The Family Limited Partnership

Although it's been around, and used for the purposes discussed, for a long time, this technique is getting increased attention. It's a way to reduce gift and estate taxes while maintaining overall control, and to protect your assets from the claims of creditors as well.

Basics of Limited Partnerships

In a usual partnership, all partners are general partners. Each is responsible for the debts of the business -- totally. One person, who may have a 1% stake in the business, could be sued by creditors if the business went bust. They could recover all the debts from him personally. He'd have a right of contribution from his partners -- but if they couldn't be found, or were themselves bankrupt -- tooooooooo bad. Furthermore, from an outsider's standpoint, every partner has apparent authority to enter into contracts and bind the partnership. This can make the key partner -- the manager -- nervous.

Enter the limited partnership. Like the corporation, it is a creature of statute because it's an exception to the general rule, and the rules must be complied with. If it's done right -- X can put in $10,000 -- and be limited in his loss. If the business goes bad, he may lose everything he's put in -- he may even lose more if he's voluntarily signed notes, etc. -- but he knows the extent of his risk. He cannot lose more than he's agreed to put in. The rest of his assets are safe.

In exchange for this safety, he's given up the right to have any say in the business, and the right to apparently represent the business. He is strictly an investor. The actual running of the business is done by one or more general partners. They are the ones responsible for business debts. For them, the normal partnership rules apply. It has served as a way to raise money for their activities (running a grocery, operating real estate, having a stock portfolio, etc.) while retaining control.

The partnership agreement will spell out the respective rights of the parties, including their respective interests in profits and in liquidation. It may say that the limited partners put in 99% of the money and get 95% of the profits, and 98% of the proceeds on liquidation. It usually restricts the ability to transfer interests.

The partnership may show a profit -- but that doesn't put money in the partners' pockets. The general partner can usually decide how much to distribute, or how much to hold back for the needs of the business.

From a tax standpoint, the partnership is a conduit. Each partner is taxed on his share of the income, whether or not he received it.

A family limited partnership has no special legal nature. It is simply a partnership whose members happen to be family members. It is governed by the same rules as other limited partnerships. In the past, it might have been used to give kids a stake in the farm, or in investments, without letting them interfere in the management.

With that background, let's look at two uses that have gotten current popularity.

The Discount Partnership

John comes to you with a great offer. A limited partnership has been formed. His cousin Harry is the general partner. Several family members have put in contributions. The partnership has $1,000,000 of cash. Not land. Not stock. Not even bank accounts. $1,000,000 of green paper. John has a 5% partnership interest. But he got carried away when he put in so much -- he really needs the money for other needs. Would you buy a 1% interest for $10,000? You think about it -- a 1% interest in $1,000,000 of cash. That's certainly worth $10,000.

But you discuss it with your lawyer who points out:

You have no way of getting at that cash unless the partnership is dissolved, and you can't force a dissolution. That cash might be invested in Arizona swampland next week -- you have no say over what is going to happen.

Even if it's invested in a good operation and makes money -- you may not see the profit if the general partner decides to hold on to it. But you'll be taxed on it.

If you want to re-sell your interest, the partnership agreement restricts your right to transfer or sell to outsiders.

Does it still look like such a reasonable deal? Are you still interested in paying $10,000 for that 1% interest in $1,000,000 cash? Or, if you're interested at all, would you offer a lot less to reflect the risks and problems?

This, simply put, is the heart of the interest in limited partnerships -- that no willing buyer would in fact pay a percentage of the underlying value without getting a sharp discount. And so if John dies owning that partnership interest, or makes a gift of it, its value for tax purposes would be sharply reduced. A good estimate would be 20-50% discount from underlying asset value. And this discount is not a trick -- it's for real problems. John's asset is simply worth less than it appears.

Of course, one might say that it's illusory because he's not really at the risk of the general partner. Suppose John himself were the general partner? The problem really wouldn't exist. And no discount would be allowed -- in his estate. But if he gave some away -- the recipient of the gift doesn't have that control, so a discount would be available for gift tax purposes on that interest. Suppose the partners were John and his wife? Already, the degree of control is slipping. And while family members may feel absolute trust in each other and not worry about the risks -- the buyer of that interest isn't a family member and can't count on the love of the general partner.

Okay, how do we use it?

You form a limited partnership to own most of your investment assets. With many variations, the General Partners can be you and your living trust, or you and your spouse, both, etc. The general partners may own perhaps a 2% interest in the partnership. 1% is owned by an unrelated trusted outsider (who has the power to prevent liquidation -- therefore you and your family cannot liquidate and remove the restrictions). The balance is owned by you (or you and spouse, etc.) as limited partners.

