Published in Estate Planning, Trust & Probate News (now, California Trust & Estates Quarterly), published by the Estate Planning, Trust and Probate Section of the California State Bar, Vol. 13, No. 1 (Spring, 1993).
I. INTRODUCTION
It has been estimated that only 35% of family owned businesses are successfully passed to the next generation.[1] The reasons for this drastic failure rate are varied and complex and are beyond the scope of this memorandum. However, a significant part of the failure rate can be attributed to poor management-succession planning as well as the high death taxes attributable to the family business. It is the purpose of this memorandum to outline for you in "Layman's language" a planning technique that may help you minimize the risk that your family business (i.e. ranch, farm, rental real estate, proprietorship, etc.) will not be successfully transferred to the next generation.[2]
II. SETTING UP A FAMILY LIMITED PARTNERSHIP
The following will briefly describe the advantages and disadvantages of the family limited partnership. Generally the family limited partnership helps reduce estate tax and settlement costs, protects family assets and provides for succession of ownership and control of property.
A. The Limited Partnership Provides for Management and Succession of Ownership
The family limited partnership has replaced the corporation as the preferred choice of entity to hold property and to pass it from one generation to the next. This is true for both tax and non-tax reasons. As far as tax issues are concerned, a limited partnership rather than an S corporation is a better choice for the taxation of interim and final distributions of appreciated property. In addition, a partner in a limited partnership may utilize partner-ship liabilities, thus allowing for more losses to be deducted. An
S corporation has limitations upon the number and kinds of owners while limited partnerships do not. In addition to the tax reasons, there are practical reasons for having a family limited partnership.
The family limited partnership helps avoid intra-family disputes, because the limited partnership interest can generally be restricted to the members of the family. This is true even with a divorce. If the partnership interest was transferred in a divorce proceeding, it still would not be a valuable asset, as the recipient would not be able to dissolve the partnership, remove the general partner or force distributions of income from the partnership. A family limited partnership protects against third parties acquiring an interest in the partnership.
Specific management of the family business assets by proper "succession planning" can be accomplished with the family limited partnership. The general partners control the assets of the partnership, to the degree outlined in the partnership document, while the limited partners simply hold an interest without management authority in those assets (see paragraph N of Part III of this memorandum for further discussion on this point). Planning the succession of general partners, often at death of the current general partners, can be set out in the agreement. Additionally, methods for dispute resolution among the general partners can be organized in order to establish patterns to minimize family conflict over the management of the assets.
Perhaps the use of a properly drawn family limited partnership to manage family assets such as ranches and rental real estate may be the best way to maximize the chance the family business will survive to the next generation and not "self destruct."
B. Asset Protection
Under California law, the rights of a creditor seeking to execute a judgment or tax lien against the ownership interest of a debtor in a limited partnership is restricted. California Corp. Code Sec. 15674(a) provides that "an assignee of a partnership interest, including an assignee of a general partner, may become a limited partner if and to the extent that (1) the partnership agreement so provides, or (2) all partners consent." The limited partnership agreement can provide that the creditor is not allowed to become a limited partner. Without voting power, the creditor cannot remove the general partner or liquidate the limited partnership. The creditor would only receive a charging order. A charging order is a court order requiring that distributions of cash and property with respect to the encumbered partnership interest be paid to the creditor until the judgment debt is discharged. This can also be avoided if the family limited partnership holds non-income producing property, such as real estate and stock of the family owned business which does not pay dividends. Also, the general partner may be authorized to retain income as reasonable reserves.
If this is the case, all the creditor realizes from its charging order is an IRS Form K-1 at the end of each tax year and an income tax liability. If the spouse of a debtor holds her interest as separate property, and her conduct did not result in a judgment against her, her separate property interest may not be charged with a judgment debt against her husband. In short, a family limited partnership can make it extremely difficult for a creditor to obtain access to the assets of the limited partnership.
While a limited partnership protects the assets of the limited partners, the general partner may still be liable. A number of businesses which choose to use the limited partnership format and also wish to obtain maximum protection for the general partner have utilized an S corporation as the general partner. If properly formulated, the shareholders of the S corporation have their liability limited to the assets they have contributed to the corporation. Therefore, both the general partner and the limited partners are protected.
A claim may be made that transfers to the limited partnership were intended to defraud a creditor. However, transfers made for legitimate business and estate planning reasons are lawful. The transfers that cause problems are those that are made without consideration while the transferor is insolvent. This raises a presumption of fraudulent intent. However, when a transfer is made for consideration, as in the case of exchange of property for a limited partnership interest, such a transfer is made for a valuable asset and should be protected by the savings clause of Section 9 of the Uniform Fraudulent Transfers Act. Marital agreements and transfers should be recorded. Liability insurance should be acquired or continued.
