As can be seen in our newsletter on Estate Taxes, the Federal estate tax has gyrated wildly over the last decade, not even existing for an entire year but now likely to increase significantly beginning in 2013. While “experts” predict a likely estate tax exemption of 3.5 million and a top rate of 35%, that is only guess work. Those same experts uniformly failed to predict the remarkable hiatus in the estate tax that the log jam in Congress caused for an entire year.
But the hiatus is unlikely to ever be repeated. It is far more likely that estate tax will increase over the years given the economic plight of the Federal government. People with estates of over three million dollars simply have to assume that if they wish to minimize estate tax, they will have to engage in some advance planning. And with the likelihood of inflation in the near term future and the undoubted eventual recovery of real estate in an already inflated real estate economy such as California, it is likely that the average middle class family may now face estate taxes if they own real estate.
Consider: If your family home is worth two million dollars upon your death and you have two million in all your other assets, for a total estate of four million dollars and there is an exemption of three and a half million dollars, then upon the death of the second spouse, taxes of well over one hundred thousand dollars due nine months from death are likely. Note that if the family home or other assets merely inflate by twenty percent by the time the second spouse dies, the taxes are likely to be close to a million dollars. That is one million dollars that the government will get nine months from date of death and which will not go to family members. Anyone owning real property in coastal California must assume sizable estate taxes in his or her medium term future.
Over the past decade, the Family Limited Partnership (hereafter “FLP”) has become an increasingly popular family strategy for both asset protection and estate planning. The asset protection and estate planning benefits of the Family Limited Partnership have been written about extensively in every national publication from the Wall Street Journalto Forbes Magazine. A web search of Family Limited Partnerships will return thousands of hits with many praising its benefits. Since most of the articles are created by those seeking to sell their services in creating the FLPs, the benefits are often exaggerated and the detriments ignored. Nevertheless, for the right family with the right assets, it is a technique worth considering.
Current changes in the law advance the advantages and opportunities of the FLP, but there are dangers and pitfalls both in tax planning and family dynamics that must be considered before electing to use that vehicle. This article shall outline the essential features of the FLP and the usual benefits and dangers to be considered. The reader should first read our article on Limited Partnerships since it will be presumed that the reader is already familiar with the essential features of that type of entity.
The Basic Structure
The FLP has certain unique attributes that are beneficial for both asset protection and estate planning. It usually is not used to the exclusion of other entities such as corporations, Limited Liability Companies (“LLCs”), and trusts but is often combined in a plan with one or more of the other structures included.
The usual role of the FLP is often to act as a holding company, owning certain assets and interests in other entities. In this way it can be the foundation of a solid plan. The distinguishing features of the FLP are pass-through taxation and a split in management rights between general and limited partnership interests. The combination of these two characteristics makes the FLP a flexible and efficient vehicle for many types of planning. Sometimes a corporation or LLC can be substituted and may be more appropriate in certain circumstances, but as a general rule the FLP performs well in this arena.
The unlimited liability feature of general partnerships is a serious impediment to conducting business using a partnership format. To mitigate the harsh impact of these rules, every state has enacted legislation allowing the formation of a unique type of partnership known as a limited partnership.
A limited partnership consists of one or more general partners and one or more limited partners. The same person can be both a general partner and a limited partner, as long as there are at least two legal persons who are partners in the partnership. The general partner is responsible for the management of the affairs of the partnership, and he, she or it has unlimited personal liability for all debts and obligations.
Limited partners have no personal liability. The limited partner stands to lose only the amount which he or she has contributed and any amounts which he or she has obligated himself to contribute under the terms of the partnership agreement. Limited partnerships are often used as investment vehicles for large real estate development or ownership projects requiring a considerable amount of cash. Individual limited partners contributing money to a venture, but not having management powers, will not have any personal liability for the debts of the business. See our article on joint ventures.
In exchange for this protection against personal liability, a limited partner may not actively participate in management. However, it is permissible for a limited partner to have a vote on certain limited issues, just as a shareholder has a right to vote on some corporate matters. A typical limited partnership agreement may provide that a majority vote of the limited partners is necessary for the sale of assets or to remove a general partner. The partnership agreement determines whether the limited partners can vote on these matters.
If a limited partner assumes an active role in management, that partner may lose the limited liability protection and may be treated as a general partner. For instance, if a limited partner negotiates a contract with a third party on behalf of the partnership, the limited partner may have liability as a general partner. For this reason, a limited partner’s activities must be carefully restricted and that restriction adhered to.
Asset Protection
The Family Limited Partnership can be an useful device for providing lawsuit protection for family wealth. However, it cannot be used by itself as a stand-alone asset protection plan. Used alone, however, a Family Limited Partnership, provides no better protection of assets than a living trust, which is small asset protection. The FLP can be a valuable component of an asset protection plan when used as part of a properly designed overall strategy, utilizing limited liability entities as the general partner and having most of the holdings in the hands of the limited partners.