Now, if you give away those limited partnership interests, they are valued at a discount.

For estate tax purposes, you should have at least one other General Partner (e.g. your spouse) to make a case for a discount on your limited partnership interests.

In recent years, Congress has taken at least one step against this. 2704(b)(2) of the Internal Revenue Code now provides that, in valuing interests, I. R. S. may disregard restrictions on liquidation which may be removed by the family. And so it is desirable to have a non-family member whose consent is required for dissolving the partnership. Furthermore, some recent proposals would change these rules.

Asset Protection

Suppose, before John is able to sell his limited partnership interest, a creditor sues him, gets a judgment and starts to collect. He levies on John's bank account and gets that turned over to him. He levies on John's stock, gets that turned over to him, and sells it to raise cash. He levies on John's limited partnership interest -- and that's when problems start. Even if he could get the partnership interest turned over to him, he'd have a heck of a time selling it for cash (see above). But he can't even get that far. Under the terms of the Uniform Limited Partnership Act, the only remedy of a creditor of a limited partner is a charging order. This is a right to receive distributions if, as, and when the general partner makes them. The creditor may not see any distributions. Neither might John if the creditor hadn't acted. But John would have been taxable on his share of partnership profits, even if he didn't receive them. Once the creditor gets his charging order, he stands in John's shoes tax-wise. He may receive taxable income without distributions.

Now suppose the same thing happens to Harry, the general partner. The creditor doesn't focus on the limited partnership interest -- he focuses on the general partnership interest. By getting that, he creates possible distributions. And so the bulk of the documentation is designed to protect from levy on the general partnership interest. We use a corporate general partner to bring in more dilution. We spread the stock around. We have a buy-sell agreement that's triggered by creditor action. And even if the creditor were somehow to get ownership of the stock -- he'd find that there's a shareholder voting agreement requiring him to vote for you and your spouse as directors, to elect one of you as president. In control of the corporation, you can get some money out as payment to the corporation for management, then out to you as salary (subject to 15%wage deduction, which isn't as bad as asset levying).

The key is to understand that this is a tool, not a cure-all. It depends on your not needing the money in the partnership, so you can outwait the creditor. I talked one lottery winner out of such a partnership -- he needed the distributions. It wouldn't provide much protection. But as long as they are assets which are there for security -- which you don't personally need in the near future -- you can afford to not distribute. And therefore the creditor ultimately says "can we talk?" and is open to settlement.

Weaknesses? To some people, it's just a "gimmick" which may get changed. But it's not that unusual. Realize there are some states with unlimited homestead exemptions -- people have been known to pour their assets into a million dollar house just before declaring bankruptcy. The "gimmick" works. Similarly, homes may be in tenancy by the entirety which are protected from levy of the creditor of one spouse.

There is a potential attack. The Fraudulent Conveyances Act enables the undoing of transfers designed to hinder creditors. While I'd be willing to defend on that if necessary (this isn't a transfer, it's a change of investment), you're far better off to avoid it. And the best way to avoid it is to have a balance sheet which shows that when you did it, you were fully solvent and had no outstanding claims.

Conclusion

Both of these uses (discounts for estate tax reduction and asset protection from creditors) require major professional planning and implementation. Don't blow a major step by getting unqualified help.

"Crummey" Powers Aren't Crummy 

Did your advisor blithely toss off technical terms and leave you wondering why you should pay them to draft a trust with "crummy" powers? They meant "Crummey" and thereby hangs a tale.

Very broadly, you may exclude from taxable gifts, gifts of up to $10,000 per person per year. However, that exclusion does not apply to gifts of "future interests". While outright gifts qualify, most gifts in trust are future interests and ordinarily wouldn't qualify for the exclusion.

Enter a brilliant attorney in California, who was drafting a trust on behalf of his clients, the Crummeys. He provided that, when the made gifts to the trust, their children would have the right to withdraw such gifts for a period of time. After that period, if they did not exercise such right, it would lapse and the property would remain in trust. After losing a court battle, the IRS conceded that such gifts would constitute present interests and qualify for the exclusion. This enables people to make non-taxable gifts in trust without giving their children early access to the money.

Over the years, the rules have evolved and become definite, although there are still areas in dispute.

The gift can be to a minor, who doesn't really have the power to act, as long as some adult (guardian, parent, etc.) has the power to make withdrawals on their behalf.

