Family Limited Partnership

Efficacy of Family Limited Partnerships in California: A Case Study

The Family Limited Partnership (FLP) is probably the most beneficial structure available for wealth preservation via asset protection, estate planning and tax minimization. Although you “can’t take it with you,” by placing your assets into FLPs you can legally and successfully protect everything you own from attack by creditors and from erosion by exorbitant taxes.

In order to illustrate the efficacy of Family Limited Partnerships from an asset protection, estate planning and tax minimization point of view, consider the case of “Dr. Franklin,” a fictitious character derived from actual client situations. [Although, for illustration purposes, we have created a hypothetical physician, the principles discussed herein apply equally to all professionals and, indeed, to all individuals who have accumulated significant wealth.]

Dr. Franklin is a successful physician in San Diego, California. He is approximately 50 years old, is married with three teen-aged children, and is chief of surgery at a major hospital. Dr. Franklin’ estate is worth approximately five million dollars.

In addition to his surgery practice, Dr. Franklin owns his home, as well as several investment properties including an apartment building and a shopping center. Dr. Franklin also sits on the board of directors of his hospital and his country club.

Dr. Franklin wanted to establish a wealth preservation strategy for three specific reasons:

  1. Dr. Franklin was very concerned by the proliferation of medical malpractice lawsuits and wanted to protect his significant assets in the event that he was sued by a patient. In addition, Dr. Franklin knew that as a landlord, he was prone to litigation from tenants and other persons who might be injured on one of his properties. He was sensitive to the fact that as a physician and a property owner, he was perceived as a “deep pocket target” by aggressive negligence lawyers.
  2. Dr. Franklin wanted to reduce his estate tax liability so that upon his and his wife’s deaths, their children would inherit as much as legally possible, with as little as possible (or nothing) paid to the I.R.S. in the form of inheritance taxes.
  3. Dr. Franklin hoped to minimize his current income tax liability on the income received from his rental properties.

FIRST GOAL: ASSET PROTECTION

Asset protection is defined as the safeguarding of personal wealth from attack by future creditors. “Assets” are broadly defined and include homes, cars, boats, jewelry, business interests, cash, bank accounts, brokerage accounts, stocks, bonds, art and other collections, real estate, etc.

“Creditors” are also broadly defined and include actual creditors as well as identifiable probable creditors, such as litigants, soon-to-be ex-spouses, disgruntled business partners, or anyone who you know that has a claim against you, even if they do not yet know it. Creditors may even include government agencies, such as the I.R.S.

The effectiveness of an FLP in providing asset protection is statutory, meaning that it has been codified as law. The Revised Uniform Limited Partnership Act (RULPA), which has been adopted in all fifty states, provides that the assets owned by a limited partnership are not owned by the individual partners.

Therefore, those assets cannot be attached by the personal creditors of a partner. If a person contributes assets to an FLP, those assets are no longer owned by that person (although, as explained below, the person may still control those assets), and creditors of that person may not attach those assets merely because they have a judgment against a partner of the FLP.

THE ESSENCE OF ASSET PROTECTION PLANNING: CONTROL EVERYTHING BUT OWN NOTHING

A family limited partnership is, by definition, a joint venture between family members. The partnership is comprised of both general and limited partners. Dr. and Mrs. Franklin are each the general partners. [Because Mrs. Franklin is not a licensed physician, Dr. Franklin is the sole general partner of the FLP that owns the stock in his medical practice.]

Dr. and Mrs. Franklin also own limited partnership interests, as do their children. The general partners manage and control the partnership. The general partners decide and implement all decisions of the partnership, such as whether to buy or sell an asset in the partnership, what investments the partnership should make, and whether to make a distribution of profits from the partnership. The general partners may even determine to dissolve the FLP. It should be apparent that the general partners control the operation of the partnership, in their absolute discretion. Dr. and Mrs. Franklin thus control the assets and make the decisions regarding those assets just as they did before the FLP. Although they transferred legal ownership or “title” to those assets to the FLP, they retained control.

Unlike corporations, FLP’s are not democracies — there is no 51% majority control. Even if they own 99% of the FLP, the limited partners do not outvote the general partners. The limited partners in the FLP are similar to “silent” partners or passive investors.

They have equity interests in the partnership, but have no decision making authority over the partnership or the assets therein. Limited partners, for example, are not entitled to demand distributions or other payments from the FLP. In addition, limited partners may not sell or assign their partnership interests without the consent of the general partners, nor force the liquidation of the FLP. The general partners are thus in complete control of the FLP, although they do not own the assets in the FLP.