C. Estate Tax Savings
A basic precept in estate and gift tax law is that, for tax purposes, assets are valued at their "Fair Market Value." The Internal Revenue Code and the IRS regulations generally define "Fair Market Value" as that amount of money a willing buyer will pay a willing seller, neither being under any compunction to buy or sell, both with full reasonable knowledge of the facts.[3] As a corollary to succession-management planning, family limited partnership interests, by definition, impact the legal ownership and management rights of the underlying partnership assets which, in turn, influence the values of those assets for estate and gift tax purposes.
A family limited partnership interest owned by your child, for example, may be worth less, for gift tax purposes, than if your child actually received a direct interest in the underlying partnership asset. Common sense tells us that a willing buyer of your child's limited partnership interest would pay less for that interest if the buyer were unable to remove the managers of the assets (the general partners), must wait until the partnership ends to receive his or her share of the underlying partnership assets, cannot resell the purchased partnership interest to anyone except family members, and cannot pledge the interest for a loan. These restrictions then lead to discounts in the value of the family limited partnership interest to be gifted (or already owned for death tax purposes) to the child.
The courts and the Internal Revenue Service recognize that discounts in valuation occur for partnership interests. In fact the IRS "Handbook" itself anticipates that discounts will be claimed by taxpayers.[4] It is not, therefore, in the IRS' view whether a discount exists, but, rather, the extent of the discount associated with the particular (minority) partnership interest. The courts have recognized the validity (based on common sense) of discounts over the years. In this regard, see the Tax Court case of John R. Moore v. Comm'r., 62 T.C.M. 1128 (1991), which includes a thorough discussion of the reasons it allowed a discount of 35% for gift tax valuation purposes.[5]
There are certain estate and gift tax risks that you must consider when planning and utilizing valuation discounts. One such risk is that the IRS will not accept the amount of the discount submitted by you. (See paragraph F, following, concerning appraisal requirements.) In this event, additional estate gift taxes plus penalties and interest may be due unless you initiate a successful Tax Court Action to defeat the IRS position. As mentioned above, the IRS position is not that a discount is available, but rather, the extent of the discount. Another obvious risk is that legislation (present and/or future) may change the valuation rules which we will discuss below.
Effective October 8, 1990, Congress added Chapter 14 to the Internal Revenue Code. Chapter 14 was designed to limit valuation discounts at death in family transfers by gift. Presently, Chapter 14 can be dealt with by having a proper business purpose for the family limited partnership (i.e., management succession planning which, in our opinion, outweighs any tax benefits) and by careful drafting of the control issues. However, since this legislation is
new, its full impact may not be known for years until after the courts have interpreted its meaning.
D. Gifts of Partnership Interests
An annual gifting program can be utilized in which capital account interests in the limited partnerships are given away instead of cash gifts. The gifts can qualify as a gift of a present interest subject to the annual gift tax exclusion. Individual gifts will also qualify for discounting as described above (see Revenue Ruling 93-13). This is extremely helpful in estate planning.
E. Reduction of Probate Costs
A family limited partnership can be utilized with a revocable living trust to avoid probate costs of transferring title. The estate settlement cost savings can be significant. The usual situation which would facilitate this would be to have the family assets owned by the family limited partnership and then transferred to the living trust.
F. Disadvantages
There are disadvantages to setting up a family limited partnership. A family limited partnership can be expensive to set up. Transferring assets to it may also trigger a due on sale clause in a mortgage. This should be examined before any transfers are made. Additionally, two separate appraisals will be necessary to properly value the gifts or partnership interests. For death tax purposes one appraisal is necessary to value the underlying assets of the partnership. For example, if the partnership consists of a ranch, a real estate appraiser must be engaged to determine the value of the ranch owned by the partnership. A second appraisal is also necessary to value the limited or general partnership interest that is given away by the donor or owned by the decedent.
If the conveyed property is rental real estate, the partnership is not entitled to the $25,000 passive loss under IRC Code section 469(i)(6)(C) that an individual owner may benefit.
Under California Law, the limited partnership cannot engage in the banking or insurance business. The partnership should not own a qualified retirement plan or individual retirement account as the transfer would be treated as a taxable termination. Because of the homestead exemption, a residence should not be transferred to the limited partnership unless the homestead exemption, as in the case of California, is insignificant.
Transfers to partnerships and trusts in the state of California may result in a change of ownership which would step up the property tax basis of the property otherwise protected by Proposition 13. Proper planning may reduce (but not eliminate) the risk of a change of ownership for property tax.
Lastly, the estate and gift tax valuation issue may be subject to challenge by the IRS as described above.
III. PRACTICAL MATTERS IN GETTING STARTED
Keep in mind, as a general rule, that partners (general or limited) must not think of themselves as individuals, or appear to do business as individuals. Although you are partners, you are not the partnership--it is a separate entity and the distinction between you and your personal affairs and the partnership and its business affairs must be maintained.