The beneficiary (or person on their behalf) must be informed of the gift and their right. This is usually done by giving them notice. In a private ruling, IRS has taken the position that they must be given notice each time -- that they cannot waive the right to notice. I disagree.

There may be no prearranged understanding that the beneficiary will not exercise their withdrawal power. IRS has argued that if remote beneficiaries don't exercise their powers, it is evidence of a prior understanding. The courts have disagreed.

Although excluded from the gift tax, such gifts do not qualify for exclusion from the Generation Skipping Transfer Tax . In such case, annual non-taxable returns may be filed to apply the exemption to the gifts, sheltering hopefully greater amounts that it will grow to.

The latest legislative proposals would deny this exclusion from gift tax.

Nothing is ever simple. A parent may give a child a lapsing right to withdraw $10,000 and exclude the gift from the parent's tax base. However, if the child allows to lapse a withdrawal power greater than $5,000 or 5% of the trust, *the child* makes a taxable gift. In order to minimize taxes at all levels, good planning and drafting takes these limitations into account.

Crummey powers are particularly useful in the case of irrevocable insurance trusts. They enable one to pay for tax-free insurance without using up one's lifetime shelter.

Give the Advantages of Trusts 

I'll give you a choice.

I'll give or leave you $1,000,000 (remember, this is all hypothetical for illustration purposes only!).

You can have it in your own pocket. At your death, it will be subject to estate tax. If you have marital problems, your spouse may have a claim on it. If you run into financial troubles, your creditors can go after it. If your kid has an accident while driving your car, the injured parties can go after that money.

Alternatively, I'll put it in trust. It's not yours. It can pass tax-free at your death. Your creditors can't get at it. If you have financial losses, it's there to give you a fresh start.

Which would you prefer? And which would you prefer to provide for your beneficiaries?

Well, you may respond, granted that a trust doesn't have some of the disadvantages (which you hadn't realized existed) of owning the money directly, are the *benefits* comparable? It doesn't do any good to keep the money away from IRS or creditors if it can't be affirmatively used for the beneficiary.

Aside from a QTIP deducted by one spouse and included in the survivor's estate, a trust created by A will only be included in C's federal estate if C is given a general power of appointment. No other restrictions on C's power are required for federal tax purposes. A may want to put on other restrictions for non-tax purposes (see Introduction to Trusts), but they are not required to avoid taxation.

A beneficiary can have:

all the income for life (for various reasons discretion is better);

principal as the trustee determines necessary for their health, education, maintenance and support;

be, or have the right to name, the trustee who determines what is necessary for their health, education, maintenance and support;

principal as the trustee determines necessary for their "best interests";

have the right to name [including broad power to change, but not be themselves] the trustee who determines what is necessary for their or their dependents best interests;

have a "quasi-general" power of appointment -- a right in life or at death to appoint to anyone other than themselves, their estate, their creditors, or the creditors of their estate;

all of this without inclusion in their estate.

On the other hand, a trust could be created in which B, the trustee, has complete discretion whether to pay any income or principal to the beneficiary, with the beneficiary having no say at all.

And these differences can be varied over time and circumstances.

Now let's look at the real-life practical consequences of giving a beneficiary a "quasi-general" power of appointment and making them trustee.

The trust will not be included in C's estate when he dies. It will not be subject to the claims of his spouse upon divorce, and it will not be subject to claims of his creditors.

Does he want a house? The trust can buy a house for him to live in, still without putting it into his name.

In many cases, a beneficiary can benefit without ever taking a dime from his trust. Think how much saving is done as protection from a "rainy day". But how much more can you afford to spend, how much can your living standard be increased, if you know there's an umbrella in the closet?

Suppose C insists on getting money out of the trust, other than regular distributions. She can appoint part or all of the trust to another trust for Y (if it were outright, then Y would later make a taxable gift), whom she trusts to then appoint to her. And if she's hesitant about Y, she can appoint 10% to Y, and only appoint the next 10% after Y has acted.

Remember that C can have a power to appoint to himself if it's for his health, education, maintenance and support. Theoretically if he exceeds those standards D can sue to stop him. Now suppose D comes to C and says "Dad, grandpa A [or Mom, Dad] said that you could use the trust for your health, education, maintenance and support. I really don't think that includes monthly trips to Acapulco."

To which C replies "you may be right, son. You might be able to sue to stop me from that spending. Just remember that I decide who gets what's left at my death. Now [assuming three children] -- do you want 1/3 of the pie that's left after my trips, or none of a large pie without trips?"

From this concept, you can play continuing variations. If, for non-tax reasons, you want more restrictions on the beneficiary, you can give those powers to outside trustees who can provide similar benefits without giving control to the beneficiaries. And the shadings are innumerable.

