Considering A Family Partnership

Looking for a way to keep control of the family business, protect assets and minimize estate taxes? One possible answer: structure your business as a family limited partnership. Why a limited partnership? There are two basic types of partnerships – general and limited. In a general partnership, the partners are essentially equal, fully sharing in the profits, losses and liabilities of the partnership. But a limited partnership has two kinds of partners: the general partner who controls the business of the partnership, and limited partners who have no management authority and limited liability for partnership debts. In a family context, that’s very useful. It gives you a way to transfer partnership assets to family members for tax purposes, while letting you stay in charge of those assets yourself.

In many small family-owned companies, the parent who runs the business is the general partner and the children are the limited partners, working for the partnership as employees. The general partner may keep a small ownership interest (say, 5 percent) while retaining control and deciding how much income goes to the limited partners. This often pacifies parents worried about spoiling their children, or getting booted out of their business by their kids.

Annual gifts of family limited partnership interests to younger generations can gradually reduce the size of an estate subject to federal estate taxes. For instance, a husband and wife, as general partners, can jointly give partnership interests worth $20,000 annually to each of their 10 children and grandchildren without paying gift taxes. After five years, they will reduce the size of their estate by $1 million. And they will have done so without giving away partnership-owned cash and other investment assets which remain under their control.

Family partnerships can also leverage your tax savings because the value of minority partnership interests may be greatly discounted in transfers. Consider this: if someone owns 20 percent of a partnership’s $100,000 asset, but has no rights of control, then the value of that 20 percent to a buyer could be much less than $20,000. When transferring a limited partnership interest, you may be able to discount the value of that interest – and get a tax break. In some cases, discounts range from 20 to 40 percent. So, if the partnership interest you give to your child is worth $15,000, you might be able to value it at only $10,000 and avoid gift taxes.

Also, what if mom dies having given away 70 percent of her business partnership to her children? The remaining 30 percent can qualify for a minority discount from estate taxes.

In some instances, family partnerships may also serve as asset shields. While trusts can serve the same purpose, that’s not always the case. If you put assets into a trust that you control or benefit from, the asset may still be exposed to your creditors. But by putting the assets into a limited partnership, you may be able to keep creditors at bay.

After you contribute assets to a limited partnership in exchange for interests in the partnership, you no longer own the assets. That leaves divorcing spouses or other creditors with few options. They generally can’t satisfy a judgment by grabbing the partnership assets. And they usually don’t become substitute partners or have a say in management. Instead, they become entitled to your share of partnership income, if and when that income is ever distributed. Since you could simply withhold distributions, your creditors may be left out in the cold. Be aware that recent court decisions suggest this protection may be eroding. So don’t assume that a family partnership can always stonewall a determined creditor.

Family limited partnerships can be used to bring children into a family business at whatever pace you desire. The children can be given a taste of running the company or managing property, for instance, while the parents remain in control. Further control can be added by having the children sign buy-sell agreements. So, if in later years they want to leave the business, the other partners can buy their shares, ensuring that the family business stays in the family.

The partnership can also provide for management succession. The partnership agreement may designate a successor partner upon the existing general partner’s death or inability to serve.

In some instances, family partnerships may trigger income tax savings by allowing parents to shift income out of their portfolios. By transferring ownership of a partnership interest, a high income parent may be able to shift income to a younger family member who is in a lower tax bracket. There are limits, however, to the amounts that can be allocated to others.

If each of the family members who are partners contributes services or capital to the business in exchange for a limited partnership interest, the IRS may find the arrangement acceptable. But if the partnership doesn’t appear genuine, the IRS may disregard the partnership as merely an attempt to avoid income taxes.