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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 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. |
