EFFICACY OF FAMILY LIMITED PARTNERSHIPS: 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. Jones," 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.
Jones is a successful physician in Long Island, New York. He is
approximately 50 years old, is married with three teen-aged children, and
is chief of surgery at a major hospital. Dr. Jones' estate is worth
approximately five million dollars.
In addition to his surgery practice, Dr. Jones owns his home, as well as
several investment properties including an apartment building and a
shopping center. Dr. Jones also sits on the board of directors of his
hospital and his country club.
Dr. Jones wanted to establish a wealth preservation strategy for three
specific reasons:
-
Dr. Jones 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. Jones 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.
-
Dr. Jones 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.
-
Dr. Jones 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. Jones are
each the general partners. [Because Mrs. Jones is not a licensed
physician, Dr. Jones is the sole general partner of the FLP that owns the
stock in his medical practice.]
Dr. and Mrs. Jones 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. Jones 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. Jones 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. Jones'
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. Jones' 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. Jones' personal
bank and brokerage accounts, which were all placed into one FLP. Dr.
Jones' home was also placed into a separate FLP. Dr. Jones' private
medical practice was registered as a professional corporation.
Dr. Jones owned one hundred percent of the stock of that corporation and
he placed that stock into a separate FLP. If Dr. Jones 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. Jones' 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. Jones' 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. Jones Apartments Family
Limited Partnership," not Dr. Jones 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. Jones' 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. Jones' insurance company offered and went away.
The very next month, an auto accident occurred in the parking lot of Dr.
Jones' shopping center. A smarter, more aggressive negligence lawyer,
realizing that a lawsuit against the "Dr. Jones Shopping Center Family
Limited Partnership" would not yield very much, also sued Dr. and Mrs.
Jones 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. Jones'
attorney promptly informed the plaintiff's negligence lawyer that Dr. and
Mrs. Jones had no attachable assets.
They owned nothing -- not even Dr. Jones' medical practice (although they
controlled a great deal). A judgment against Dr. and Mrs. Jones 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. Jones'
insurance company's offer.
The
following summer, when a guest was hurt in the swimming pool at Dr. Jones'
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. Jones. 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. Jones' attorney promptly explained to the plaintiff's attorney
that Dr. Jones had no attachable assets. In order to avoid a lengthy
litigation and its attendant legal expenses, Dr. Jones offered to settle
the lawsuit against him for a nominal amount -- less than the expected
cost of legal fees to defend it.
Dr. Jones 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. Jones watched from the golf course.
Finally, one of Dr. Jones' patients developed a post-surgical infection
with complications. The patient sued Dr. Jones, 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. Jones' 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. Jones would be personally
liable for $4,000,000. Once again, Dr. Jones' 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. Jones and dropped the doctor from the lawsuit.
In each of the above cases, the fact that Dr. Jones 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. Jones' 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. Jones? 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. Jones'
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. Jones.
As general partners, they may determine never to make a distribution. The
FLP may still pay salary to Mrs. Jones, who is not a judgment debtor, and
it may make loans to Dr. Jones' children, who also are not judgment
debtors. Neither of these payments are "distributions" to Dr. Jones. 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. Jones' share
of the FLP's distributions, the FLP will issue the Schedule K-1 to that
creditor instead of to Dr. Jones.
Pursuant to Revenue Ruling 77-137, the IRS will
require the judgment creditor in possession of a charging order to pay tax
on Dr. Jones' 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. Jones, whose assets are owned by
FLPs.
Dr. Jones' 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. Jones'
insurers and left Dr. Jones 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.
SECOND GOAL: MINIMIZATION OF ESTATE TAXES
As noted earlier, when Dr.
and Mrs. Jones 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. Jones' 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. Jones
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 Jones' children ($1,500,000),
and 50% to the IRS ($1,500,000).
Clearly, Dr. and Mrs. Jones 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. Jones 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)("[T]he 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. Jones), 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 Jones family home was worth $1,000,000 before Dr. Jones 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 "Jones 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 Jones 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. Jones wished to gift as
much as possible to his children during his lifetime in order to minimize
the value of his estate at death.
Using $500,000 of their combined $2,000,000 unified credit, Dr. Jones 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. Jones transferred 98% of a $1,000,000 partnership, with an actual
value of $980,000.
Upon their
deaths, Dr. and Mrs. Jones, as 1% general partners, would each own $10,000
worth of partnership interests, but 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. Jones' taxable estate.
