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Personal Trust Administration

Fran M. DeMarisExecutive Vice President

Cannon Financial Institute

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Family Limited Partnerships

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Overview of the Situation• Family owned businesses comprise

around 85% of all business enterprises in North America.

• Family firms account for 50% of the GDP and employ 60% of the U.S. workforce.

• Family owned businesses account for 75% of all new jobs created in the past two decades.

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Overview of the Situation• Family firm performance is greater

when the founding family maintains an ownership stake.

• However, only 12% of family businesses will still be viable into the third generation; 3% to the fourth and beyond

• Thus, the inability to pass the family business on poses a significant national problem.

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Overview of the Situation

• Family Limited Partnerships (FLP) offer many attractive estate planning advantages over most other business forms and transfer devices.

• However, due to the establishment and appraisal costs associated with making multiple transfers of the limited partnership interests, FLPs usually are not recommended unless the parents owning the business have a net wealth in excess of two or three million dollars.

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Overview of the Situation

For those that qualify, an FLP has numerous advantages:

1. The parents can give away wealth and still retain control;

2. Transfers can be made at substantial discounts as compared to the value of underlying assets, thus saving unified credit and gift taxes;

3. Restrictions can be placed on transfers by children; and

4. There is some protection from creditors.

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Establishing a FLP

• To establish an FLP, one must follow the requirements of the state’s limited partnership act.

• Legally, there is no difference between a “Family Limited Partnership” and most other limited partnerships.

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Establishing a FLP• With an FLP, one or both parents serve as the

general partner, owning all but a very small portion of the limited partnership units initially.

• Over time, the parents transfer by gift a significant portion of the limited partnership units to their children.

• If the parents are very wealthy, it is unlikely that the transfer can be accomplished using just gifts covered by annual exclusions alone.

• Therefore, to make this work, the parents will need to use up both of their unified credits, and perhaps even incur some gift taxes.

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Establishing a FLP

• A limited partner cannot take assets from the partnership or otherwise force liquidation of the partnership before its term is up.

• The term is likely to be set at 50 years, however, once both general partners are dead, a vote by the limited partners could liquidate the partnership.

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General State Laws Regarding Set Term Limited Partnerships

• Limited partnerships cannot withdraw before the end of the term and are entitled to distributions only at the term’s end.

• All partners have to agree to dissolution.• If there is more than one general partner,

no general partner can force dissolution unilaterally by withdrawing.

• A general partner may be assessed damages for withdrawing before the end of the term.

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General State Laws Regarding Set Term Limited Partnerships

• A general partner who withdraws early may be entitled to partnership repurchase at its “fair value” minus the damages caused by its early withdrawal.

• If that general partner also owns limited partnership interests, however, those limited partnership interests need not be purchased on a withdrawal before the end of the partnership term.

• Thus, as a result of state law, a limited partnership interest that is to last a set term has a much lower value than its liquidation value since the assignee of the interest may not withdraw until the end of the term.

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General State Laws Regarding Set Term Limited Partnerships

• The only exception would be where the limited partnership interest is owned by a sole general partner, since they then control liquidation.

• If the limited partnership has no termination date, state law generally provides for withdrawal with 6 months notice, and therefore this does not have much effect.

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FLP Costs• Attorney’s fees, depending on the nature of the

business assets, to establish the partnership, • Appraisal fees to establish both the underlying

value and the appropriate discounts• In addition, when partnership shares are

transferred as gifts, an appraisal will again have to be made.

• Annual accounting fees for preparation of partnership returns and K1s that must be distributed to all partners.

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Valuation Discounts

• Valuation discounts play a significant role in why clients want FLP.

• Limited partnership units can be transferred at a significant discount because the units have limited marketability. The business is closely held by just a few owners.

• The owners of limited partnership units have extremely limited control because the general partners manage the partnership assets.

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Valuation Discounts

• One option is to reorganize the business in such a way as to limit the owner’s interest to the capitalized value of its distributable cash flow.

• If this is done, the owner’s only way to get a return from the business is through cash distributions from the business.

• Thus, the owner’s interest is usually worth less than the liquidation value of the business.

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Valuation Discounts

• Because most family businesses reinvest the majority of the earnings in the business, a prospective buyer who does not control liquidation will tend to pay less than a prospective buyer who does control liquidation since that would enable them to access the earnings of the company.

