The Broker and the Family Partnership

If you are serving high-net-worth clients or hope to do so you should be familiar with family limited partnerships, or their kissing cousins, limited liability companies. These are estate planning and asset management tools that wealthy families employ to control assets during their lives and, under the right conditions, get a discounted valuation on these assets after death, thus reducing the value

If you are serving high-net-worth clients — or hope to do so — you should be familiar with family limited partnerships, or their kissing cousins, limited liability companies. These are estate planning and asset management tools that wealthy families employ to control assets during their lives and, under the right conditions, get a discounted valuation on these assets after death, thus reducing the value of a taxable estate. These are entities that also provide a structure for a broker or advisor to manage a large investment portfolio.

Those who create these entities (and they are not unsophisticated devices) are able, with good planning, to retain significant control. A husband and wife can “run” the partnership together, vs. the husband and wife solely owning their assets and controlling them individually. With shared control (decisions about investments and distributions of partnership assets being made by them jointly), they have positioned themselves to take the first step toward depreciating for estate and gift tax purposes the assets they transferred into the partnership.

They no longer “own” the assets individually. The partnership contains the assets and what they own in equal exchange for the assets transferred to the partnership are now units in the partnership, usually two types — general and limited. The general units represent control; the limited units represent the balance of their ownership interests. Usually, the general units are no more than 1 percent of the initial value of what is placed in the partnership and the limited units are the balance. Often, the general units are placed inside a limited liability company to achieve creditors' protection and for other purposes as well. This, then, creates two entities and adds complexity.

An alternative which is emerging as more and more popular is the use of the limited liability company solely and no partnership, so there is only one entity. You can achieve virtually every objective a partnership attains with a limited liability company, and spare some complexity with no sacrifice in estate planning or investment objectives.

How are the estate planning objectives achieved? It is through the shared control, the terms and conditions of the partnership agreement which must carefully conform to state law requirements (but you can pick any state you want to form your partnership) and the change in individual asset ownership for units.

For example, your customer at age 50 (or, given the favorable court rulings of the last several years, at age 80 or beyond) forms a partnership with $2 million of assets that he had owned individually, names himself and his wife as general partners for the 1 percent of general partnership units and keeps 99.5 percent of the balance of the limited units. He has now restructured his asset ownership and you, the investment advisor, are now engaged by the general partners (your wealthy client and his wife) to continue to manage the same assets inside the partnership and to proceed as usual.

Here's where the valuation discount comes in. Under this scenario, if your customer dies he has given half of 1 percent of his assets to his wife in the form of general partnership units, but retained 99.5 percent of the balance of the partnership interests. For federal estate tax purposes, what are the assets now worth? The assets inside the partnership, assuming he has transferred his securities portfolio, are worth the same as if he still owned them individually. (The amount for tax purposes is usually fair market value on the date of death.) But he does not own them individually anymore. He owns units, and their value is what a willing buyer, having knowledge of all relevant facts, would pay for the units.

However, the assets are unlikely to fetch their market value because they are only available to a buyer of the units and that poses difficulties. If, for example, a buyer wants to buy the units from the estate, the buyer would need your customer's spouse's consent to liquidate the partnership and reach the assets. The spouse would only distribute to the buyer if the spouse and the buyer could agree upon the distribution, and that is highly unlikely — hardly the best purchase a buyer could ever make.

Given these restrictions, the buyer would not pay for the units what the partnership assets are worth, but something substantially less, like 65 cents on the dollar, or 50 cents on the dollar, or 40 cents on the dollar. Remember that another restriction on the buyer of these units is not only lack of control, but he would have great difficulty selling them. So the courts recognize these discounts readily for lack of marketability and lack of control. The $2 million would be fully includible in your customer's estate if he just had the assets in his name in an account with you. But if the account is in the partnership, the assets will be valued at possibly $1 million, and that is a 50 percent discount. That just happens to equal what you can leave in your estate in the year 2002 and be exempt from the estate tax if your customers' descendants are the beneficiaries. As all of you know who read this column, gifts to a surviving spouse, properly structured, are not taxed when the first spouse dies.

I mentioned investment objectives as an important reason for creating a partnership. If a family pools its assets into one family partnership (and this must be done very carefully for income tax and estate tax purposes), the husband and wife are general partners, and may be joined by their children as partners, if they wish. They can now engage you to run the whole family's assets without multiple accounts and perhaps with less cost and better results because you are managing, trading, or both, a lot more money in a single entity.

I have not discussed gifts of partnership units, a very important aspect of partnership planning, which I will address in the next several columns. In case you have heard of the Hackl case (Hackl vs. Comm., 118 Tax Court No. 14, 2002), you may have been told that the $11,000 annual gift exclusion per person is now unavailable for gifts of family partnership units. Nothing could be further from the truth — if you know how to do it.

You are an integral part of what your customers do. And the greatest compliment I can pay any reader is that you, with your ideas and initiative, represent the reason your customers plan, in many cases. Remember, we just turned virtually $2 million of value into $1 million for federal estate tax purposes — not a bad day's work — and without assuming undue risk.

Writer's BIO:
Roy M. Adams is a partner in Sonnenschein Nath & Rosenthal in New York, where he serves as senior chairman of its trusts and estates practice group.

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