Related Matters Newsletter Summer 1995
by Ronald P. Weiss, Esq. Bulkley, Richardson and Gelinas Springfield, Massachusetts
You pay a fortune in taxes. You pay income taxes on what you earn and on what your investments earn. You pay taxes on what your employees earn. You even pay taxes on inflation. And the income tax rules are so complex, so you have to spend days and incur substantial fees just to pay your income taxes. Then, when you die, the government plans on taking a substantial portion of the wealth you have left after all the income taxes. If you are in the highest income and estate tax brackets, this means that for every dollar you earn that is taxed at ordinary income tax rates, your children will inherit only 27 cents.
The laws of our country are designed to make it difficult for you to transmit a substantial estate relatively intact to your children. In response, estate planners have created a number of techniques to help you leave as much as you can to the next generation. Unfortunately, the most common techniques, outright gifts and placing assets into irrevocable trusts, will most likely put assets outside of your control. This may make you uncomfortable if income producing assets, especially your family business, are involved. These methods may also give rise to estate and gift taxes based on the full value of what has been transferred.
There are several ways you can achieve major estate and gift tax savings without giving up control over your assets. One that has achieved much recent publicity is the “family limited partnership.” In a nutshell, this merely involves putting income producing assets, such as the family business (if it is a C-corporation, general partnership, limited liability company, or proprietorship), life insurance, securities, cash, or business or other rent producing real estate, into a limited partnership.
There is nothing special about the kind of limited partnership you use. It’s just a garden variety limited partnership. You keep a general partnership interest and a limited partnership interest. Over time, you give away limited partnership interests to your children or grandchildren, taking care not to give any donee a majority interest.
As a child becomes active in the business and achieves sufficient maturity, you may want to make the child a co-general partner and involve the child in management and investment decisions. By using substantial valuation discounts that courts have been permitting and that the IRS has recently sanctioned, the gifts can be valued at 25%, 30%, and in some cases as much as 40% below the proportionate value of the partnership assets they represent. Meanwhile, while you are the sole general partner, you retain control over the partnership assets. If the portion of your business that you give away is worth $1 million, and your other assets are substantial, the use of the family limited partnership could save your family over $200,000 in estate taxes.
The benefits of the family limited partnership extend beyond just saving estate taxes.
- Asset protection. You may wish to insulate your assets or your children’s interests in your business from creditors, including divorce spouses. In a typical limited partnership, an attaching creditor of a partner cannot become a partner without the consent of the other partners. Without their consent, all the creditor or divorced spouse can get is the economic benefit of the partnership interest. This can be a problem for a creditor who finds himself with the annual tax liability of a partner, but with the distinct possibility of no cash distribution with which to pay the taxes. Moreover, limited partners cannot touch underlying assets, and so, neither can their creditors.
- Avoidance of double tax. When you go to sell your business, if you are a corporation, you may well have a double tax on the sale: a tax at the corporate level on appreciated assets and a tax at the shareholder level on the difference between what you received on liquidation and your basis in your stock. If you run your business as a limited partnership, you would avoid the double tax.
- Income tax savings. You can save on income taxes by giving a limited partnership interest to a child or a grandchild in a lower income bracket than you. If you do this, you should watch out for the effect of the “Kiddie Tax” that taxes unearned income of children under 14 in excess of $1,300 at the parent’s highest rate. You should also avoid giving partnership net operating losses to children or grandchildren who cannot immediately use them. Lowering the income allocable to you also saves taxes by lowering your adjusted gross income, which can prevent loss of personal exemptions, itemized deductions, and the use of losses from rental property.
- Annual gift giving. Making gifts of limited partnership interests can be much simpler than making gifts of business assets or real estate.
- Family dispute resolution. The limited partnership agreement can set up a mechanism for resolving asset-related family disputes. Mediation or arbitration can be specified. If arbitration is used, costs can be assessed to the loser to avoid harassment actions among family members.
- Avoidance of multiple probate proceedings. Your partnership interest is tangible personal property for probate purposes. So when you die, real estate in the partnership is not treated as an asset subject to probate in the state in which the real estate is located. Your partnership interest will be subject to probate only in your home state. Other ownership vehicles also provide this benefit.
- Keeping assets in the family. You can have the limited partnership agreement include enforceable provisions on transfer, so that assets remain in the family. There are other mechanisms for accomplishing this end, regardless of what form your business organization may take. You should put some transferability protection in place if you have not already done so.
- Family communication. Every partner gets a K-1, which gives you a golden opportunity to discuss family business matters on a regular basis with your family.
If you set up a family limited partnership, make sure the agreement provides that the partnership cannot be liquidated unless all or a substantial majority of partners agree. The general partner, that is you or a corporation owned and controlled by you, should be given broad management and investment powers and the power to distribute income at will. Finally, you should retain the power to give away portions of your retained limited partnership interest to your children, grandchildren, charities, and so forth, at your sole discretion. The partnership should be of long enough duration to carry out your planning goals. This normally means 20 years or longer; the longer the better.
Back to the main reason you will have set up a family limited partnership in the first place: to save estate and gift taxes. What are the valuation discounts that work the savings? First, there is a minority discount when the donee receives less than a controlling interest in the partnership. Second, there is a marketability discount because the limited partnership interest is not easily marketable. Finally, there is a discount for illiquidity because no partner has the unilateral right to liquidate the partnership and get control of the assets, and the assets are tied up for the duration of the partnership, which may have decades of continuing existence before its term expires.
Are there any risks to using a family limited partnership? Not if you are careful and follow the legal and tax formalities associated with that form of entity. If the IRS challenges your discounts, you will probably be able to compromise on some discount level that will permit you to end up in a better position than if you had not used the limited partnership form. But if you compromise or lose a valuation dispute, you must be prepared to pay the additional gift or estate taxes and interest that will be assessed.
Of course, the family limited partnership is not right for everyone or for every situation. If you own an S-corporation, under present laws a limited partnership is not an appropriate stockholder. Moreover, appraisal fees and legal fees to set up the limited partnership and to value gifts are not inexpensive, and can be relatively high if your business or assets are not easily valued. But the benefits can be enormous. So, if it seems that a family limited partnership might be useful for you, you should contact your lawyer and accountant to discuss it soon.