Family Limited Partnerships Can Frustrate Creditors and Uncle Sam
By Craig D. Hasenbalg, J.D.
All business owners are concerned about reducing their exposure to liability. Some are moved to act, while others stand idly by and risk disaster. Although other business structures (Limited Liability Companies and traditional corporations) offer creditor protection, the family limited partnership offers qualities the others do not. Specifically, a family limited partnership provides a mechanism for an orderly succession of the family business and, perhaps more importantly, a vehicle for reducing estate and gift taxes. Of all the various ways available to conduct business, only the family limited partnership gives the business owner the capability of frustrating creditors in a litigious world, while implementing an effective estate plan. By its very nature, the family limited partnership shields assets from creditors. The typical family partnership is initially funded by a contribution of assets from mother and father, who in turn make gifts of partnership interests to their children. Illinois partnership law (as well as the partnership law of all other states) provides that the liability of each limited partner cannot exceed that partner’s capital contribution. Therefore, lawsuits against the partnership cannot result in personal claims against the individual limited partners. Moreover, placing business assets into a family limited partnership may provide the creditor with some unpleasant surprises. Typically, collection against a limited partnership interest entitles the creditor only to such distributions as the general partner decides are not necessary for the reasonable needs of the business. Since the general partner is related to the debtor/partner (oftentimes being the debtor/partner’s parent), and presumably sympathetic to frustrating creditors, it is unlikely that significant funds will be distributed. At the same time, under state and federal law, the creditor becomes responsible for the debtor’s share of the income tax generated by the partnership. When the dust settles, therefore, the creditor can only collect the (typically) small amount of money distributed to the debtor/partner, but must pay the debtor/partner’s share of the partnership’s income tax.
Unfortunately, a limited partnership does not completely thwart a creditor’s collection efforts. The law requires a valid limited partnership to have a general partner who manages the operations of the partnership and has unlimited liability. To secure an additional layer of insulation from creditors, many limited partnerships are structured with a corporate general partner (or an LLC) that is, not coincidentally, also controlled by the family. As a result, family members–usually mom and dad—control the partnership through the corporate general partner, and successful creditors of the partnership can take only the assets of the corporation. The personal assets of the individual shareholders and limited partners, absent some fraud on their part which would allow the corporate veil to be pierced, remain secure within the family.
Unlike the other business forms the family limited partnership provides an effective tool for estate planning. At the death of a partner, business assets are usually valued based on a variety of different factors. Two of the most important factors are comparable sales and the earnings potential of the business (more frequently referred to as capitalization of income). As the name suggests, under the comparable sales approach, the value of a decedent’s business assets is based on the current sale prices of similar assets in the same general geographical area. Under the second approach, values are based on the current and anticipated stream of income from the business. That income stream is given a current value by use of a multiplier, which is directly related to current interest rates.
In the family limited partnership context, application of these factors results in a low value for estate tax purposes. A properly drafted family partnership agreement severely restricts the ability of an individual partner to transfer a partnership interest outside of the family circle, and provides that the partnership shall continue despite the death, divorce or bankruptcy of a family member. The agreement also provides that the partnership cannot be dissolved and the assets of the partnership cannot be taken by the unilateral action of a partner. With these restrictions in place, no knowledgeable buyer would pay a price proportionate to the underlying asset value of the selling partner’s interest. A buyer of the partner’s interest would be an outsider among family members, would have no voice in the management of the business, could not force a liquidation or distribution of partnership assets, and could not easily re-sell the partnership interest. Therefore, any reasonably sophisticated purchaser would only buy the limited partnership interest on a discounted basis, and some courts have given discounts ranging up to 60%. The capitalization of earnings approach also produces a low value for a decedent’s business assets, since many family businesses show low rates of return after reasonable salaries are taken out for all employees, including family members involved in the business. For that reason, the capitalization of earnings method often produces a lower valuation than the comparable sales approach. As a result, the value of business assets included in a partner’s estate, and (not coincidentally) the corresponding estate tax, will be significantly reduced.
Finally, since the parents usually dominate the general partner, and therefore the operations of the partnership itself, the understandable desire of a parent to retain "control" over the family’s wealth can be satisfied. This desire for control often conflicts with an effective estate plan, for the more control over assets a person retains, the larger that person’s estate and estate tax becomes. Using a family limited partnership, this tension can be resolved, allowing parents to control wealth, but still reduce estate and gift taxes through the use of valuation discounts. As an added benefit, the involvement of children and grandchildren provides important training for younger family members.
Although the IRS has for years been seeking an effective way to curtail the use of family limited partnerships and avoid capitulating on oftentimes substantial valuation discounts, to date, the successful challenges have come in abusive circumstances (i.e. a partnership created entirely with publically traded stock, and formed on a person’s death bed). Thus, while no business form is perfect, the family limited partnership comes closest to satisfying most needs of the typical family business.
Craig D. Hasenbalg earned a B.A. in History in 1990 from the University of California at San Diego, and his J.D. degree from the University of California at Berkeley in 1993. In January of 1998 Mr. Hasenbalg received his LL.M. in Taxation from Chicago-Kent College of Law. He is a partner with the Aurora law firm of Goldsmith, Thelin, Dickson and Brown.
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