The family limited partnership has become a darling of tax advisors in recent months. The tool also has become the talk of the tax circuit because it could be eliminated as soon as next year, given the resolve of the Clinton Administration to tax the wealthy. So the time to consider the device is now.
A family limited partnership can be extremely effective in reducing estate taxes and protecting a family's assets against creditors. Families in partnership have saved up to 87 percent of their estate-tax burden and shielded their resources from a predatory legal system. Available since 1987, the family limited partnership (FLP) is not difficult to understand, or use. It is essentially a family business organized as a partnership rather than a corporation. It is effective in shifting value in the business to heirs, keeping control in the family, and reducing the inevitable estate taxes that will have to paid when parents die.
The protections of the FLP come from revisions made in 1985 to the Uniform Limited Partnership Act. These revisions were adopted nearly uniformly by 49 states plus the District of Columbia; Louisiana has its own Act that includes some of the recommended provisions. The adopted revisions limit the rights of a creditor to collect assets from the income of a partner in an FLP. A creditor may not “take” or “own” or “vote” the interest of a limited partner. Bankruptcy protection and the ability to discount the value of an estate for estate tax purposes make the family limited partnership an excellent option for a family's closely held business.
The only partners in an FLP are family members or family trusts. Assets transferred into an FLP may be commercial stocks and bonds, cash, the family farm, or stock in the family business. Once the partnership is formed the parents no longer own these assets. In exchange for their contributions they receive units of ownership in the partnership. Transfers of ownership to children reduce the taxable estate but do not give children voting rights in the partnership, so the parents maintain control of the business. Management and investment control are vested in one member (or more) of the family known as the general partner. The general partner must exercise fiduciary responsibilities as custodian of the assets of the limited partners, but in reality he or she is fully in charge.
The FLP structure prohibits the sale or transfer of units of ownership and prevents outsiders from buying these units without the consent of the family partners. Further, the limited partnership units cannot be taken from a son or daughter in a divorce proceeding; state courts cannot award them. State law says an outsider cannot have an interest in a family limited partnership and cannot do anything to force liquidation of the partnership. Someone acting to divide the family, whether in divorce or bankruptcy proceedings, can get none of the family's assets if they are in an FLP, unless it is proved that the family formed the partnership specifically to block such claims or to defraud.
The partnership structure reduces the value subject to estate taxes but does not affect the value of the business itself in any way. For families in agreement, the family limited partnership can vote to buy one partner's assets if he or she requires liquidity. The family can terminate the partnership or change it in any way, as long as everyone is in agreement. If families disagree, as is frequently the case, the general partner maintains control and no one can force the general partner to make changes. No takeover attempt by grown children will ever remove a parent from control of his company either, as has been the case when a corporation has gifted stock to family members.
The ability to discount the value of the assets of an estate held within an FLP is based on the non-transferable and non-marketable nature of the partnership units to both the general partner and the limited partners (usually children).
Suppose you own a 35 percent interest in a family limited partnership worth $1 million. Let's say the partnership was established four years ago, with a duration of 40 years—enough to see your father through his retirement as well as protect the various children after his death. If this limited partnership were to dissolve today, the value of your 35 percent share would be $350,000. However, the partnership will continue for 36 more years before it terminates. Someone who would want to buy your 35 percent interest in the partnership could not resell the newly acquired units of ownership. In addition, the buyer would have insufficient votes to replace someone as a general partner, and could not force the general partner to hand over his or her share of the partnership earnings. Furthermore, the buyer would lack the right to withdraw as a partner, that is, cash out of the partnership. Would someone be willing to pay $350,000 for an investment with those rules? Probably not. Hence the discounted value of the business assets.
Family limited partnerships discount the value of estates, too. In contests between taxpayers and the Internal Revenue Service regarding the value of estates, the IRS has repeatedly lost when primary assets are tied up in a family limited partnership. In cases that have come to trial, the taxable values of different estates have been reduced from 39 percent in some cases to almost 87 percent in others.
Cases in the U.S. Tax Court show the success families have had in using the FLP to lower the tax value of their estate.In the Estate of Daniel J. Harrison Jr. (a Tax Court Memorandum on an evaluation question), for example, Harrison owned at the time of his death a 78 percent interest in a family limited partnership. The share, though large, was insufficient to require a forced liquidation of the partnership, because the partnership agreement required consent of 100 percent of those holding the partnership units. The IRS took the position that Harrison's partnership interest was worth about $60 million, the value of the assets he contributed to the partnership only 5 months prior to his death. The Tax Court held that Harrison's partnership interest was non-controlling and that his 78 percent interest had a fair market value of only $32 million.
