Family limited partnerships can be useful vehicles for accomplishing certain estate planning and asset protection planning goals. Historically, they were often used as an alternative to a corporation for purposes of holding real estate or as an operating vehicle for a family business because they offer limited liability protection of the same type afforded by a corporation and they are pass-through entities for tax purposes (meaning that it is the individual owners rather than the entity itself which is responsible for paying taxes on the profits and losses of the entity). However, in 1993 the IRS issued a revenue ruling which recognized the idea that valuation discounts might be available in certain circumstances when calculating the value of transferred interests in a family business entity for estate or gift tax purposes. Since that time, family limited partnerships (and recently family limited liability companies) have become the form of business entity which is most commonly used to take advantage of valuation discounts applicable to the calculation of estate and gift taxes on family real estate or business assets.
Limited Partnerships General
Limited partnerships are partnerships in which there are two classes of partners, general partners and limited partners. The general partners are generally the founders or organizers of the partnership and, in their capacity as general partners, have the legal authority to manage the partnership and its business operations. As is the case with a general partnership, unless steps are taken to register the partnership as a limited liability entity, the general partners of the partnership are also jointly and severally liable for the debts and obligations of the entity. Thus, any limited partnership which does not take the additional step of registering as a limited liability partnership is not the type of entity which provides liability protection for the general partners.
The limited partners, on the other hand, are in the nature of passive investors or owners. They do not participate in management of the partnership business and have no, or very restricted, voting rights within the partnership. To go along with their limited role in management of the partnership and its business, limited partners are afforded the benefit of limited liability protection . Thus, limited partners have no liability for the debts or obligations of the partnership, meaning that creditors of the partnership are not entitled to seek payment of partnership debts from the limited partners.
Limited partnerships are formed by filing a Certificate of Limited Partnership with the Secretary of State. After the entity is formed, property is transferred or contributed to it in return for partnership interests or units. In most cases, the contribution or transfer of assets to a partnership in return for an ownership interest in the partnership is a tax free transfer.
Ownership of the interests or units is divided between the general partners and limited partners in whatever proportions are deemed to be appropriate. The interests or units represent the right to share in the economic benefits of the partnership on a percentage or pro rata basis, but do not represent a direct ownership interest in the underlying assets of the partnership.
Family Limited Partnerships
A family limited partnership is a limited partnership in which all partners are family members. In the typical situation, one or both parents form a limited partnership and contribute assets to it in return for 100% of the partnership interests or units. They own a small portion of their interest (1-2%) as general partners and the remainder as limited partners. When they decide it is appropriate to do so, they begin to transfer portions of their limited partnership interests to their children. These transfers are generally in the form of annual gifts which correspond in value to the annual gift tax exclusion (currently $11,000 per person per year). The parents remain as the sole general partners and, regardless of the overall ownership interest percentage reflected by that interest, they thereby retain control of the partnership. This includes the ability to make all management decisions, the ability to purchase and sell assets on behalf of the partnership, and the ability to determine the timing and the amount of partnership distributions to partners. Although the parents retain control of the partnership, by making gift transfers of limited partnership interests to their children, they begin the process of reducing the size of their taxable estate by transferring value to younger generations.
One of the main incentives for creating a family limited partnership is to take advantage of valuation discounts which are applicable to the gift transfer of limited partnership interests to younger generations. These valuation discounts are generally available because of the lack of control (a limited partner is not entitled to participate in management) and the resulting lack of marketability (potential purchasers are generally reluctant to purchase a partnership interest which does not carry with it any right to participate in management). These discounts usually range from 20% to 50% and create the leverage that allows the family limited partnership technique to produce significant gift tax savings.
For example, assume a couple wants to make a gift $100,000 of real estate to their 3 children. In 2003, the annual exclusion is $11,000, and through gift-splitting, the couple could make a gift of $22,000 to each child. Instead, of making a direct gift of interests in the real estate, the couple contributes the real estate to a family limited partnership in which each spouse initially owns a 1% interest as a general partner and a 49% interest as a limited partner. They then make gifts of limited partnership interests to their children. In this manner, the nature of the gift to each child is changed. Instead of an interest in real estate which has a readily determinable market value, the gifts are limited partnership interests which may be discounted.
