Your Entity Menu : Part 11

Own Your Own Corporation : Why the Rich Own Their Own Companies and Everyone Else Works for Them
By Garrett Sutton, Esq.

(Page 11 of 11)

Restrictions on Transfer

The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.

Protection from Creditors

Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner. Thus if, for example, you and your family owned three separate apartment buildings, it may be prudent to compartmentalize these assets into three separate limited partnerships, using three separate corporate general partners. If a litigious tenant sued over conditions at one of the properties, the other two buildings would not be exposed to satisfy any claims. Creditors of the individual partners can only reach that person's partnership interest and not the partnership assets themselves. Assume you've gifted a 25 percent limited partnership interest in one of the apartment building partnerships to your son. He is young and forgets to obtain automobile insurance. Of course, in this example, he gets in a car accident and has a judgment creditor looking for assets. This creditor cannot reach the apartment building asset itself because it is in the limited partnership. He can only reach the limited partnership interest, and then only through a charging order procedure; a charging order allows the creditor of a judgment debtor who is in a partnership with others to reach the debtor's partnership interest without dissolving the partnership. Charging orders, which can result in phantom income to the creditor, are not favored by creditors. This is because phantom income is the allocation of a tax obligation to the creditor without the receipt of money to pay the taxes on such income. Not many creditors enjoy paying taxes on an uncollectable debt.

Family Wealth Transfers

With proper planning, transfers of family assets from one generation to the next can occur at discounted rates. As a general rule, the IRS allows one individual to give another individual a gift of $10,000 per year. Any gifts valued at over $10,000 are subject to a gift tax starting at 18 percent. In the estate planning arena, senior family members may be advised to give assets away during their lifetimes so that estate taxes of up to 55 percent are minimized.

By using a family limited partnership, a limited partnership used for the management, and gifting of family assets, gifting can be accelerated with an IRS-approved discount. As discussed, because limited partnership interests do not entitle the holder to take part in management affairs and are frequently restricted as to their transferability, discounts on their value are permissible. In other words, even if the book value of 10 percent of a certain limited partnership is $12,500, a normal investor wouldn't pay that much for it because, as a limited partner, they would have no say in the partnership's management and would be restricted in their ability to transfer their interest at a later date. So, instead of valuing that limited partnership interest at $12,500, the IRS recognizes that it may be worth more like $10,000.

The advantage of this recognition comes into play when parents are ready to gift to their children. Assume a husband and wife have four children. Each spouse can gift $10,000 per year to each child without paying a gift tax. As such, a total of $80,000 can be gifted each year (two parents times four children times $10,000). With the valuation discount reflecting that the $12,500 interest is really only worth $10,000 to a normal investor, each parent gifts a 10 percent limited partnership interest to each child. Their combined gifts total an $80,000 valuation, thus incurring no gift tax. However, of the partnership valued at $125,000 they have gifted away 80 percent of the limited partnership with a book value of $100,000. Had they not used a limited partnership they would have had to pay a gift tax on the $20,000 difference between the $80,000 discounted gifted value and the $100,000 undiscounted value of eight $12,500 10 percent partnership interests that were gifted.

As the example illustrates, transfers of family wealth can be accelerated through the use of limited partnership discounts. Once this technique is appreciated, the question always becomes: How much of a discount will the IRS allow? Is it 25 percent, 35 percent, or can you go as high as 65 percent? While there is no brightline test or number, the simple answer is found in this maxim: Pigs get fat, hogs get slaughtered. If you get greedy with your discounting, the IRS will call into question all of your planning. In my practice, I do not advise my clients to go over a 30 percent discount. That may be conservative. I have dealt with some professionals who with certainty assert higher discounts are easily justified. Again, there is no correct answer. You and your advisor should establish your own comfort level.

Flexibility

The limited partnership provides a great deal of flexibility. A written partnership agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted partnership agreement.

Taxation

Limited partnerships, like general partnerships, are flow-through tax entities. The limited partnership files an informational partnership tax return (IRS Form 1065, "U.S. Partnership Return of Income," the same as a general partnership), and each partner receives an IRS Schedule K-1 (1065), "Partner's Share of Income, Credits and Deductions," from the partnership. Each partner then files the K-1 with their individual IRS 1040 tax return.

Copyright © 2001 by Garrett Sutton, Esq.

About the Author

Garrett Sutton, Esq. has over twenty five years experience assisting and advising entrepreneurs, families and business in selecting the appropriate corporate structures to limit their liability, protect their assets, build their credit and advance their personal and financial goals through real estate investments and other means of wealth creation. Sutton is the owner of Sutton Law Center, Sutton Law which has offices in Reno, Nevada, Jackson Hole, Wyoming and Sacramento California.