should be obtained by the donor at the time of the transfer. 

            In certain instances, there may be an opportunity for double discounting.  For example, if the limited partnership if funded with general partnership interests in real estate, there may be lack of control at both levels, resulting in a double discount.

            After the transfers have been completed, the limited partnership will remain under the control of the donor as the general partner.  The donor is not required to make any distributions whatsoever and the Family Limited Partnership can accumulate profits without distributing them. This permits accumulation of substantial family wealth without the need for distributing it to members of the younger generation who may be tempted to utilize the funds for undesirable purposes. 

            Taxable income of a Family Limited Partnership is attributable to each of the partners pro rata.  Therefore, if younger family members are in a lower tax bracket, transferring income to them will result in reducing aggregate income tax on the profits of the Family Limited Partnership.

            Family Limited Partnerships also provide a substantial measure of protection against creditors.  If a limited partner is subject to claims by a creditor, that creditor can obtain a charging order on the debtor-partner's limited partnership interest.  However, that will only entitle the creditor to distributions, if made, upon that limited partnership.  And, the general partner doesn't need to make these distributions.  Worse yet, for the creditor, income normally attributable to the limited partner, may be attributable to the creditor with the charging order.  The creditor ends up with tax liability and no proceeds.   Most creditors in this position will settle their claims at a substantial discount.

            Lastly, and perhaps of primary importance, the Family Limited Partnership is a tool for keeping the family together.  It automatically creates a family business, even if funding is limited to stocks and bonds.  In effect, the Family Limited Partnership can be an investment club for the family. 

            Note, a Family Limited Partnership may not be an appropriate entity for a business selling goods and services.

Discussion

Preface

If your net worth is over $600,000 [$1.2 million for a married couple] you can reduce future death taxes by giving property away today. This technique is greatly underutilized for two reasons:

• Who has extra cash to give away?
• Most children will abuse such gifts.

Together, a Husband and Wife can give away $20,000 per year to each of an unlimited number of recipients. However, if you give a check to your son, he can then spend it, waste it, get sued, get divorced, or die and leave the gift to his wife or other beneficiary.

A better technique is to give something they cannot spend, sell, give away, or lose in a divorce. Something valuable, which does not cost you cash out of your pocket. Something which allows you to retain control.

The answer: real estate. You can give away real estate without giving up liquidity, without losing control, and without risk.

However, if you deed a child even 1% of a property he can sell it, mortgage it, or give it to his wife. He can even sue you to force a sale of the entire property (a lawsuit for Partition).

To prevent this, it is possible to form a Family Partnership. You give your descendants non-voting Limited Partnership shares. You retain 100% control as General Partner. You can never be outvoted, even if you have only 1% ownership.

Gifts up to $10,000 per donor, per year, per recipient, are free of all taxes. No taxes to the giver; no taxes to the recipient.

Each year a Husband and Wife can give $20,000 (of equity) of real estate to each child and grandchild. If you own property worth $800,000 of equity, you can give 2.5% ($20,000) Limited Partnership shares to each recipient.

You can do this every year, although the annual percentage given will (hopefully) diminish as the value of the property grows. When the property value grows to $1 million, 2% per person is all you can give tax free.

How Does It Work?

A Family Limited Partnership ("FLP") is simply a limited partnership among members of a family. A limited partnership has both general partners (who run the partnership) and limited partners (who are passive investors). General partners have unlimited personal liability for partnership obligations, while limited partners have no liability beyond their capital contributions. Typically, the partnership is formed by the older generation family members (for the purpose of our discussion, the parents), who contribute assets to the partnership in return for general partnership units and limited partnership units. The parents can then embark on a plan of giving limited partnership units to their children and grandchildren, while retaining the general partnership units that control the partnership.

Any type of property can be contributed to an FLP. For example, FLPs have been formed to hold family compounds, businesses, rental real property, and in some cases marketable securities.

The partnership agreement will govern how partnership income is divided among the partners. Generally, both general and limited partners share income and cash flow based on their percentage interest in the partnership. It is important to realize that although income tax liability passes through to partners automatically, cash is not distributed to partners until the general partners determine to make a distribution. In this way, the general partners retain control over the assets in the FLP, whereas limited partners are granted very limited rights. Limited partners also have restrictions on their ability to transfer their partnership units to others, so that the general partners can prevent the units from being transferred outside of the family.

First - let us "place the cart in front of the horse" by skipping to see a final result - or how the goal is going to be accomplished.  Then we will cover the actions that the transferor (you) must perform.

Who Should Be Partners?

We recommend only one general partner and that entity should be a limited liability company.  We recommend that all other partners (entity type discussed next) be limited partners.