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Valuation Discounts

• The difference in valuation between liquidation value and the capitalized value of the distributable cash flow can be substantial.

• Cases over the last 10 years have found the difference to be between 30-70% depending on the amount of distributable cash.

• Thus, if a client gives up liquidation control the business may be valued at 30-70% less in their estate, possibly enough to enable them to retain the business in the family.

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Appraisals

• Despite numerous attempts by the IRS to disallow discounts in a family setting, it has lost numerous times in the tax court and finally concede the existence of the discounts, provided the client can back them up by creditable professional appraisals using current market date for the discounts.

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Ability to Control Gifted Assets

• In addition to the discounts, the most attractive feature of the FLP is the ability of the donor to retain control over the assets. The general partner maintains all the managerial control over the partnership assets, determining when and whether to make income distributions to all the partners or to reinvest the income into additional assets.

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Getting the Children Involved

• Once the children have a vested interest in the business, they should take a greater interest in how it works.

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Using the Children’s Lower Tax Bracket

• One benefit of the FLP is that it is possible to shift income into the lower tax brackets of the children

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Protection Against Failed Marriages of Children

• One nice protection is that the assets can be held as the separate property of each child.

• The partnership interest is usually clearly identified as the child’s separate property. In community property states, only the community property is divided in a divorce proceeding.

• While everything is presumed to be community property unless it can be traced to a gift, an inheritance, or to property owned prior to the marriage, it should be easy to establish the units as gifts, and therefore, they can stay in the family.

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Limited Asset Protection• If sufficient time has passed, the parent is

generally the only one liable to the creditors of the partnership.

• It is also important to recognize that the “limited liability” available to limited partners can be lost if they actively participate in the business.

• Therefore, a corporation is a preferred organization for a “family business” if the goal is to gradually transfer management and control of the business to the next generation.

• However, a corporation and limited partnership may both be used to maximize the available discounts.

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Loss of Step-Up In Basis on Gifted Assets

• One disadvantage in gifting assets is that the donees (the children) lose the ability to get a step up in basis at the death of the parent of the part of the partnership that was given to the children.

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Example of Application of the Technique

• Dad, Son and Daughter own an undivided 1/3 interest in vacant land in a developing area. The property is appraised at $1.5 million dollars in 2004.

• Dad, Son and Daughter decide to contribute that property to a limited partnership.

• Each receives a 3.33% general partnership interest and a 30% limited partnership interest representing their contribution.

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Example of Application of the Technique

• The partnership term is set at 40 years unless all partners agree to terminate earlier. Each partner has the same pro-rata rights to income and gains and losses. If any general partner attempts to transfer their general partnership interest, that interest will be converted to a limited partnership interest.

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Example of Application of the Technique

• As a result of the partnership terms, Dad’s interest is valued at $175,000 ($500,000 less 65% discount).

• This difference in valuation is not subject to gift tax since it has not transferred to anyone. It is a result of the application of state laws for partnerships.

• Son and Daughter’s shares have likewise been discounted.

• Although none received full consideration for their investment, the expectation of each is that the joint creation of the partnership would generate greater net worth over the long term. This is the business purpose for the partnership.

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Example of Application of the Technique

• Dad, Son and Daughter develop the property successfully and most of the income is retained fro additional development, thus limiting distributable yields to about 3% of underlying asset values.

• Dad dies 10 years later with the partnership assets worth $30 million.

• Fair market value of Dad’s portion, however, is only $3.5 million ($30 million less 65% discount based on low distributable yields and lack of management rights and liquidation rights for another 30 years).

• If Dad had retained the right to liquidate the partnership, his interest would have been $10 million.

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Example of Application of the Technique

• Presumably if a majority of control is retained, a premium would be placed on the valuation of the interest.

• Even if that control ended at death (as a result of the general partnership shares converting to limited partnership shares), the control, and the value thereof, would shift to the remaining general partners which appears to be a transfer for value and therefore a taxable event.

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Four Issues to Reduce Liability and IRS Audit

Potential1. The business interest consideration2. The actual operation and follow-

through on the partnership activities

3. The filing of timely 709s for discounted gifts (no gift tax annual exclusion)

4. Timing -- the sooner, the better.