Under the typical arrangement, the FLP is set up so that Husband and/or Wife (or a specially formed Limited Liability Company) is each a general partner. (Corporations are not typically used as a general partner if asset protection is a goal since the shares of a corporation can be seized by a creditor, which then effectively transfers to the creditor all management rights over the partnership.) Thus an LLC is the general partner, owned by the Husband and Wife, and the other family members, including the Husband and Wife, are limited partners.
The general partners might own only a minimal 1 or 2 percent interest in the partnership. The remaining interests are in the form of limited partnership interests. These interests will be held, directly or indirectly, by one or more other entities or family members, based on the particular tax, estate planning, and asset protection goals to be achieved.
After setting up the FLP, selected family assets are transferred into it. These may include investment accounts and shares in other business interests. Often it is real property or interest in entities that own real property. When the transfers are complete, Husband and Wife no longer own a direct interest in these assets. Instead, they own, directly or indirectly, a controlling interest in the FLP, and it is the FLP that owns the assets. The general partners have management over the affairs of the partnership and can buy or sell any assets they wish, subject to the terms of the partnership agreement. The general partners also may have the right to determine what portion of partnership income and assets are retained by the partnership and what amount is to be distributed to the partners.
Now, let’s see what happens if there is a lawsuit against either Husband or Wife. Assume that Husband is a physician and that there is a malpractice judgment against him for $1 million. The plaintiff in the action is now a judgment creditor, and he will try to collect the $1 million from Husband.
The judgment creditor would like to seize Husband’s bank accounts and investments in order to collect the amount which he is owed. However, he discovers that Husband no longer holds title to any of these assets. In fact, since all of these assets have been transferred to the FLP, the only asset held by Husband is his interest in the FLP. Can the creditor reach into the partnership and seize the investments and bank accounts?
The answer is no in most jurisdictions. Under the provisions of the Uniform Limited Partnership Act, a creditor of a partner cannot reach into the partnershipand take specific partnership assets. The creditor has no rights to any property which is held by the partnership. Since title to the assets is in the name of the partnership and it is the Husband partner rather than the partnership which is liable for the debt, partnership assets may not be taken to satisfy the judgment. For example, California Corporations Code Section 15907.03 (f) states this clearly:
No creditor of a partner shall have any right to obtain possession or otherwise exercise legal or equitable remedies with respect to the property of the limited partnership.
It is important to note however that a charging order or a foreclosure of a partner’s interest in the partnership may be an equally powerful remedy of a creditor. A charging order against Husband’s partnership interest means that the general partner is directed to pay over to the judgment creditor any distributions from the partnership which would otherwise go the debtor partner, until the judgment is paid in full. In other words, money which comes out of the partnership to the debtor partner can be seized by the creditor until the amount of the judgment is satisfied. Cash distributions paid to Husband could, therefore, be taken by the creditor. A charging order does not give the creditor the right to become a partner in the partnership and does not give him or her any right to interfere in the management or control of partnership affairs. He or she only receives the right to any actual distributions paid to Husband.
And, more recently, the remedy of a creditor is being expanded in many states and the trend in legislation and case law, is to allow a creditor to foreclose on a limited partnership interest (or an LLC interest. Even so, the creditor would still face the fact that the entity, if properly constructed, would still not be within his or her control and the right agreement may even require buy out of the interest of the Husband for a formula price before the creditor can collect.
To protect the Husband, under the circumstances in which a creditor has obtained a charging order, the partnership would not make any distributions to the debtor partner. This arrangement would be provided for in the partnership agreement and is permissible under partnership law. If the partnership does not make any distributions, the judgment creditor will not receive any payments. The partnership simply retains all of its funds and continues to invest and reinvest its cash without making any distributions. In such instances, the creditor often settles for a relatively small sum.
The result of this technique is that family assets have been successfully protected from the judgment against Husband. Had the FLP arrangement not been used and had Husband and Wife kept all of their assets in their own names, the judgment creditor would have seized everything. Instead, through the use of this technique, all of these assets were protected.
While this sounds good for asset protection, the aggressive creditor may seek other remedies. In California, for example, case law and the statutes specifically allow a creditor to foreclose on a limited partnership interest, in addition to the charging order remedy. Corporations Code Section 17302 (b) states: (b) A charging order constitutes a lien on the judgment debtor’stransferable interest. The court may order a foreclosure upon theinterest subject to the charging order at any time. The purchaser atthe foreclosure sale has the rights of a transferee.
See also (Hellman v. Anderson, 233 Cal. App. 3d 840; ( Foreclosure of partnership interests); Section 17302 (Foreclosure of LLC interests) In Re: Ashley Albright, U.S. Bankruptcy Court for the District of Colorado (decided April 4, 2003) Olmstead, et. al., vs. The FederalTrade Commission, Supreme Court of Florida. Case No. SC08-1009 June 24, 2010).