If a valuation discount of 33% can be justified for the limited partnership shares, a partnership interest allocable to $33,000 of family partnership assets (i.e. a 33% interest in the partnership) would have a $22,000 gift tax value. Thus, gifts of partnership interests allocable to $99,000 of the value of the real estate held by the family partnership (as compared to $66,000 of value if the gifts consist of direct interests in real estate) could be transferred to the 3 children in one year and be fully covered by the gift tax annual exclusion.
The IRS has ignored the existence of a family limited partnership and denied the availability of valuation discounts in situations in which it has determined that the entity had no legitimate business purpose and was formed only for the purpose of seeking to avoid taxes. Thus, in order to avoid questions regarding the availability of valuation discounts, the family limited partnership must be organized as a bona fide business arrangement and the purposes for which it is formed should be documented. In that regard, the IRS has recognized that a partnership formed to conduct a family’s business or nonbusiness financial affairs should generally be recognized as a bona fide business arrangement.
Asset Protection Planning
Another incentive for formation of a family limited partnership is that it may protect assets in the event of future problems with creditors. Provided that the transfer of assets to a family limited partnership is not a fraudulent transfer (i.e. a transfer made with the actual intent to hinder, delay or defraud a creditor) the creditors of the partner who made the asset transfer should not be able to attach the partnership’s underlying assets. Instead, such creditors are limited to seeking a “charging order,” which is the equivalent of a garnishment of any distributions made by the partnership with respect to the partnership interest of the debtor partner. However, if the general partners elect not to make any distributions, the charging order has little or no value because the creditors have no ability to compel the general partners to distribute partnership profits. In addition, such charging orders may create potential tax problems for the creditor. In such a situation, the creditor risks being treated as the taxpayer with respect to partnership profits and losses allocated to the partnership interest it has attached. Thus, the creditor could be required to report partnership profits on its tax return with no assurance as to when or whether distributions of cash would actually be made. This type of problem is a major disincentive to creditors and may create a situation in which the creditor becomes much more willing than it would otherwise be to negotiate a favorable settlement of its claim.
Use of a Limited Liability Company
Colorado first adopted a limited liability company statute in 1990 and was only the third state to have such a statute. Now, LLC’s are the most popular form of organization for new business entities because of the liability protection they provide and because of the flexibility they afford in defining the business relationship between the parties. As a result, family LLC’s are increasingly being used in place of family limited partnerships to accomplish the same estate and asset protection planning objectives.
In a typical family LLC the parents who form the entity are designated as the initial managers. In that capacity, they are the equivalent of the general partners in a family limited partnership and have the exclusive authority to manage the LLC and its business operations.
The ownership interests in a family LLC are typically divided into two classes. One class of units (Class A units) is given general voting rights. These Class A units, which typically represent only a small portion of the total number of outstanding units, are initially owned by the same people who are designated as the initial managers of the LLC. The other class of units (Class B units) either has no voting rights or has limited or restricted voting rights (which do not include the right to vote on replacement of the managers). The Class B units are the equivalent of limited partnership units in a family limited partnership, and it is these Class B units which are gifted to the younger generations of family members.
Family LLC’s provide the same type of estate planning and asset protection planning opportunities as are available with family limited partnerships. The valuation discounts which are applicable to gifts of limited partnership interests also apply to gifts of Class B units in an LLC, and the asset protection planning features of a family LLC are the same as those of a family limited partnership. In fact, depending on the structure which is used, a family LLC may be preferable to a family limited partnership for asset protection planning purposes because all members of an LLC are afforded protection from liability for the debts and obligations of the LLC.
Family limited partnerships (and family LLC’s) can be used to achieve significant estate planning and asset protection planning objectives. The asset protection benefits are the result of the basic limited liability nature of these entities as well as the statutory provisions which limit creditors of individual partners or members to “charging orders.” Creditors cannot compel the general partners or managers to make distributions which would be subject to any charging order and such creditors are prohibited from attaching the underlying assets of the entity itself. The estate planning benefits are primarily the result of the availability of valuation discounts on transfers of limited partnership or LLC shares. Family limited partnerships and family LLC’s provide a mechanism through which ownership and management of family assets is divided among family members. All management rights can be retained by the older generations while value is transferred to the younger generations through gifts or transfers of limited partnership units or non-voting LLC interests. The IRS has acknowledged that the lack of marketability of these interests, which results from the fact that these interests do not entitle their owners to participate in management of the entity or control of is underlying assets, causes them to have a substantially reduced market value for gift and estate tax purposes.