THE STRUCTURE OF THE ASSET PROTECTION PLAN: SEGREGATION OF HIGH RISK ASSETS

Dr. Franklin and his advisors set up a complete FLP plan in order to achieve his first goal, asset protection. Early in the process, they took inventory of Dr. Franklin’ assets. They examined each asset individually and evaluated its likelihood of being attacked, based on the chances it would generate a liability. They placed each of Dr. Franklin’ properties into a separate FLP.

Thus, the shopping center that he owned was placed in one FLP, and his apartment building was placed in another FLP. The reason for treating each real estate asset individually and placing each one in its own FLP is to minimize the litigation exposure of each asset.

If an FLP would be sued as owner of a property by someone hurt on that property, assets in a different FLP would not be in danger. In general, high risk assets or those prone to litigation, such as rental property, should be kept separate from low risk assets, like Dr. Franklin’ personal bank and brokerage accounts, which were all placed into one FLP. Dr. Franklin’ home was also placed into a separate FLP. Dr. Franklin’ private medical practice was registered as a professional corporation.

Dr. Franklin owned one hundred percent of the stock of that corporation and he placed that stock into a separate FLP. If Dr. Franklin were to get sued, the professional corporation would cease paying him a salary. Instead, it would distribute profits (and management fees) directly to its shareholder, the FLP, where the money would be protected.

Thus, Dr. Franklin’ assets were protected from each other and, as explained below, they were all protected from any future personal attack against him.

KEEPING THE WOLVES OUT: A FEW EXAMPLES

During one snowy winter day, a tenant in Dr. Franklin’ apartment building stepped outside, took a few steps and promptly slipped on the icy sidewalk. An aggressive personal injury attorney convinced the tenant to sue her landlord for injuries sustained in the fall, including pain and suffering, loss of income and post-traumatic stress. The tenant’s spouse also sued for “loss of consortium”.

The attorney, expecting to reap a windfall from a “deep pocket” doctor, took the case on a 33% contingency. When the attorney investigated who the landlord was, to his chagrin he learned that it was the “Dr. Franklin Apartments Family Limited Partnership,” not Dr. Franklin himself.

A little more research revealed that the partnership owned no assets other than the apartment building, and a local bank held a large mortgage on the building. All of Dr. Franklin’ other assets were owned by other FLPs which had nothing to do with this accident and could therefore not be included in this lawsuit.

To their great disappointment, the tenants and their attorney quickly understood that there was no “deep pocket” and there would be no windfall. The attorney realized that, even if he won the case, the judgment would be uncollectible. Since 33% of zero equals zero, he quickly settled for whatever Dr. Franklin’ insurance company offered and went away.

The very next month, an auto accident occurred in the parking lot of Dr. Franklin’ shopping center. A smarter, more aggressive negligence lawyer, realizing that a lawsuit against the “Dr. Franklin Shopping Center Family Limited Partnership” would not yield very much, also sued Dr. and Mrs. Franklin personally as general partners of the FLP.

He claimed that, as general partners, they were personally liable for the FLP’s negligence in maintaining the shopping center. Dr. and Mrs. Franklin’ attorney promptly informed the plaintiff’s negligence lawyer that Dr. and Mrs. Franklin had no attachable assets.

They owned nothing — not even Dr. Franklin’ medical practice (although they controlled a great deal). A judgment against Dr. and Mrs. Franklin would therefore be uncollectable. Once again, there was no “deep pocket” and no windfall. Rather than wasting his time on a case with little or no potential reward, this lawyer also quickly settled for Dr. Franklin’ insurance company’s offer.

The following summer, when a guest was hurt in the swimming pool at Dr. Franklin’ country club, the injured guest sued not only the country club, but also each of the members of the club’s board of directors, including of course, Dr. Franklin. The plaintiff claimed negligent supervision of the club by its directors. Unfortunately, the country club did not carry errors and omissions insurance for its directors.

Again, Dr. Franklin’ attorney promptly explained to the plaintiff’s attorney that Dr. Franklin had no attachable assets. In order to avoid a lengthy litigation and its attendant legal expenses, Dr. Franklin offered to settle the lawsuit against him for a nominal amount — less than the expected cost of legal fees to defend it.

Dr. Franklin made his settlement offer to the plaintiff on a “take it or leave it” basis. Since the settlement offer was better than an uncollectible judgment, the plaintiff reluctantly took it. The plaintiff pursued his litigation against the country club and the other unprotected directors, while Dr. Franklin watched from the golf course.

