FAMILY LIMITED PARTNERSHIPS IN ESTATE PLANNING

FizerBeck
Fizer, Beck, Webster, Bentley & Scroggins
a professional corporation
1330 Post Oak Boulevard, Suite 2900
Houston, TX 77056-3022
713-840-7710
www.fizerbeck.com
 

1. INTRODUCTION

   There has been increasing interest over the last few years in the use of limited partnerships as an estate planning tool. The unique status that limited partnerships occupy under state law, and the flexibility afforded partnerships in the income tax area, make limited partnerships an attractive device in many family planning situations, particularly as a vehicle for the ownership of family assets. Limited partnerships can be structured to provide administrative convenience, income, estate and gift tax benefits, as well as a measure of asset protection. This outline discusses the basics of family limited partnerships and describes some of their benefits in estate planning.

2. LIMITED PARTNERSHIPS IN GENERAL

   A limited partnership is formed by filing a certificate with the Texas Secretary of State and entering into a limited partnership agreement among the partners. At least one general partner must be designated to accept personal liability and manage the affairs of the partnership. The limited partners must agree to take no active role in the day-to-day management of the business of the partnership. By doing so, the "limited" partners will be protected from personal liability for the actions of the partnership. The liability protection afforded to limited partners is similar to the protection afforded the shareholders of a corporation. However, unlike corporations, limited partnerships are pass-through entities for federal income tax purposes and are potentially exempt from state gross margin taxes if 90% of the income is “passive” as more fully discussed below.

3. FAMILY LIMITED PARTNERSHIPS

   A "family limited partnership" is simply a limited partnership in which all or substantially all of the partners are family members. Family limited partnerships are commonly used to achieve a variety of business and tax objectives.

1. Common "Business" Reasons for the Formation of a Family Limited Partnership.

   It is important that a family limited partnership be formed for valid business purposes and not merely to reduce estate and gift taxation. Some of the more common "business" purposes are discussed below.

1. Avoidance of Co-Tenancies.

   Direct gifts or bequests of interests in family assets, even in trust, can create co-tenancies among family members and trusts. Over time, these co-tenancies can expand to involve more and more co-tenants. This often leads to frustration in decision making, keeping up with the investments for multiple investors and trusts, and dealing with undivided ownership of real estate, oil and gas properties and other assets. For example, real estate owned in a co-tenancy would require the unanimous agreement of all parties to sell the property. A family limited partnership would permit the investments to be consolidated into one partnership, thereby providing for a formal decision-making mechanism and avoiding a multiplicity of investment accounts and co-tenancy. Also, consolidation into the partnership may allow a family investment portfolio to be professionally managed by achieving minimal investment amount levels often required by professional money managers, which otherwise may not be reached because of the multiple accounts caused by separate trusts or co-ownership.

2. Simplification of Gifting.

   Many assets, particularly real estate, are not susceptible to being easily divided into multiple shares for purposes of gift giving. Additionally, breaking up the family assets into small pieces for gift giving fragments the assets leading to some of the management and co-tenancy problems discussed above. These problems can be solved through the use of a family limited partnership, since gifts of fractional partnership interests are easily made. Each donee simply receives a fractional partnership interest, but the underlying assets remain consolidated. Often a limited partnership will be preferable to a trust as a vehicle for making gifts because limited partnership agreements are more flexible than irrevocable trusts, which are difficult, if not impossible, to amend. Also, as discussed below, in a limited partnership the donor, as general partner, can maintain control over the partnership, which would not be possible in a trust without the trust being taxed to the grantor.

3. Centralized Management of Family Assets.

   The nature of a limited partnership is that the management is consolidated in a general partner or partners. The limited partners may not participate in management. Accordingly, a family limited partnership allows the general partner to control the partnership and its assets, while at the same time effectively transferring indirect ownership of portions of the assets to second and third generation family members who are limited partners. Additionally, the general partner will have the power to control distributable cash flow of the partnership. For example, the general partner could choose to reinvest significant portions of the earnings of the partnership into new investments, or reinvest in a family business. Recent court decisions have called into question the amount of control that can be vested in the senior generation. Unless and until these cases are overruled, caution should be exercised in the control rights of the senior generation; and it may be advisable in certain situations to permit the junior generation to control the general partner interests in a family partnership, and/or to severely restrict discretionary distributions.