The general partner should ensure that the following tasks are accomplished:
A. Certificates/Statements of Partnership
If your family partnership is a limited partnership, a Certificate of limited partnership (which lists the names and addresses of all partners, the address of the principal office, and the agent for service of process) must be filed with the Secretary of State. Normally your attorneys handle this at the time they prepare the partnership agreement. If the partnership owns real property, a certified copy of this Certificate of Limited Partnership must be recorded in each county in which real property is owned. Failure to properly file the Certificate of Limited Partnership will result in the partnership being classified as a general partnership notwithstanding the terms of the agreement itself.
If your family partnership is a general partnership, a Statement of General Partnership (which lists the names and addresses of all partners) will be prepared and recorded in each County in which the partnership owns real property. [Note: since this article was written and published, California law has changed in regard to general partnerships. Now a Form GP-1 may be filed with the Secretary of State's Office, and then recorded in each county. Click here to see article on new partnership law.]
B. Fictitious Business Name Statements
You may file a Fictitious Business Name Statement with the county clerk of each county in which the partnership does business; however, if a Certificate of Limited Partnership or Statement of General Partnership is recorded in that county, a Fictitious Business Name Statement often is not filed. If the partnership does business under a name other than the partnership name, a Fictitious Business Name Statement should be filed in addition to a recorded Certificate of Limited Partnership or Statement of General Partnership.
C. Transferring Ownership Interests to Partnership
When a partner contributes property to the partnership in exchange for an ownership interest in the partnership, the transaction should always be in writing (in some cases, such as with real property, it must be in writing). Normally these documents are prepared by your attorneys at the time you establish the partnership; however, if any additional property is to be contributed to the partnership, be sure to check with us to make sure it is properly documented and transferred.
D. Amendment Leases or Other Agreements
If there are any agreements concerning property transferred to the partnership, such agreements must be amended in the partnership name. For example, if a partner is contributing a 10% ownership interest in real property to the partnership, and that property is leased to a third party, the lease must be amended or assigned to show the partnership as one of the lessors.
E. Accountant
The general partner should retain an accountant who will assist you in setting up a partnership bookkeeping system, audit partnership records, and prepare the required tax returns.
F. Tax Identification Number
A federal tax identification number for the partnership must be obtained. The partnership accountant can obtain this number; or the general partner may complete IRS form SS-4 and send it to the IRS to obtain the number.
G. Income Tax and Informational Returns
Annual informational returns are required for the partnership, and the partnership must also provide to each partner (within 90 days of the end of each taxable year), information necessary to complete federal and state income tax or information returns (usually IRS form K-1's). In addition, where there are 35 or fewer limited partners, a copy of the limited partnership's federal and state returns for the year must be sent to each partner within the 90 days. Your accountant will normally prepare these returns and you can assist the accountant to make sure they are timely filed and sent to the partners.
H. Property Income
Where property is owned by both the partnership and others (e.g., real property owned by other family members along with the partnership ownership interest), all income produced by such property must be paid to each owner according to the owner's respective interest. For example, if the partnership owns a 40% interest in property which earns $100,000 per year from a lease, $40,000 of the income must be paid to the partnership and the remaining $60,000 must be paid to the remaining owner(s). Again, in order to maintain the existence of the partnership as a separate entity (and to validate any gifts of ownership interest which have been made), it is imperative that the partnership receive its respective share of property income and that the partnership income actually distributed in accordance with the partnership agreement.
I. Real Property Taxes
If the partnership owns real property, the partnership is responsible for paying the property tax proportionate to its percentage interest. For example, if the partnership owns a 40% interest in property which is assessed $1,000 for real property taxes, $400 of this tax bill must be paid by the partnership and the remaining $600 must be paid by the remaining owner(s). In order to maintain the existence of the partnership as a separate entity (and to validate any gifts of ownership interest which have been made), it is imperative that the partnership pay its portion of such taxes.
J. Bank Account
The general partner should open an interest-bearing checking account in the name of the partnership with all cash contributed to the partnership at the time of its formation. (You will need to provide the bank with the tax identification number, and may also need to provide a copy of the Certificate of Limited Partnership or Statement of General Partnership if requested.) For family partnerships which do not have numerous financial transactions, it is often easiest to make sure all income is deposited into one checking account and all expenses paid out of the one checking account so that the check register provides a record of all partnership transactions. (Of course, excess funds may later be transferred to a savings or other investment account to obtain an increased interest rate.)
K. Recordkeeping
Clear accounting records must be kept of all partnership funds, partners' respective capital accounts, and distributions of profit and loss. The general partner should work with the accountant to set up a system workable for your partnership. In the case of any limited partnership with more than 35 limited partners, the general partner must send an annual report to each partner not later than 120 days after the close of the fiscal year; this is prepared by the accountant.
