A family limited partnership is a regular limited
partnership that happens to have family members involved.
You create the partnership to accomplish certain business
purposes, such as consolidation of family wealth or teaching
younger generations how to manage wealth. In return for
partnership interests, you transfer your assets into the
partnership.
A partnership must have at least two partners. In most
family limited partnerships, there is a general partner and
limited partners. The general partner manages and controls
the partnership. The limited partners have no control. The
partnership terms are memorialized in a written operating
agreement.
Typically, you control the general partner. On occasion, you
will not wish to control the general partner, and we will
discuss the reasons for that with you. Often, you will own
limited partnership units, and you use these units to
gradually gift limited partnership interests to younger
generations. Control stays with you (because you control the
general partner), while wealth moves out of your estate.
Because of the way the partnership operating agreement is
written, the limited partners have very little ability to
transfer ownership. This is helpful in many ways. First, in
case of divorce, the soon-to-be-ex may have claim to the
value of the partnership units, but will have a hard time
actually getting the units. Second, because the units are
difficult to transfer outside of family, the units very
often qualify for a discount for lack of marketability.
Third, because they are limited partnership units, and the
general partner is in control of the partnership, the
limited partners have no control. The limited partnership
units typically are appraised with a discount for lack of
control.
How does this work for your benefit? Let's assume that your
partnership owns as an investment a share of IBM stock that
is selling on the stock market for $100. Anyone could buy a
similar share of IBM via the stock market. If you offered an
investor the opportunity to buy the stock on the stock
market, the investor would pay $100 for it. If you offered
the same investor the opportunity to buy a unit of limited
partnership interest equivalent in value to the share of IBM
stock, the investor would not be willing to pay $100 for it.
Why? Because the investor knows that the share of IBM stock
comes wrapped in a package that includes dealing with
someone else's family, as well as an onerous partnership
agreement. The limited partnership unit has limited
marketability, no control, and family drama. How much is the
discount? That depends on an appraisal by an independent,
qualified business valuation analyst. However, discounts of
10% to 40% or sometimes even higher are not unheard of.
Why does this benefit you? Let's say that you have gifted to
your son 20% of the limited partnership units in your family
limited partnership. The assets of the family limited
partnership include $1 million of IBM stock. Logically, your
son's wife would think that your son is worth $200,000.
However, if your son's wife were to initiate divorce
proceedings against your son, the assets would have to be
valued to be split up. Imagine her disappointment when the
appraisal for the partnership showed that your son's limited
partnership units were worth merely $140,000 due to a 30%
discount for lack of control and lack of marketability.
And it gets better! Let's assume instead that your son was
at fault in a car accident. This is an outside liability,
meaning it did not occur within the confines of an entity.
The injured party sued your son, went to trial, and won a $1
million dollar judgment against your son. Perhaps your son
is very handsome, absolutely charming, a great tennis
player, but not much of a go-getter, and the only asset your
son owns is the 20% of the limited partnership units in your
family limited partnership that you gifted to him. The
assets of the family limited partnership include $1 million
of IBM stock.
Logically, your son's creditor would think that your son is
worth $200,000, and would want to take ownership of the
limited partnership units away from your son in partial
satisfaction of the judgment against your son. However, the
injured party cannot take title of your son's limited
partnership units. Instead, your son's creditor would have
to go back to court to get something called a "charging
order". A charging order is a piece of paper that says in
essence, "Dear General Partner. Son owes me money. Instead
of writing distribution checks to Son, please write them to
me instead. Sincerely, Injured Party."
You as General Partner are in charge of what? Determining
distribution checks! So, while the charging order is valid,
what do you do? Don't write distribution checks to your son!
Does this mean that no money can come out of the partnership
while any limited partner has a charging order against
him/her? No. You as general partner may loan money, borrow
money, pay wages, sell assets, buy assets-there are many
ways to get money out of a partnership. You just don't want
to make a distribution, because if you did, your son's
pro-rata share would have to be paid to your son's creditor.
As a partnership, under US Federal income tax law, your
partnership files each year an informational income tax
return known as Form 1065. The partnership pays no income
tax itself, but is considered a "flow-through entity". The
Form 1065 has attached to it Forms K-1. Each partner gets a
K-1 that reflects his/her income tax from the activities of
the partnership. Each partner includes the numbers from the
K-1 on his/her personal income tax return, Form 1040.
And here is the part where you may stand up and sing. While
the judgment creditor holds a charging order against your
son, your son's judgment creditor gets your son's K-1, and
your son's judgment creditor has to include on his 1040 the
income tax items as a result of the activities of the
partnership. In other words, although the judgment creditor
is not getting any cash flow because the general partner is
not writing distribution checks, the judgment creditor will
have to pay income tax on income attributable to your son
from the family limited partnership.
What does this mean in the big picture? If you have your
family wealth tied up in a family limited partnership, it
will be much easier to convince creditors or predators to
settle immediately for whatever cash you offer them rather
than fight in court. Personal injury attorneys are less apt
to take on as a client someone who wants to sue you. If the
personal injury attorney does take the client, he/she likely
will counsel the injured party to settle, and quickly. The
personal injury attorney knows that his client will be the
most unhappy person in the world if the client goes all the
way through trial, wins the trial, goes back to court, gets
a charging order, and then, instead of getting cash, sits
around waiting, and at the end of the year gets a K-1 that
means he has to pay income tax to the IRS. The personal
injury attorney's client now has lost money by winning-and
the personal injury attorney, who most often gets a
percentage of the winnings, has been paid nothing.
This has been a gross simplification of an area of law that
is onerously complicated. Partnerships are expensive to set
up, expensive to maintain, and require constant care and
feeding. If you do not have the time, energy, and money to
do your partnership right, then choose a different law firm.
Family limited partnerships are one of our most gratifying
practice areas, but we have strict maintenance expectations.
We, as your attorneys, your CPA, and you have to work
together as a well-oiled machine to build and maintain your
partnership to withstand assault. A poorly-maintained
partnership is next to useless. |