4. Transition of Power upon Death of Senior Generation; Avoidance of Family Disputes.

   Texas partnership law allows for great flexibility in drafting a limited partnership agreement, so that it can be tailored to fit the specific needs of a family. This flexibility allows for provisions directing how the partnership will be managed after the death of the senior generation. For example, the agreement could provide for an automatic succession upon the death of the primary general partner, for succession to be determined by a vote of the remaining general or limited partners, for a designated "manager" to take over upon the death of the patriarch, or a variety of other possible provisions. Also, a limited partnership agreement can be drafted with a provision which requires the partners to settle disputes by arbitration. In many situations, arbitration will be preferable to jury trials between family members. Often arbitration will be quicker, less expensive, and the dispute will be resolved by an arbitrator who is an experienced business person, rather than a judge and jury.

5. Keeping Family Assets in the Family.

   Under Texas partnership law, a transferee of an interest in a limited partnership becomes an "assignee" of that interest unless and until expressly admitted as a partner. An assignee is not a partner and has no voting rights. An assignee's only right is to receive the transferor's share of partnership distributions if and when the general partner decides to make a distribution. Therefore, the very nature of a limited partnership restricts the transferability of the partnership interests and thus the indirect ownership of the assets. Additionally, family limited partnerships can be drafted with buy/sell provisions which further restrict transferability of the partnership interests. The partnership agreement will generally provide that the other partners or the partnership will have the right to purchase any partnership interest sought to be transferred outside family before the interest can be so transferred.

6. Protection from Future Creditors of Partners.

   A creditor who attaches a partner's interest in a limited partnership does not become a partner and cannot vote or cause the dissolution of the partnership. Rather, the creditor becomes an "assignee" of the partnership interest. As an assignee, the creditor's only right is to receive distributions from the partnership at such times and in such amounts as the general partner may determine. On the other hand, an assignee's share of the partnership's income is taxable to the assignee, regardless of whether such income is actually distributed. As a consequence, a creditor may find itself in a situation where it must pay tax on income that it cannot reach. This exposure may deter a creditor from seeking to attach a partnership interest or may encourage a creditor to make a favorable settlement.

7. Protection of Family Assets upon Divorce.

   An interest in a family partnership given to a child or grandchild should be separate property and not susceptible to much dispute over characterization. Use of a family limited partnership also simplifies characterization issues and avoids complicated tracing problems as family assets are bought and sold over the years. Additionally, the partnership agreement may provide that an involuntary transfer, such as a divorce court award, may be subject to the buy/sell agreement so that the partnership interest can be purchased by the other partners, or the divorced partner, at its fair market value, if the interest should be awarded to the "non-family spouse."

8. Pass-Through Income Tax Treatment.

   A limited partnership is a "pass-through" entity for federal income tax purposes and generally may be terminated without adverse income tax consequences. This contrasts to the often severe income tax consequences that may result on the termination of a corporation.

9. Simplification of Probate.

   The assets held by a family limited partnership will not be part of the decedent's probate estate; rather, the decedent's estate will include the partnership interest. Thus, a lengthy probate inventory can be avoided and a greater degree of confidentiality achieved. As discussed below, this may be particularly important in the area of real property.

10. Facilitation of Post-Death Sales of Real Estate.

    When an estate is selling real property, title companies routinely require "IRS closing letters" before the title company will insure a clear title to a buyer purchasing property from a decedent's estate. This often means that property cannot be sold out of a decedent's estate for a considerable period of time following the date of death, until the IRS audit procedures can be cleared and a closing letter obtained. On the other hand, if real property is held in a limited partnership that does not dissolve upon the decedent's death, the typical title company requirement for a closing letter would not apply and the property should be available for immediate sale.

