Family Partnership

What is a family partnership?

A “Family Partnership” is an entity you set up to maximize the wealth you pass on to your heirs instead of to the IRS or your creditors. The partners are family members or family trusts. The family partnership presents amazing planning opportunities.

What are the advantages?

– You can reduce estate taxes by as much as 35 percent or more.

– You can do much to protect assets from future creditors.

– You have more flexibility to change your mind than in co-ownerships, trusts, or corporations.

What are the disadvantages?

– The amount of the discount remains (or may actually be created) as capital gain that will be triggered upon a subsequent sale of the assets.

– Fees to set up: our fees and appraisal fees.

– Annual cost of preparation of partnership income tax return.

How does the family partnership work?

You typically would transfer some asset(s) to a partnership you form. The partnership, and not you, would then own the asset(s). You instead would own units of ownership in the family partnership. You would then give at least a 1 percent unit to each of your family members. The units could not be sold or otherwise transferred. Outsiders could not purchase or otherwise acquire units without the consent of all family partners.

There are two key factors:

(1) You, as managing partner, may own as little as 1 percent of the partnership units but still control the management of the partnership assets. On the other hand, your family members may own as much as 99 percent of the units but have no control.

(2) The total of the value of all partnership units is less than the total value of the underlying partnership assets. This occurs because an outsider would not pay you 100 cents on the dollar for a partnership unit.

A primary benefit of the family partnership is you can reduce your taxable estate and so reduce the estate taxes your family pays when you are gone. This is done by your carrying out a “planned gifting” program to divest yourself of partnership units by giving them to your family members over time. This will reduce your estate subject to the estate tax, but you, as managing partner, will still control the partnership and its assets.

For gift tax purposes, a partnership unit you give to a family member will be valued after deducting the discounts discussed below. These discounts make gifting a partnership interest more attractive because more value can be passed out of your estate at a lower gift tax cost.

Who are the partners?

You, as trustee of your living trust, are the managing partner of the family partnership and each of your children (or the trustee of a trust for them) is a partner.

Who controls the family partnership?

You are generally the managing partner and so you manage and control the family partnership. As managing partner you decide whether to buy or sell assets and whether to make distributions, especially cash, to the partners.

What determines the discount in value?

The primary advantage of a family partnership is a 1 percent interest in a family partnership is not worth 1 percent of the partnership assets. Thus, the unit you give to a child during your life (or that passes to them at your death) is not worth what you would think is its full value. The reason is “the sum of the parts does not equal the value of the whole.”

The key is how we define “fair market value.” The fair market value of an asset that is gifted during life or passed at death is how much a willing buyer would pay a willing seller. Let us say I put a $300,000 piece of property into a partnership with me owning 80 percent and my children owning 20 percent. The property cannot be sold unless a majority of partners agree. I probably will get most of the partnership income as compensation for my services in managing the property. Moreover, the property may be tied up until the partnership dissolves in 30 years.

I offer to sell you 20 percent out of my 80 percent. Would you pay me $60,000 (20 percent of $300,000) to be a partner with me and my children? You simply would not. Your $60,000 would likely be tied up for years. Would you pay me $1,000? Sure! You would willingly tie up $1,000 to get hopefully $60,000 and more in the future. Hence, the “fair market value” of the 20 percent partnership interest lies somewhere between $1,000 and $60,000.

Studies show that your “average” buyer would be willing to buy and your “average” seller would be willing to sell a 20 percent partnership interest in a $300,000 partnership for about $39,000. This is an $21,000 or 35 percent discount. That is the key.

You can give to your family members a 20 percent interest in a $300,000 family partnership during life or at death and it only uses $39,000 (instead of $60,000) of your gift or estate tax exemption. When you pass away your 80 interest is valued for estate value purposes with the discount at $156,000, instead of the undiscounted value of $240,000. This is a value discount of $84,000!

What is the Disadvantage Relating to Capital Gains?

The discount, however, is a two-edged sword. If we use the example just shown, the $156,000 discounted value becomes the income tax basis of the 80 percent interest. If your children have the partnership sell its $300,000 in assets, the 80 percent interest you had owned would generate $84,000 in capital gain and probably generate about $21,000 in federal and state income taxes. The estate taxes saved are more, about $40,000. Therefore, if your beneficiaries are likely to sell the partnership assets right after you are gone, the partnership may not be so desirable. On the other hand, if the assets will be held and not sold, the result can be absolutely marvelous.

What determines the value of the partnership interest?

