Article:
Family Limited Partnership for Family Investment Management
by Paul H. Roskoph
July 1, 2006
Structure:
A family limited partnership may be formed to centralize asset management and serve as a basis for transferring ownership interests to the children, it is treated as a partnership with a full partnership structure. The limited partnership is formed upon the creation of a limited partnership agreement among the general and limited partners, and is "perfected" when a certificate of limited partnership is filed with the secretary of state. It is managed by the general partners who have a fiduciary responsibility to each of the other general partners and limited partners. The general partners have unlimited personal liability for partnership events and obligations; limited partners have liability for partnership activities limited to their respective investment. The partnership is not a taxable entity, but its income and capital transactions flow through to the partners (see "Pass-through Entity" below.) The liability of a general partner can be avoided through the use of a limited liability company as the general partner, or using an LLC in lieu of the partnership.
Management:
Typically, a husband and wife and, if available, their revocable trust, initially would be the sole general and limited partners of the partnership. The roles easily could be intermingled and confused (as are the roles of small family corporations), and care must be taken to assure that the entity is distinguished as separate from the individuals.
The general partners are responsible for the management of the partnership. Limited partners have no management authority, but generally provide the source of the funds. Therefore, contributors of assets to this entity generally receive limited partnership interests in exchange.
Formation:
The partnership is created when the Partnership Agreement is signed and assets are transferred to it. The partnership will be qualified in the State of California as a limited partnership only after the Agreement is signed and a Certificate of Limited Partnership is filed in Sacramento. An annual "franchise fee" of $800 is payable to the State of California.
Business Purpose:
The partnership agreement should provide for a projected date for its termination. This date can always be accelerated or extended by vote of the partners, but we recommend a specific term for the partnership. The partnership will also terminate as a matter of law and agreement upon the death of the last surviving general partner. We recommend naming a revocable trust as a general partner, by design, to avoid an automatic termination of the partnership at the death of an individual partner. The partnership may terminate for tax purposes even if it continues operationally if, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in the partnership capital and profits. A transfer by gift will not trigger termination.
Pass-through Entity:
The partnership is generally a "pass-through" entity for tax purposes. The tax law allows the transfer of assets to and from the partnership without tax consequences. There are exceptions. Contributions to the partnership are not taxable events because the transfer will retain all the interests personally in the contributor's capacity as general or limited partner. The general tax rule provides that there is no taxable event upon contribution of an asset to the partnership.
Additional Capital Contributions:
Additional contributions may be made subsequent to the formation of the partnership. We recommend, however, they be made in the contributor's capacity as limited partner since the role as a general partner is primarily management and not investment. Other than cash, the encumbrance issue must be considered. Generally, however, we do not recommend transferring additional assets to the partnership after it is formed since it will require the issuance of additional limited partnership interests and an accompanying valuation. If a client contemplates additional transfers in the future, this should be discussed carefully.
Additional Limited Partners:
As part of the original plan, one of the prospective purposes of the partnership is to bring the children (or trusts established for them) in as limited partners. This will be accomplished by the transfer of some or all of the contributor's partnership (limited) interests. The donors will continue as general partners. This is an excellent device for bringing the children into the family business matters and providing an education to them on investment management. The law now permits limited partners to take more active managerial roles without causing the partnership to lose its protection as a limited partnership.
Accounting:
It is necessary to maintain accounting records of contributions to capital and transactions within the partnership. The partnership agreement sets forth the general accounting approach to maintaining capital account records and income accounts. These follow general accounting procedures and the tax requirements. Cash flow affects the balance of capital accounts which fluctuate by gains, loses, additional contributions and distributions.
Tax Returns:
The partnership is a separate entity for tax reporting purposes but is not an independent taxpayer. The partnership is required to file annual partnership tax returns both for federal and California purposes. As a limited partnership, the partnership must pay an $800 annual fee to the State of California for its "franchise." A federal tax identification number will be used on all these matters. The partnership is a "pass-through" entity for tax reporting purposes. Thus, the partnership pays no income taxes, but the items of income and expense are passed through to the partners via schedules K-1 prepared by the partnership. Unlike your personal revocable trust which is ignored for tax reporting purposes and each item is reported on your personal income tax return, the partnership return is an entity return with the reporting by the individuals of the collective results for the year. Certain items are passed directly through, but generally only the net income (or loss) is reflected. If partnership interests are transferred to children, a pro rata portion of the partnership activities will be reportable by them for each taxable year.
Trusts as Partners:
The client may want to control the amount of cash received by their children from a limited partnership. This can be done by adding a further layer between the children and the partnership. This is done by creating irrevocable trusts for each child (one trust for each) so that when the partnership elects to distribute cash to the partners (including the clients); the cash attributable to the interests of the children will be controlled by the trust to be established for each of them. Partnership distributions will flow to the trust as a partner, but the trust beneficiaries (your children) would receive distributions only when the Trustee decides it is appropriate.
This plan is very flexible.
Tax Issues:
The IRS does not like the discount valuation features of partnerships. Congress continues to uphold them, but recent cases disallowed the gift tax "annual exclusion" and, more recently, the IRS has been successful (with bad facts such as "last minute, death bed" formation) in treating the partnership as a "retained interest" by the transferor, causing the entire partnership (including all transferred interests) to be included in the decedent's estate.
This notwithstanding, properly and timely formed partnerships can provide excellent management for property and an opportunity to transfer fractional interests in a convenient manner.
If you are interested in further information regarding a family limited partnership or would like to establish a family limited partnership, please contact our office by email or at (650) 470-5300.
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