In Estate of Catherine Campbell v. Commissioner, the IRS alleged that Catherine Campbell's 33.3 percent ownership in a family ranching partnership was worth $7,642,000, allowing some discount for her minority and non-controlling ownership interest. The Tax Court held that the fair market value of Campbell's interest, in an outside market, was worth only $4,300,000. Likewise, in Novak v. United States, the Tax Court held that the fair market value of a partner's 50 percent ownership interest was $1,006,750. The IRS had asserted that the ownership interest was worth $1,657,465.
According to Watts v. Commissioner, liquidation value is a material consideration only if the owner has the authority or control to sell the investment, or the control to force a liquidation of the enterprise. Without the control to liquidate, the only real value to the owner is the income that can be realized from the investment.
The Watts case resulted in a valuation of Martha Watts's 15 percent non-controlling ownership interest in Roseboro Lumber Co., a family partnership, at 87 percent less than the value of the assets of Roseboro, multiplied by Watts's 15 percent interest. If Watts had no power to force a liquidation of Roseboro and gain control of her interests in the assets of the partnership, the only value which was material to the valuation of her interest was the capitalization of the income stream that she would likely realize over the term of the partnership. The Tax Court held that the market value of the 15 percent interest was only $2,550,000.
Unable to win against taxpayers whose FLP substantially reduces the value of the estate, the IRS has tried to litigate cases in which they believe the only reason for the existence of the FLP is to avoid estate taxes. The first and best test for asset protection in limited partnerships is whether the partnership is, in fact, established to accomplish legitimate estate planning goals of the family business owner. The best proof that can be offered in tax court is the existence of a bona fide estate plan.
Texas was one of the first states to be hit by the great recession of this past decade. The Texas slide was fueled by a devastating decline of oil and gas prices, followed by a collapse of real estate markets and the attendant ruin of once powerful lending institutions. Many developers and business owners lost almost everything they owned. The prudent few who had committed seed capital to a family limited partnership were to have the financial resources necessary to regenerate. Each has withstood the test of litigation—or the threat of litigation—and bankruptcy.
In one instance, the Federal Deposit Insurance Corp. failed to make its case against a family partnership in Federal District Court. The FDIC attacked the formation of a limited partnership, and transfers to the partnership, under the Uniform Fraudulent Transfers Act. The husband, who had suffered financial loss, did not stand alone. His wife, the children, and a charitable remainder trust were partners and interested parties. The evidence clearly indicated that the partnership, formed by the family, was motivated to accomplish valid estate planning objectives, not to defraud or hinder the FDIC. The FDIC did not have a chance against the family's bona fide estate plan, especially with a jury of sympathetic human beings.
Although there are several strong benefits to a family limited partnership, there are a few negatives, too. Chief among them are the time and expense required to set up the partnership.
The legal costs of establishing a family limited partnership and a living trust can be substantial. However, it becomes a matter of paying an attorney now or paying an attorney later, not to mention the IRS.
Some additional cost is incurred because additional tax returns must be filed for the various tax entities set up in a family limited partnership. However, the cost is incidental when compared with the savings attainable for an estate.
To set up a family limited partnership, family members must identify every asset they own. This is a time-consuming hassle, but it only has to be done once. For example, each family member must transfer assets, such as money in bank accounts, to the partnership. It takes time to tell attorneys and the estate planning team what each person is trying to achieve, and to review documentation as it is prepared. Time is money. But either you, or those you leave behind at death, must do the work. If it is not done up front it will have to be done by heirs later—and at a cost to the estate.
Some states, such as California, impose a franchise tax on limited partnerships. There are other states that do not, such as Nevada and Texas.
Finally, some assets are not transferable into an FLP. These include qualified plans; IRAs; S-corporation stock; stock in professional corporations, professional associations, professional partnerships, or investment partnerships with restrictions on transfer; mortgages with clauses requiring payment at the time of sale; or licensed companies. Licensed companies include bank holding companies, insurance agencies, private educational institutions, or companies operating under a franchise contract.