Finally, one of Dr. Franklin’ patients developed a post-surgical infection with complications. The patient sued Dr. Franklin, the hospital and every doctor and nurse who had any contact with the patient during and after the surgery. The lawsuit demanded $5,000,000 in damages from each defendant, jointly and severally. Unfortunately, last year Dr. Franklin’ malpractice insurance company had reduced the liability limits of all policies across the board to $1,000,000 maximum per occurrence.

If the plaintiff were to win his lawsuit, Dr. Franklin would be personally liable for $4,000,000. Once again, Dr. Franklin’ attorney uttered the magic words, no attachable assets. The plaintiff accepted the insurance company’s payment of $1,000,000 in full settlement of his claim against Dr. Franklin and dropped the doctor from the lawsuit.

In each of the above cases, the fact that Dr. Franklin had no attachable assets served to effectively discourage the lawsuit. Once the plaintiff realized that, even if it wins the lawsuit, it would be almost impossible to collect a judgment, the plaintiff was forced to accept a settlement on Dr. Franklin’ terms. This, indeed, is the real value of asset protection via FLPs.

RECOURSE OF A JUDGMENT CREDITOR: K.O. WITH A K-1

But what if a plaintiff refuses to settle, prosecutes its lawsuit and wins a humongous judgment against Dr. Franklin? The successful plaintiff in this scenario (who is now known as a judgment creditor) is limited to a “charging order.”

A charging order entitles the judgment creditor to receive Dr. Franklin’ share of any distribution of profits or assets made by the FLP. The judgment creditor is still not entitled to reach the assets owned by the FLP. Distributions are, however, made in the sole and absolute discretion of the general partners, Dr. and Mrs. Franklin.

As general partners, they may determine never to make a distribution. The FLP may still pay salary to Mrs. Franklin, who is not a judgment debtor, and it may make loans to Dr. Franklin’ children, who also are not judgment debtors. Neither of these payments are “distributions” to Dr. Franklin. They are therefore not subject to the charging order and beyond the reach of the judgment creditor.

The judgment creditor’s charging order is, however, a poisonous piece of paper, one that will cause the creditor great harm. Although the FLP might never make a distribution, the judgment creditor’s right to such distribution makes him liable for the tax on the income he never receives. This is known as the “phantom income doctrine.”

The FLP issues a tax form known as a Schedule K-1 to each partner once a year. This Schedule K-1 sets forth that partner’s share of FLP income, whether distributed or not. Each partner attaches the Schedule K-1 to his or her income tax return and includes his or her share of FLP income on the tax return, whether distributed or not.

If a creditor obtains a charging order entitling him to Dr. Franklin’ share of the FLP’s distributions, the FLP will issue the Schedule K-1 to that creditor instead of to Dr. Franklin.

Pursuant to Revenue Ruling 77-137, the IRS will require the judgment creditor in possession of a charging order to pay tax on Dr. Franklin’ share of FLP income, even though that income is never distributed!

This has a profound effect in deterring litigants and creditors from bringing lawsuits against defendants like Dr. Franklin, whose assets are owned by FLPs.

Dr. Franklin’ asset protection plan provided him and his family with complete protection from lawsuits, not only by protecting their assets from attack by judgment creditors but, more importantly, by discouraging the lawsuits in the first place.

Injured parties did receive reasonable compensation from Dr. Franklin’ insurers and left Dr. Franklin alone.

A WORD ABOUT FRAUDULENT CONVEYANCES

It should be noted that the establishment of an asset protection plan solely to protect assets from existing creditors may be construed as an improper attempt to thwart such creditors. In this regard, a creditor may attack an FLP plan as having been established fraudulently, for the specific purpose of evading debts due to that creditor.

For this reason, clients should establish their asset protection plan before any claims arise against them. If it is too late to do this, clients should at least have another valid purpose, apart from asset protection, as the reason behind their FLP plan. Estate planning and income tax minimization (both of which are discussed below) are such valid purposes.

Thus, it is important to implement an FLP plan in the context of complete estate and tax planning, including the execution of a valid will and the establishment of appropriate trusts. If the FLP plan is included as part of a comprehensive estate and tax plan, creditors will have far less likelihood of successfully arguing that the FLPs were established solely to avoid creditors.

