I am currently working with the second generation of a family that utilized a family limited partnership as a means to control the family wealth by their parents. I represent the two general partners that succeeded their parents. We are now working on the changes to both the form of the limited partnership and drafting of key provisions in the next agreement.
The parents created the partnership to make certain that key assets of the family would benefit the next generation in years to come. They also wanted to avoid death taxes that may impact the amount of family wealth after the passing of the first generation. As it worked out, because of the planning involved none of the key assets will be impacted by death taxes.
I often mention to family members that a partnership or limited liability company (LLC) is one of the best ways to control family wealth. Partnerships and LLCs are very tax efficient because of only one level of tax. On the death of a parent, their partnership or membership interest gets a step up in basis on both the inside assets (stock, in the case of this family) and the outside asset (partnership interest.)
For example, if the stock was bought by the parents at $1,000 per share and at their death was worth $5,000, their basis moves (stepped up) to $5,000 per share. The stock could be sold at $5,000 and there would be no income tax to pay. This planning is not available for either C or S Corporations dealing with inside assets.
The important point is to remember that the partnership has to make a timely IRC 754 election, in order to have both the inside and outside assets get stepped up in basis. It is not uncommon for this election to be missed by non tax professionals.
One of the recommendations that I made to the two general partners mentioned above was to create a separate LLC for their general partnership interest or convert to an LLC. The reason for this is because general partner(s) are liable for the partnership liabilities to the extent that the partnership assets cannot cover the creditor’s obligation. If the general partners were the manager(s), they would not have this exposure.
This recommendation is one major reason why most people choose LLCs rather than limited partnerships. If the partnership has income that causes the gross receipts to be taxed higher than $1,600 per year, and if it were an LLC, then the partners may want to have a separate LLC for their general partnership interest. Right now, there have been two superior court cases that ruled that LLCs being taxed on their gross receipts is an unconstitutional tax and is being appealed by the franchise tax board.
Another recommendation is to have a strong arbitration clause if there is a dispute among the parties. I often mentioned that this is partners’ opportunity for built-in “tort reform”. The arbitration provisions I use include (i) that the arbitrator has to have a minimum number of years of experience in the area of controversy and (ii) limits the amount of discovery (legal cost) that can be conducted by each side. These are two very important points to address in any arbitration proceeding because of the binding nature of arbitration under California law.
Limiting the fiduciary duty of the general partners to a “business judgment rule” helps curtail the liability owed to the other limited partners. This standard is less than what a trustee of a trust owes to a beneficiary. I often mention to clients that a trustee (also a general partner) is a moving target by beneficiaries or partners. Having the ability to limit this exposure is very important in the drafting process. People are not perfect and make mistakes.
Since the general partners were not the parties that transferred the partnership interest to the other partners (parents were the transferors) having mandatory income distribution is not required. This helps for asset protection purposes if a limited partner has a non partnership creditor (outside creditor) trying to seize his distribution interest by a charging order.
Contrast this recommendation if the parents were the general partners and made gifts to their children. In this case, the partnership agreement would have to have mandatory income distributions in order to qualify for the annual $13,000 annual gift exclusion and avoid the IRS argument of a “retained interest” under IRC 2036. The IRS has been very successful in attaching family limited partnerships where the income has not been distributed to each partner according to their interest in the partnership.