2. Tax Objectives in Forming a Family Limited Partnership.

   If a limited partnership can be formed for valid business reasons, a valuation "discount" may be available for partnership interests for federal estate and gift tax purposes. Due to provisions of the Texas Business Organizations Code and restrictions contained in the partnership agreement, and depending on other facts and circumstances, the value of the limited partnership interests may be "discounted" as compared to the underlying value of the partnership's assets. The value of an asset for estate and gift tax purposes is its fair market value; that is, what a willing buyer would pay a willing seller for the asset in an arms-length transaction. In a limited partnership, no limited partner would have the right to compel the liquidation of the partnership at any time prior to the expiration of the stated term of the partnership (which would be a considerable period of time, such as 50 years). Also, the partnership agreement generally would not guarantee any specified cash flow to a partner. Limited partners have very limited voting rights, and the limited partnership interests would generally lack marketability. Therefore, a third-party purchaser generally would not be willing to pay a price for a limited partnership interest that would equal the pro rata value of the underlying partnership assets. Rather, the price would be discounted substantially due to the foregoing considerations. Congress has legislated in this area with IRC §§ 2701-2704. These Code sections limit the availability of a discount under certain circumstances. However, in most cases a family limited partnership can be structured in such a manner which accomplishes the family's business objectives and still maintains the possibility of achieving at least some valuation "discount" as compared to the liquidation value of the underlying assets.

3. Texas “Gross Margins” Tax.

   Corporations, limited partnerships and other liability protected entities are subject to the Texas gross margins tax. In a nutshell, the margin tax starts with a taxable entity’s (or affiliated group’s) gross receipts, and deducts either (x) certain compensation or (y) cost of goods sold. The tax rate is 1% for all taxpayers except a narrowly defined group of retail and wholesale businesses who pay a .5% rate. An affiliated group must choose the deduction it will use for the entire group. A group’s tax base is apportioned to Texas using a single-factor gross receipts apportionment formula with no throwback rule. There is a safety net so that the margin tax base may not exceed 70 percent of a business’s total revenues. An entity with gross receipts of less than $300,000 pays no tax. Additionally, the 2007 Texas Legislature amended the tax to create discounts for taxable entities with total revenue of more than $300,000 but less than $900,000, as follows:

• 80% discount for entities with revenues equal to or more than $300,000 and less than $400,000

• 60% discount if $400,000 or more, but less than $500,000

• 40% discount if $500,000 or more, but less than $700,000

• 20% discount if $700,000 or more, but less than $900,000.

Limited partnerships are exempt from the gross margins tax only if 90% of the income is “passive.” Rent is not defined as “passive” income, but dividends, interest, capital gains and royalties are passive. Other entities, such as corporations and LLCs are not eligible for passive treatment.

4. COMPARISON WITH OTHER ENTITIES

   There are various other legal entities which may be used to own family assets and businesses. Traditionally, corporations and trusts have been used for various purposes. In many cases, the combination of one or more of these other entities and a limited partnership may make sense.

1. Corporations.

   Corporations are separate legal entities formed by filing a charter or "Articles of Incorporation" with the Secretary of State. The business owners (shareholders) transfer cash or assets into the corporation in exchange for stock. As a general rule, the corporation, and not its owners, is liable for debts incurred in the course of its business. A corporation is governed by a board of directors elected by the shareholders. Corporations are separate taxable entities and pay state franchise taxes in addition to federal income tax. Corporate dividends are taxable to the shareholder, but not deductible by the corporation, resulting in "double taxation" of dividends. An exception to this rule is made for "S corporations," which are discussed below. All corporations are subject to gross margin taxes in Texas, and are not eligible for “passive” treatment.