What does this mean? As distinguished from a mere charging order, which allows a creditor to only reach actual distributions to a debtor-partner, a foreclosure of a limited partnership interest is a powerful remedy. In states other than California, case law and ambiguities in the interpretation of existing laws make a reliance on the charging order protection speculative and, therefore, dangerous. Even when the state where the partnership is formed specifically bars foreclosure, rules regarding jurisdiction may dictate that the law of the plaintiff ’s home state may control the applicable law. In other words, there is no guarantee that a lawsuit against you will end up in a state with favorable laws. Many factors are considered by the courts in determining jurisdiction and the applicable law.
Use of the proper terms in the FLP and limited liability entities as general partners can increase the protection here and the FLP may still be a valuable tool for asset protection. It merely requires that the proper steps be taken to ensure that ownership of the FLP has been correctly established from the beginning so that neither a charging order nor a foreclosure can be applied and the goal of asset protection will be accomplished.
Estate Tax Benefits and Children as Owners
A transfer of ownership of the limited partnership interests to a child or children may provide one good solution both for asset protection and estate tax planning. A lawsuit against Husband and Wife would not impact the partnership interests because ownership is no longer in the name of Husband and Wife. Although Husband and Wife may retain management powers, directly or indirectly, over the assets as general partner, there are no limited partnership interests available for the plaintiff IF Husband and Wife do not own such interests or only own a small amount. Husband and Wife have effectively protected assets by gifting the limited partnership interests to their children.
The disadvantage is that a direct gift to the children in this form may create gift tax liability, depending upon the amount involved. Most families use the lifetime exemption or the annual exemption to slowly but surely transfer more interest to the children over the years. In that way, a couple can give in excess of twenty thousand dollars worth of interest to the children tax free each year, up to millions if they wish to use the life time exemption. The asset will no longer be in their estate upon death, any appreciation is no longer part of the estate and thus savings in estate taxes is achieved. With the right FLP, they still maintain effective control of the property and decide distributions and use.
But note that the children have legal rights as limited partners, which must be respected. The gift to the children is a completed and real gift under this arrangement, so assets in the FLP must be those which Husband and Wife are willing to part with, a matter which requires serious consideration and planning. Those in a position to make an irrevocable transfer to their children may accomplish good asset protection and possibly advantageous estate tax savings with this strategy.
When real property is transferred into the FLP as part of family gifts, the property must be appraised to determine its value as a gift. Here is the major advantage of using an FLP to save estate taxes since the gifts can be heavily discounted being a minority ownership in a non liquid asset, and typically the value of the gift, hence the gift tax amount, is discounted by twenty, thirty or even forty percent. Too high a discount can lead to an audit and it is wise to spend the money for an appraiser to create a formal written analysis to justify the discounted amount. This can cost many thousands of dollars-but can save far, far more.
You should note that the Family Limited Partnership, like all tax planning strategies, is likely to be attacked by the IRS if the requisite formalities are not properly followed. Although Congress has rejected attempts by the Administration to eliminate these benefits, those who claim highly aggressive discounts or establish the FLP in near death circumstances can anticipate some level of opposition. As a general rule, if you are using the FLP to achieve estate tax savings, make sure that:
- A credible appraisal is obtained to support the amount of the discount which is claimed.
- The documents are properly drafted.
- There is a sound purpose for the plan other than mere tax avoidance (such as asset protection or privacy).
Income Tax Benefits
If family assets are held in the form of a limited partnership, it will be possible to obtain certain income tax savings in addition to the asset protection benefits. Tax savings can be realized by spreading income from high tax bracket parents to lower tax bracket children and grandchildren or other family members
Since the partnership is a “pass through” entity, there is no potential for income tax on it. Unlike corporations and irrevocable trusts, a partnership is not a taxpaying entity. A partnership files an annual informational tax return setting forth its income and expenses, but it does not pay tax on its net income. Instead, each partner’s proportionate share of income or loss is passed through from the partnership to the individual. Each partner claims his or her share of deductions or reports his share of income on his own tax return.
This avoids the potential for double taxation that is always present in a C Corporation. Typically, when a business is expected to show a net loss rather than a gain, the partnership format is used so that the losses can be used by the partners. Limited partnerships have always been used for real estate and tax shelter investments in order to pass the tax deductions through to the individual investors. These losses are then used by the partner to offset other income he might have. Although the Tax Reform Act of 1986 now limits the ability to immediately deduct losses from “passive activities” to offset wages or investment income, the partnership format may still be desirable if the circumstances of the individual partner are such that he is able to take advantage of these losses.
The rules regarding the taxation of partnership activities are lengthy and cumbersome. As a general rule, however, transfers of property into and out of a partnership will not ordinarily produce any tax consequences.
Conclusion
The complexity, formality and record keeping required to create and maintain a FLP are not incidental. Nor is the cost minor. A typical structure with FLP, limited liability company for the general partner, additional tax returns and guidance can easily cost in excess of five thousand dollars to create and, if other complexities occur, closer to ten thousand dollars.
The savings can be substantial and if estate and income tax rise as all predict, the savings for a five million dollar estate can approach a million dollars when all is said and done. Perhaps more if taxes truly escalate.
This is not a structure for everyone but a very valuable option for those with families to protect, assets in excess of three million dollars, and an expectation of increasing taxes over the years.