Although the individuals may be limited partners we advise the use of trusts.  By using trusts, there is obtained an additional layer of asset protection.  Trust instruments may be drafted in any way the taxpayer chooses.  We advise that the Dynasty Trust be given serious consideration as the main type of trust.  Multiple trusts can be drafted and the number of trusts that one can use is nearly without limit to use for the limited partners.  Moreover, one may use the intentionally defective trust where it might be advantageous for income tax purposes.

GIFTS TO MINORS

Custodianships are self-created, without any lawyers, Court involvement, documents, or other headaches.

However, if the donor is the parent, assets subject to Custodianship by the parent are part of the parent's taxable estate at his death.

If the parent is the donor another person should be Custodian for any gifts to the minor.

RETAINED CONTROL

You decide when to sell the property. You decide how to reinvest the proceeds. You control everything.

Cash Distributions

However, if you desire a cash distribution from the property, and do not want to make distributions to other partners, the only way is a taxable management fee to yourself.

NO STEP-UP IN BASIS

If you own a property with an initial cost of $100,000, after several years you may have claimed $25,000 of depreciation. Your tax basis therefore is $75,000.

If you sell for $160,000, your taxable profit is $85,000. [Economic profit is $60,000, plus depreciation `recapture' of $25,000.]

Instead, if you hold the property and die when it is worth $160,000, the property is subject to death taxes (at your highest marginal tax rate). However, your children who inherit get a free step-up (increase in their income tax cost) to the date of death value, $160,000. They can sell it later and they pay income tax only on the profit above $160,000. Or they can start depreciating it all over, based on their cost of $160,000.

However, if you make lifetime gifts, your children never get a step-up in basis; they did not inherit the property. Their tax cost is the same as yours. When they sell it (unless they do a tax free trade), all the profit is subject to income tax.

DISCOUNTS

Legal Formation of the FLP or FLLC

Opening bank and other financial institution accounts

Transferring Assets to the FLP or FLLC

We have discussed the role of marketable securities and how to get around the 80 percent limitation. Assets that should not be put into a Family Limited Partnership include your principal residence and any qualified pension money that you may have. You don't want to transfer your principal residence, because then you would lose your potential $250,000/$500,000 gain exclusion upon sale. And you don't want to include qualified pension plan assets, because those assets would then become income taxable to you upon transfer.

How to transfer the assets

Which Assets Should be Transferred?

Appropriate Types of Real Estate

A Family Partnership may enter a tax deferred exchange (§1031), but Partners may not §1031 their individual shares. If all of the Partners want to do a tax deferred exchange the Partnership may, but if some Partners want to cash out, the others cannot easily avoid taxation.

Monthly Accounting

Annual Tax Returns

Prop Tax

Federal Returns

Each Partner gets a K-1 and reports his proportional share of income, expense, and depreciation on his own Income Tax Return. The Passive Loss Rules apply and may limit deductibility of losses to passive Partners.

This may cost you some tax deductions you had before you gave away a piece of the property, or cause reallocation of taxable profits to your descendants if the property has taxable income.

A partnership agreement is a contract among the partners. In order to sign a partnership agreement, therefore, you must be at least 18 years old. What do you do if you have children tinder age 18 that you want to make limited partners. The solution to that problem is the creation of a separate trust to hold the limited partnership interests until your children hit age 18. At age 18, or later if you so desire, those limited partnership shares can be distributed to your children. It's important to remember, however, that regardless of who owns the limited partnership shares-be it the trust or your children directly-you, as general partner, will always have full and absolute control over the assets that are within the partnership itself.

State Returns

Annual Gifting

How To Get Money Out of The Family Limited Partnership

We have discussed the advantages and disadvantages of Family Limited Partnership, but we haven't discussed how you get money out of that partnership. There are three ways to accomplish this:

1. The general Partner can take compensation for services rendered. I don't recommend this alternative because it makes those dollars taxable to the general partner.
 
2. The general partner can take expense reimbursement for expenditures incurred in running the partnership. However, this doesn't amount to a lot of dollars.
 
3. You can borrow! I strongly suggest that the best way to take money out of a Family Limited Partnership is to borrow it from the partnership. As general partner, you would have to sit down in front of a mirror and negotiate with yourself. I would suggest a demand note (a note that can be called at any time by the creditor). However, remember that You are the creditor, you are the general partner. I would provide for interest to be paid at least every 10 years. If the partnership is structured appropriately, the interest will be deductible by you and 99 percent taxable to your kids.

Solutions

Solutions are dependent upon facts & circumstances, law and the objectives.  These elements vary from one time to another, from one circumstance to another and from person or entity to another.

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