Family assets that are not transferable can result in a substantial estate tax burden if they are not considered in the total estate planning strategy. Such assets must first be identified. Then they must be eliminated from the estate or reduced, or their tax implications deferred. While there are many techniques that can be employed to this end, the remaining estate tax liability can be lessened through the use of gifting and life insurance. Remember, estate taxes are the liability of the estate, and cannot be paid by the partnership. Gifts to family members can substantially reduce the estate tax liability. Whether those gifts are in the form of partnership interests or cash, the impact can be significant to the beneficiaries of the estate.
One way of providing for immediate liquidity in the event of death is to buy a “second-to-die” life insurance policy to provide for liquidity on the death of the parents. For example, a couple that is 65 years old can buy a $2 million life insurance policy for approximately $60,000 a year for 10 years (based on current interest rates).
Such a policy can be purchased by cash that is gifted to children or grandchildren outright or in trust. If owned outside of their estates, the insurance will be free of estate tax. If owned by the partnership, a percentage could be included in their estate—determined by the amount of partnership interest they own at their death. In this approach, however, the value of the interest would be further discounted because the assets that the interest represents are within a family limited partnership. Whatever method is chosen, there is tremendous leverage in the money used to buy life insurance. Even if the 65-year-old couple lived to life expectancy (approximately 20 years) the premiums paid would represent only a little more than 25 percent of the death benefit.
One of the most visible example of how a family limited partnership works with an estate plan is provided by Sam and Helen Walton. The partnership was formed early in the Walton family's life, before the advent of Wal-Mart. Wal-Mart grew out of the family partnership. Sam Walton, at the time of his death in April of 1992, owned only a 10 percent interest in the partnership. Since an amount equal to the share of the family assets is scheduled to go to non-profit organizations, the best guess is that the estate tax will be zero. As Sam Walton said, “the best way to reduce paying estate taxes is to give your assets away before they appreciate.” The family limited partnership allows you to give away those assets while still maintaining control.
Larry W. Gibbs is a principal of Croman, Gibbs, Schwartzman, an estate planning firm in San Antonio, Texas. Todd Healy is a member of The Partners Group and president of Healy & Associates, a firm in San Antonio specializing in wealth accumulation and preservation for closely held businesses.This article is adapted from a presentation given at the winter meeting of The Partners Group in San Antonio, Texas.
State havens for family limited partnerships
Owners of closely held businesses would be well advised to examine the family limited partnership laws of their own state, because protections differ significantly from state to state. Texas and Florida provide substantial statutory asset protection for their citizens. And it may be possible for family limited partnerships from other areas to gain those protections.
Whether a family limited partnership can qualify in either Texas or Florida depends on the kind of asset which the non-resident seeks to protect. Real estate cannot be protected unless the owner is a resident of either state. Otherwise, family limited partnerships can be formed in both states.
The Texas partnership structure does require the formation of a Texas corporation or management trust to serve as general partner of the limited partnership. A management trust is a revocable trust which is controlled by trustees who are members of the family. It is possible to make the trust a Texas trust if the trust specifically provides that it is formed to serve as the general partner of a Texas partnership. This trust does not require a Texas resident as trustee. A Texas corporation can likewise be owned and controlled by members of the family without participation of a Texas resident.
The Texas limited partnership has particular merit because anyone, regardless of his or her state of residence, can create and control a Texas limited partnership without an office in Texas. In addition, Texas does not impose a franchise tax on limited partnerships. Texas's limited partnerships may create diversity of jurisdiction sufficient to gain access to a Federal Court. In addition, Texas does not have an income tax which would burden the partnership.
An example: A husband and wife are residents of Illinois. They own and operate a closely held business. The company and other assets have a probable value of $3.2 million. These are scheduled to go to the family's three children. One child has married a person who has caused a division in the family and is much too interested in the potential of an inheritance. The overriding question is whether a Texas or Florida partnership provides greater protection for the financial heritage of the couple's children.
The answer is: probably. Although the limited partnership units the children will receive are protected under Illinois law, a partnership formed in either Texas or Florida would add one more barrier to a spouse or heir seeking to collect from an FLP. For example, Texas law does not permit the court overseeing a divorce proceeding to award the “separate property” of a spouse to the other. If an original or ancillary proceeding is filed in Texas, then, the contest will be litigated in a forum which understands and protects separate property. – Larry Gibbs