Family Limited Partnership

SECOND GOAL: MINIMIZATION OF ESTATE TAXES

As noted earlier, when Dr. and Mrs. Franklin pass away, assuming no change in the value of their assets, their estate would be worth five million dollars. The “unified credit” that is currently allowed by law exempts estate assets valued at $1,000,000 per person.

Dr. and Mrs. Franklin’ combined unified credits of $2,000,000 would reduce the value of their taxable estate to $3,000,000, which would be subject to estate tax at a current rate of approximately 50%. Thus, if Dr. and Mrs. Franklin did not set up an FLP plan, $2,000,000 would pass to their heirs free of taxes (via the unified credits), and their heirs would split the remaining $3,000,000 with the government, 50% to the Franklin’ children ($1,500,000), and 50% to the IRS ($1,500,000).

Clearly, Dr. and Mrs. Franklin would like to redirect (legally, of course), as much as possible of the IRS’ $1,500,000 to their children.

At this point, it is important to digress from Dr. Franklin and his family and consider an important issue: the propriety of tax minimization. There is absolutely nothing immoral, illegal, unethical or even unpatriotic about minimizing your tax obligation.

It is a criminal act to engage in tax evasion or tax fraud. However, the structuring of your assets, through legal means, to pay as little as possible to the IRS and preserve as much as possible for yourself and your family is completely valid and legal.

Consider the comments of Judge Learned Hand, one of the most important federal judges of the last century:

“Over and over again, courts have said that there is nothing sinister in arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions.”

[Commissioner of Internal Revenue v. Newman, 159 F.2d 848 (2d Cir. 1947) (dissenting opinion). See also, Gregory v. Helvering, 293 U.S. 465 (1935)(“The legal right of a taxpayer to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits cannot be avoided.”)]

Family limited partnerships legally save estate taxes by the combined operation of discounting the value of limited partnership interests, and gifting the discounted limited interests. The two principals work together.

First, the value of a limited interest in the FLP is discounted. Once discounted, more FLP interests can be gifted tax-free to the next generation, which results in more assets passing out of an individual’s taxable estate. It is important to remember that, as explained above, a limited interest has no right to control the FLP. That right is reserved to the general partners (Dr. and Mrs. Franklin), and is never given away.

The principal of discounting recognizes two inherent reductions in the value of a limited interest in a family limited partnership. One reduction in value is due to the fact that a limited interest in an FLP is a non-controlling interest in a family enterprise. A purchaser of such a limited interest would be an outsider and would have no right to expect any distributions from the FLP unless the general partner decided to make one or unless all general partners died and the FLP liquidated.

A second reduction in value is due to the fact that there is no ready market for the purchase and sale of FLP limited interests and therefore no liquidity. The courts have forced the IRS to recognize the validity of these two discounts and such recognition has been codified by the IRS in Revenue Ruling 93-12.

The IRS routinely accepts discounts in values of limited interests in FLPs varying from thirty percent to as high as fifty percent, depending, among other things, on the liquidity of the FLP’s assets, the likelihood of a distribution or liquidation and the profitability of the FLP.

It is important to understand that the discount applies to the value of the interest in the FLP; the value of the asset held in the FLP remains the same.

Thus, for example, the Franklin family home was worth $1,000,000 before Dr. Franklin began his estate planning, and the value of the home remained $1,000,000 after it was contributed to the FLP. If the home was sold, it would command a sale price of $1,000,000 whether or not it was contained within the FLP.

Although the value of the home is preserved, the FLP can accomplish significant estate tax savings via gifting of discounted limited interests in the “Franklin Residence Family Limited Partnership.” The IRS would recognize a 50% discount in the value of a limited interest in an FLP containing non-liquid assets such as a home.

Thus, although the FLP containing the Franklin family home is worth $1,000,000, the value of all the limited interests of the FLP, discounted at a rate of 50% equals $500,000. Assume that Dr. Franklin wished to gift as much as possible to his children during his lifetime in order to minimize the value of his estate at death or to take the asset out of his name for asset protection purpose.

Using $500,000 of their combined $23,000,000 unified credit, Dr. Franklin and his wife would make a tax-free gift of $500,000 worth of limited partnership interests to their three children. [The unified credit is not exclusively reserved for death; it may instead be used to exempt a gift made during one’s life from gift taxes.]

Because of the discounting, this gift would effectively transfer all the limited interests in that FLP out of their estate to their children.

In effect, by making a $500,000 tax-free gift of discounted interests, Dr. and Mrs. Franklin transferred 98% of a $1,000,000 partnership, with an actual value of $980,000.