The real limitations are not legal but human. You cannot give a beneficiary virtually unlimited control -- and try to restrict them. Are you afraid they'll give some to their spouse rather than their descendants (your descendants)? Then you have to tie them up, restrict their powers of appointment, and face potential resentment from them. If you want to go through that, there are ways to find intervening points.

Tax-Oriented Planning Steps

There are some planning techniques which can only be used by married couples. On the other hand, there a techniques which are useable by both married couples and individuals. Sometimes the latter seem to be ignored in the focus on explanations of the former. I've highlighted the latter group with **.

The First Level of Planning

Assume Mary has $1,500,000 in various assets. If she leaves everything to her husband, Roy, her estate can deduct it all and pay no Federal Estate Tax. Roy now has an estate of $1,500,000. When he dies, his estate will pay a tax of $320,250. (For the sake of ease, we'll assume Roy has no assets to start with, ignore potential growth or diminution, and ignore the increasing shelter equivalent -- all of which can change the particular numbers but not the overall effect).

Mary can achieve a zero tax at her death by leaving Roy only $825,000. There will be no tax due on her $675,000 estate. The tax at Roy's death will be reduced to $57,000.

This is the most basic step of tax planning for a couple. In essence we want to keep too much from going to the survivor - at least making sure there is enough going separately to use the shelter. This may mean breaking up joint tenancies, changing beneficiaries, etc.

This is frequently referred to as an "AB trust" arrangement, though practitioners may use different names for the actual trusts or distributions involved.

This basic plan, repeated over and over in thousands of estates, can have thousands of variations that will produce the same numbers. This is where the plan should be tailored to your individual needs and goals, rather than pulled out of boilerplat

Non-Tax Planning **

In what form does that $825,000 go to Roy? In terms of tax planning, that can range from outright to a QTIP trust. That's a non-tax issue.

What happens to that $675,000? It could range from passing immediately to the children (inadvisable in an estate this size) to a trust for the family with an outside trustee to one controlled by Roy (see Give the Advantages of Trusts), available for his benefit, but not includible in his estate. I'll refer to this generically as the shelter trust.

Who gets it at the survivor's death? The descendants? Equal of special provisions? Are they mature enough to handle money or do you need a trust for a period? What ages for distribution? See Introduction to Trusts Rather than outright distribution, consider leaving in controlled trusts. (see Give the Advantages of Trusts)

Mary should probably use a living trust for incapacity protection, with her will leaving her estate to the trust. Whether the trust should be funded to avoid probate is a separate question

Equalize Estates

The previous plan works fine if Mary dies first. But what if Roy dies first? Mary's estate no longer gets a marital deduction, but pays a tax of $320,250. Roy's potential shelter is unavailable. If acceptable to the parties, some of Mary's assets could be given to Roy so he could leave them to a shelter trust for Mary if *he* died first. (Actually "equalizing" is too broad -- the important thing is that each have the shelter amount -- in larger estates, enough for the GSTT exemption)

Next -- Move Insurance **
If, after an AB arrangement to use both credit shelters, a couple or an individual still faces potential estate tax, the next consideration should be to remove life insurance from taxation with an irrevocable insurance trust

Use a QTIP for GSTT Planning
I favor leaving your estate to your children in trusts which they control rather than outright. Among other things, this avoids estate tax. This leads to potential Generation Skipping Transfer Tax. An estate this size will fit within the exemption without special planning, but as it gets larger we need special planning steps. A QTIP can maximize the exemption available.

Reduce Values **
Tax is based on numbers. We've been adding steps as the size of the estate increases. But what if we can reduce the value of the estate? A family limited partnership has become very popular as a means of reducing the value. A $3,000,000 estate might be reduced to a taxable $2,000,000 estate and worked from there. There are other tools available for value reduction, dependent on circumstances.

Reduce Creditor Exposure **
This probably runs across all sizes of estates, but if you face potential liability risks (your first line of defense is insurance) consider asset protection steps. Again, a family limited partnership is a good vehicle.

Buy Life Insurance **
In an irrevocable insurance trust, of course.

Life insurance proceeds will always be more than you paid in premiums. By appropriate gift tax planning, you can use non-taxable gifts to generate non-taxable insurance proceeds.

If your estate consists mostly of non-liquid assets, you'll need insurance to come up with the liquidity to pay taxes.

But even if your estate was highly liquid, well planned insurance will usually produce more dollars for your family than keeping the money used for premiums, often more than making gifts to the family.

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