First, the assets of the family partnership are valued. Any real estate must be appraised. Next, a business appraiser determines the value of the units of the family partnership. That determination boils down to the business appraiser giving his or her opinion on the discount discussed above. That percentage discount is actually the sum of several: (a) lack of marketability, (b) minority interest, and possibly (c) others, such as limited voting rights. A discount of at least 35 percent appears to be the standard.

How does the family partnership discourage creditors?

Unless the family partnership is set up when current debts are causing serious problems, the family partnership may protect family assets from creditors. The reason is if a creditor obtains a judgment against you, the creditors can generally only seize cash or assets distributed out of the partnership. This is called a “charging order.”

The creditors cannot seize assets of the family partnership, unless it is dissolved. Of course, the partnership is structured so it is dissolved only with the consent of all the partners. The creditor cannot seize your partnership interest and so cannot exercise any rights as a partner. You remain in control as the managing partner. You can choose as managing partner to not distribute partnership profits, and so the creditor with a charging order has the unpleasant result of having to pay income tax on profits the creditor is not currently receiving. This possibility discourages creditors from obtaining a charging order. Therefore, assets in a family partnership, in general, are protected from creditors.

How is the partnership taxed?

The family partnership itself is not subject to federal income tax. Each partner reports his or her proportionate share of partnership income or loss. Therefore, if the partnership’s income comes from capital, such as rental real estate, and not services, you can split income with your family members and take advantage of their possibly lower marginal income tax rates.

Is the family partnership flexible?

The family partnership is much more flexible than a trust or a even a corporation. The partners can at any time amend the terms of the partnership or dissolve the partnership. You are not locked into a predetermined course of action developed before knowledge of changing facts and circumstances.

What does the IRS think of all this?

The IRS obviously is not too happy about the family partnership. The IRS has fought the large valuation discounts. However, they constantly lose in court when the discount claimed is only 35 percent, and so the IRS is beginning to soften its negotiating position in estate and gift tax audits of the family partnership.

Why not use a co-ownership of fractional interests (a tenancy-in-common) instead?

Instead of a family partnership, you could hold assets with your children as co-owners as what is called “tenants-in-common.” As tenants-in-common, you would each literally own an undivided piece of the asset. In some situations, the tenancy-in-common may more easily avoid a “change in ownership” under Proposition 13 with its increase in property taxes. However, most times the family partnership may be structured to avoid such an increase.

A tenancy-in-common generally is not as desirable as a family partnership because the IRS contends the “minority” and “lack of marketability” discounts do not apply to a tenancy-in-common. In addition, the deeds involved in annual gifting are burdensome. Also, you cannot control the entire asset; all the co-owners have to agree to do anything. In addition, the co-tenancy provides no creditor protection.

Limited partnership versus general partnership?

There are two types of partnerships: general and limited. The advantages of a limited partnership are (1) your heirs, the limited partners, have no say in management, and (2) it is harder for creditors to get at a limited partnership interest. On other hand, the advantage of a general partnership is that it does not have to pay the $800 per year state franchise tax that a limited partnership incurs for the right to exist in California.

What assets are appropriate for the family partnership?

The most common assets put into a family partnership are the following:

– real estate;

– other partnership interests (limited or general);

– corporate stock (in a “C”, not an “S” corporation); however, you should not be general partner if the stock is closely held; and

– cash.

The family partnership is not appropriate for the following:

– your home;

– life insurance (an irrevocable trust is best); and

– retirement plans (IRA’s, etc.).

Do some income tax traps exist?

Some transfers to a family partnership would trigger income and so are traps for the unwary. Some of these traps include the following:

– transferring more than 50 percent of the interests of another partnership to the family partnership may cause a “taxable termination” of the other partnership; or

– transferring an asset that has liabilities in excess of its income tax basis will trigger income, most likely capital gain.

Another trap is if the partnership dissolves within five years, you must be careful as to which partner receives appreciated property that had been contributed to the partnership.

Do the property taxes change on real estate?

If you transfer California real estate to the family partnership, you must be careful so as not to trigger a “change in ownership” under Proposition 13 and so increase the property taxes. We can avoid such with proper planning.

How does the family partnership relate to my living trust?

You should generally hold title to your assets as trustee of your living trust. This includes your interests in the family partnership.

Why act now?

If you transfer assets now to the partnership, you can get more assets into the partnership than if you wait and the same assets increase in value in the future. In addition, the IRS has been successful in voiding a valuation discount on a property transferred a short time before death.

How Can I Find Out More?

To learn more about family partnerships, or if you would like a free consultation to learn if a family partnership is right for you, please do not hesitate to contact us at (805) 482-2282, or e-mail us at  KGS@Staker.com.

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