Upon their deaths, Dr. and Mrs. Franklin would each own $10,000 worth of partnership interests, but through their out of state Limited Liability Company (LLC) as the 1% general partner, they would have controlled the entire $1,000,000 FLP until the very end. In addition, future appreciation on the value of the limited partnership interests given to the children will be excluded from Dr. and Mrs. Franklin’ taxable estate.

Dr. and Mrs. Franklin used their a combined gift of $2,000,000 to make four sets of tax-free gifts of $500,000 worth of discounted limited interests in the following FLPs :

Franklin Residence Family Limited Partnership
– Actual FLP value: $1,000,000
– Discounted value of limited interests: $500,000

Dr. Franklin Apartments Family Limited Partnership
– Actual FLP value: $1,000,000
– Discounted value of limited interests: $500,000

Dr. Franklin Shopping Center Family Limited Partnership
– Actual FLP value: $1,000,000
– Discounted value of limited interests: $500,000

Dr. Franklin, M.D., P.C. Family Limited Partnership
– Actual FLP value: $1,000,000
– Discounted value of limited interests: $500,000

[In addition to exempt gifts of limited partnership interests as described above, Dr. and Mrs. Franklin may also take advantage of tax-free “exclusionary gifts” of $15,000 worth of limited partnership interests that may be conveyed each year by each parent to as many people as the parent chooses. Thus, Dr. Franklin is able to make an annual gift of $15,000 worth of limited partnership interests to each of the three Franklin children, and Mrs. Franklin may make an identical $15,000 gift each year to each of the three Franklin children. These exclusionary gifts of limited partnership interests may take advantage of the same discounting as above. Again, these tax-free gifts of discounted interests totaling $60,000 would effectively remove assets with an actual value of $120,000 from Dr. and Mrs. Franklin’ taxable estate.]

After these gifts, Dr. and Mrs. Franklin each owned no interest directly in the above-mentioned FLPs but own the Management LLC as general partner which owns 1% of the partnership and their children together owned 98% of each FLP as limited partners. In addition, Dr. and Mrs. Franklin each still owned 47% (1% general partner interest and 46% limited partner interest) in the Franklin Liquid Asset Family Limited Partnership (total FLP value: $1,000,000).

[Dr. Franklin owned 1% of the Dr. Franklin, M.D., P.C. Family Limited Partnership as general partner and the Franklin children together owned 99% of that FLP as limited partners. Mrs. Franklin was not a general partner of the Dr. Franklin, M.D., P.C. Family Limited Partnership. See footnote 2, supra.]

If they were to die at that time, the total value of their combined taxable estate would be approximately $1,000,000. The estate tax would be approximately $490,000, instead of $1,500,000. [The current estate tax rate on $1,000,000 is approximately 49%.]

Dr. and Mrs. Franklin would benefit from an immediate tax savings of more than $1,000,000. In 2004, the unified credit will increase to $1,500,000 per person.

In one more year, Dr. and Mrs. Franklin may utilize the increased credit to gift limited interests in the Franklin Liquid Asset Family Limited Partnership, again at discounted values, to their children. Thus, in approximately one year, Dr. and Mrs. Franklin will each own only 1% of a $5,000,000 estate but control that estate in its entirety and their estate tax liability will be essentially reduced to zero.

In summary, Dr. Franklin’ second goal — minimization of estate taxes and preservation of family wealth for his heirs — is efficiently and completely accomplished by the use of FLPs. Through the principle of discounting, coupled with tax-free gifting of the discounted limited partnership interests, the value of Dr. and Mrs. Franklin’ taxable estate will be reduced to zero, although they will retain complete control over their assets, as general partners of the FLPs.

Through the implementation of the FLP plan, the Franklin children will be able to enjoy all of their parents’ wealth, with nothing paid to the IRS.

THIRD GOAL: MINIMIZATION OF INCOME TAX

FLP’s accomplish income tax minimization via the principle of “income spreading”. The principle of income spreading essentially allows for income to be spread among various partners of the FLP, including children, who are usually in lower tax brackets [income earned by children under 14 years of age is taxed at their parents’ income tax bracket; income earned by children over 14 years of age is taxed at the children’s own income tax bracket], rather than taxing all of the income at the highest tax bracket of the wealthy parents. [“Income spreading” is available to partnerships actually engaged in business (e.g., owning or managing rental property or owning a controlling interest in a business.)]

Consider, once again, Dr. Franklin and his family. Dr. Franklin, with income as chief o