2. S Corporations.

   For state law purposes, "S corporations" are just like any other corporation. However, for federal income tax purposes S corporations are not themselves taxed. Rather, shareholders pay tax on the corporation's income as though it were distributed to them. In order to be an S corporation, the corporation must have 75 or fewer shareholders, all of whom are individuals, trusts containing special provisions or certain tax-exempt organizations. In addition, the corporation must maintain a single class of stock (which can be divided into voting and nonvoting stock). Beginning in tax year 1992, an S corporation may own more than 80% of the stock of a C corporation and may own 100% of the stock of another S corporation.

3. Professional Associations and Corporations.

   For certain professionals (such as doctors, lawyers, and accountants) state law provides an exception to the rule that owners of corporations are not liable for its debts. In general, a licensed professional who forms a professional corporation or association cannot avoid liability for his or her own professional misconduct. Thus, a malpractice claimant can reach the assets of the professional corporation or association, and also reach the personal assets of the professional that committed the malpractice. In a general partnership, however, the same claimant could reach not only the personal assets of the negligent professional, but also the personal assets of his or her partners.

4. Limited Liability Companies.

   In 1991 the Texas Legislature enacted the Texas Limited Liability Company Act, making Texas the eighth state to allow a business to organize as a limited liability company ("LLC"). LLCs are formed in a manner similar to corporations. LLCs are governed by members who (like corporate shareholders) are not generally liable for the debts of the LLC. LLCs are afforded "pass-through" tax treatment similar to S corporations and partnerships. However, LLCs do not have severe restrictions on the identity of owners, classes of interests, and other matters. LLCs are subject to gross margin taxes in Texas, and are not eligible for treatment as “passive” entities.

5. Trusts.

   Trusts are a form of asset ownership whereby a legal entity (the trust) is set up to hold title to assets for the benefit of one or more persons or entities (the "beneficiaries"). The creator or "grantor" of the trust transfers assets to a "trustee," who is charged with handling the assets as instructed by the grantor for the benefit of the trust's beneficiaries. As a general rule, trusts are taxpayers, but they are entitled to deduct from income amounts paid to beneficiaries during the year. The beneficiaries must report the amounts so deducted as income. Thus, tax is paid only once, either by the trust or by its beneficiaries, depending upon the amount of distributions made by the trust. If a grantor retains a right to income, a reversion, or undue administrative controls over the trust, all income of the trust is taxed to the grantor regardless of whether it is retained by the trust or distributed.

6. General Partnerships.

   Under Texas law, a Texas partnership is formed whenever two or more persons join together for the purpose of obtaining a profit. No formal written agreement is required. Each partner is personally liable for all the debts of the partnership. This liability extends to partnership loans or other contracts, and to "torts" or injuries committed by any partner in the course of partnership business. Partnerships are pass-through entities for tax purposes and are not subject to state franchise or “gross margin” taxes in Texas as long as all partners are individuals.

7. Limited Liability Partnerships.

   A limited liability partnership ("LLP") is a general partnership where the partners file a formal election with the state to be treated as a LLP and pay an annual fee ($200 per general partner) so that each partner will not be personally liable for the negligence of each other partner. For other debts, however, joint and several liability for partnership debts remains in effect. Limited partnerships also may elect to be treated as a LLP, thus creating a “limited liability limited partnership.” The purpose of such an election for a limited partnership would be to attempt to limit the liability of the general partner of the limited partnership. LLPs are subject to gross margin taxes in Texas.

5. CONCLUSION

   The foregoing outline gives a broad overview of the structure of family limited partnerships and their uses in estate planning. In many situations, a combination of corporations, trusts, and a family limited partnership may be appropriate. For example, it may be preferable to run an operating business as a corporation to compartmentalize liabilities associated with that business in the corporation. The stock of the corporation, however, together with family real estate and other family investments may be held in one or more limited partnerships. Trusts for children and grandchildren may participate as limited partners in the limited partnership(s). Of course, whether a family limited partnership is appropriate in any given circumstance depends upon the goals of the particular family, the relationship of various family members, and the nature of assets held by the family. In proper circumstances, the use of family limited partnerships should be considered for the potential benefits of providing administrative convenience, potential income, estate and gift tax reductions, and creditor deterrence.