Dr. and Mrs. Jones used their total combined unified credits ($2,000,000)
to make four sets of tax-free gifts of $500,000 worth of discounted
limited interests in the following FLPs :
-
Jones Residence Family
Limited Partnership
- Actual FLP value: $1,000,000
- Discounted value of limited interests: $500,000
-
Dr. Jones Apartments Family
Limited Partnership
- Actual FLP value: $1,000,000
- Discounted value of limited interests: $500,000
-
Dr. Jones Shopping Center
Family Limited Partnership
- Actual FLP value: $1,000,000
- Discounted value of limited interests: $500,000
-
Dr. Jones, M.D., P.C. Family
Limited Partnership
- Actual FLP value: $1,000,000
- Discounted value of limited interests: $500,000
[In addition to unified
credit gifts of limited partnership interests as described above, Dr. and
Mrs. Jones may also take advantage of tax-free "exclusionary gifts" of
$11,000 worth of limited partnership interests that may be conveyed each
year by each parent to as many people as the parent chooses. Thus, Dr.
Jones is able to make an annual gift of $11,000 worth of limited
partnership interests to each of the three Jones children, and Mrs. Jones
may make an identical $11,000 gift each year to each of the three Jones
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 $66,000 would effectively remove
assets with an actual value of $132,000 from Dr. and Mrs. Jones' taxable
estate.]
After these gifts, Dr. and
Mrs. Jones each owned 1% of the above-mentioned FLPs as general partner
and their children together owned 98% of each FLP as limited partners. In
addition, Dr. and Mrs. Jones each still owned 47% (1% general partner
interest and 46% limited partner interest) in the Jones Liquid Asset
Family Limited Partnership (total FLP value: $1,000,000).
[Dr. Jones owned 1% of the Dr. Jones, M.D., P.C. Family Limited
Partnership as general partner and the Jones children together owned 99%
of that FLP as limited partners. Mrs. Jones was not a general partner of
the Dr. Jones, 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. Jones 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. Jones may utilize the increased credit to
gift limited interests in the Jones Liquid Asset Family Limited
Partnership, again at discounted values, to their children. Thus, in
approximately one year, Dr. and Mrs. Jones 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. Jones' 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. Jones' 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 Jones 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. Jones and his family. Dr. Jones, with income as
chief of surgery at the hospital, his private medical practice, his
ownership of a shopping center and an apartment building, is taxed at the
highest income tax bracket possible. On the other hand, Dr. Jones'
teen-aged children are all students and each is in the lowest tax bracket.
When Dr. and Mrs. Jones transferred their assets into FLPs, the FLPs
became the owners of the assets. Any income earned on these assets, for
example, rental income received from the shopping center and rental income
from the apartment building, is no longer directly taxable as Dr. Jones'
income, but instead is treated as income of the appropriate FLP.
Partnerships, including FLPs, are treated as "flow through" entities for
tax purposes.
Income earned by
an FLP "flows through" to the general and limited partners of that FLP,
and is taxed according to the tax bracket of each respective partner.
As noted above, Dr. and Mrs. Jones gave each of their children a 32.67%
interest in each realty FLP. Thus, when the partnership's income "flows
through" to each partner, each child will pay income tax at his or her
lower bracket on 32.67% of the income earned by that FLP. [The FLP may
distribute or lend enough money to each partner to pay the income taxes.]
Dr. and Mrs. Jones will pay income tax at their higher bracket on only 2%
of the FLP's income. As a result, there is an overall lower tax on the
family's income.
FLP's also allow for another level of income tax minimization, similar to
the income tax deduction granted to an individual for contributing to a
qualified retirement plan. Since the realty FLPs are engaged in the
business of owning and managing rental properties, these FLP's may employ
Dr. Jones, Mrs. Jones and each of their children to provide services to
the FLP (e.g., management, bookkeeping, rent collection, etc.)
The FLPs can therefore contribute pre-tax dollars to qualified pension
plans on behalf of the FLPs' employees. Contributions made by the FLPs to
such pension plans would be tax-deductible expenses of the FLPs, reducing
the gross income of the FLPs prior to the "flow through" of net income to
the individual partners.
CONCLUSION
Family Limited Partnerships
allowed Dr. Jones to achieve three very important wealth preservation
goals. First, he protected his assets from litigants and creditors and
discouraged a variety of potentially severe lawsuits. Second, he
eliminated the estate taxes that would be due upon his and Mrs. Jones'
deaths, thus preserving the family's entire wealth for their children,
rather than paying exorbitant estate taxes to the IRS. Third, he reduced
his income tax liability on the income received from his real estate
investments.
These goals were
achieved expeditiously, professionally and legally by taking advantage of
the provisions of the Revised Uniform Limited Partnership Act and the
favorable tax treatment of Family Limited Partnerships.
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