The Family Partnership
by Robert L. Tate, CPA
If properly structured, the use of the family partnership as a planning tool can create income tax and estate tax savings. Also, there can be nontax succession planning benefits for family-owned businesses that adopt the family partnership. This article addresses some of these planning opportunities and discusses the potential problem areas that may be encountered in structuring family partnerships. Although the article focuses on the family-owned business, it should be remembered that the same planning techniques also would apply to other assets owned by a family that involve appreciation and/or control.
In the typical family-owned business, the parents have been primarily responsible for developing the business and are very cautious in making decisions that will shift any degree of control or ownership to the children. In many cases, the business represents the principal source of income for the family and the family's basis for recognition within the community where the family resides, and creates definite and well understood roles within the family. These fundamental benefits of the family-owned business, when combined with any number of other human and financial factors unique to each family, create a complex set of relationships within each family business. In many cases, however, the issues presented by these relationships are not addressed in a manner appropriate to the ultimate long-term success of the business.
Family Partnership Offers Alternatives
The solution to many of the potential problems found in planning for a family business can be found in setting up a family partnership. The family partnership can be formed as either a general partnership or a limited partnership. In most cases, the limited partnership will be the preferable form of organization because it provides for the resolution of the issue of control by the parents through the issuance of both general-partnership units and limited-partnership units. The individuals who hold only limited-partnership units are not entitled to a say in the management of the partnership and have no personal liability for the debts or obligations of the partnership beyond their investment. Holders of the general-partnership units control the business and the assets of the partnership, but have personal liability for the debts and obligations of the partnership.
The family limited partnership allows for the orderly transfer of wealth to other family members in increments that can easily accommodate the $11,000 annual gift tax exclusion, the current unified estate tax credit equivalent of $1,500,000 or the current generation-skipping tax transfer exemption of $1.12 million.
At the time of the gift, the fair market value of the family partnership should be determined to establish the value of: (1) the gifts for tax purposes and (2) the new partnership interest (limited or general) to be created in the family partnership. Because the valuation of the family business is critical to the success of the plan, the process should be well documented. In addition, it would probably be advisable to retain a professional business evaluator to appraise the business. This would provide a sound and supportable base for the decisions affecting the division of the business among the family members.
The family limited partnership allows income splitting which can yield an income tax benefit, although the benefit has been limited in recent years by compressed income tax rates. Any increase in the maximum income tax rate could increase the income-splitting benefit that is based on rate differences.
Pitfalls to Consider in Family Partnerships
The Internal Revenue Service has waged an ongoing battle against the family limited partnership. Essentially, the IRS has attacked such partnerships as not having any business purpose and then attempted to include in the decedent's estate, partnership interests transferred to family members. The question of business purpose is certainly one of facts and circumstances which will vary with each situation. Any planning which results in the creation a family limited partnership should include substantial documentation of support for the position that the entity is not being created for tax minimization purposes, but rather, is being created for sound business purposes.
The IRS has also challenged the appraisals of value which have been used for the limited partnership interests which have been gifted to family members. In some cases, such appraisals have used discounts which are clearly in excess of what would constitute a reasonable amount. Again, documentation is the key. The appraisal must be performed by a competent appraiser who utilizes reasonable discounts based upon supportable criteria and assumptions.
Another concern that must be addressed relates to the anti-estate-freeze provisions of the Internal Revenue Code. These provisions effectively eliminate the traditional family partnership estate freeze: giving the younger partners the future growth interest while retaining the income in the hands of the current owners. Therefore, the family partnership arrangement that transfers by gift a disproportionately large share of future appreciation in a closely held business will not work and will result in elimination of any estate or gift tax savings that may have been contemplated. This results from a new Code requirement that emphasizes a proper gift tax valuation. An explanation of these rules is beyond the scope of this article.
The last tax pitfall to consider in structuring a family partnership concerns the family partnership rules of Internal Revenue Code Sec. 704(e) that require a number of tests to be met for the income splitting benefits of a family partnership to be recognized:
1. Capital must be a material income producing factor in allocating income. This rule distinguishes a partnership in which personal services are the principal source of income from a partnership in which capital is a material income producing factor. If capital is not a material income producing factor, the partnership arrangement will probably be disregarded as an attempt to assign income.
2. The recipient family member's share of income can be determined only after the donor partner is allowed reasonable compensation. Accordingly, if the donor partner is not allocated income constituting reasonable compensation for the services rendered to the partnership, the Internal Revenue Service could reallocate partnership income to correct this.
3. The recipient family member must be a real partner and must have control over the partnership consistent with partner status. There is a special exception for limited partnership that specifically states that limited partners need not participate in the management of the partnership for this test to be met. However, there are factors other than management participation that must be considered in order to meet this requirement. The Internal Revenue Service has established a number of guidelines to use to determine whether a partner is a real owner of a partnership interest.
The family limited partnership can be a very effective business structure for meeting the various needs of a family wishing to transfer business interest or other assets from the parents to the children. The transfers can be made in controlled increments, which allow precise income- and estate-tax planning and enable the parents to evaluate how the plan is working from an operating standpoint, before additional interests or ultimate control is transferred.