L. Records Required to be Kept at Principal Office
The partnership is required to keep the following records at the address of the principal office listed on the Certificate of Limited Partnership (or Statement of General Partnership):
1. A current list of the full name and last known business or residence address of each partner set forth in alphabetical order, together with the contribution and the share in profits and losses of each partner.
2. A copy of the Certificate of Limited Partnership (or Statement of General Partnership) and all certificates of amendment thereto, together with executed copies of any powers of attorney pursuant to which any certificate has been executed.
3. Copies of the partnership's federal, state, and local income tax or information returns and reports, if any, for the six most recent taxable years.
4. Copies of the original partnership agreement and all amendments thereto.
5. The partnership's books and records as they relate to the internal affairs of the partnership for at least the current and past three fiscal years. These records will include all agreements and important documents, such as notices given to the partners, deeds, leases, contracts.
Each partner has a right to inspect each of these documents upon reasonable request.
M. Avoid Commingling
It is imperative that no personal funds or affairs of an individual partner (general or limited) is mixed with funds or affairs of the partnership. For instance, you should not use the partnership's checks to pay your personal and household bills, or vice versa. You should not borrow money from the partnership or loan money to the corporation without signing a promissory note and complying with the terms of the partnership agreement and California law.
N. Management Responsibilities
In a limited partnership, only the general partners have management authority and it is imperative to review and abide by the provisions of the partnership agreement concerning the management responsibilities of the general partner. The limited partners do not have management authority. In a general partnership, all partners have management responsibilities, although such responsibilities may be delegated to one managing partner. In any event, all management decisions and operations of both limited and general partnerships must be in accordance with the terms of the partnership agreement as well as general partnership law.
Where there are any substantial, unusual, or peculiar transactions, it is advisable that they be taken only after notifying all partners and holding a meeting to discuss any such matters (such as selling the real property owned by the partnership). Similarly, if other partners are concerned about your actions, there are provisions under California law whereby they may call a meeting of all the partners to discuss the matter.
O. Partnership Name
Whenever a transaction involves the partnership, the partnership name (and not your individual name) must be used. If the partnership owns a majority interest in property, all contracts, accounts, utilities, and other similar related matters should be transferred into the partnership name.
Whenever signing on behalf of the partnership, the general partners should never sign in their own names (even "John Smith, General Partner of The Smith Family Partnership" is improper) but should sign the partnership name, designate it as a partnership, and then sign by the partner's name as general partner; e.g.:
THE SMITH FAMILY PARTNERSHIP,
a California limited partnership
By ________________________________
Mary Jane Smith, General Partner
By ________________________________
John Smith, General Partner
(Be sure to check your partnership agreement and Certificate of Limited Partnership or Statement of General Partnership to see how many general partners are required to sign on each document.)
P. Personal Guarantees
Some creditors, banks, and other entities may require you to sign a "Personal or Continuing Guarantee" or to co-sign notes or contracts individually in addition to the signature of the partnership. Sometimes you cannot avoid this if you need the loan or other agreement. But keep in mind that by signing such a guarantee, or by co-signing, you become personally liable if the partnership cannot pay. If a creditor does require a personal guarantee you should consult with us to determine if there are any other estate planning ramifications to your guarantee.
Q. Ownership Interest and Assignment
An interest in a limited partnership is personal property and a partner has no interest in specific partnership property. An interest in a general partnership includes an interest in specific partnership property, an interest in the partnership, and a partner's right to participate in the management. A partnership interest may be assigned to another, in whole or in part, except as provided in the partnership agreement (normally, your family partnership agreement will restrict assignment of partnership interests to persons outside of your family). An assignment of partnership interest will not dissolve the partnership.
However, keep in mind that under the rules for taxation of California real property, if the partnership owns real property and if 50% or more of a partnership interest is assigned or transferred, this will result in a "change in ownership" of the real property and will result in re-assessment of the value of the real property (finally resulting in increased real estate taxes).
R. Addition or Subtraction of Partners
If new partners are added to the partnership, or if a partner withdraws, dies, or assigns the partnership interest to another, the Certificate of Limited Partnership must be amended and the amendment filed with the Secretary of State. A certified copy of the filed amendment must also be recorded in each County in which real property is owned by the limited partnership. (If the partnership is a general partnership, the Statement of General Partnership must also be amended recorded.) If a Fictitious Business Name Statement has been filed, that must similarly be amended.
S. Dissolution of Partnership
At the time the partnership is dissolved, final tax returns must be filed, and the partnership assets be distributed according to the terms of the partnership agreement. If a limited partnership, a Certificate of Dissolution must be filed with the Secretary of State. You will need to work with us and your accountants to properly comply with California law in winding up the affairs of the partnership.
IV. REGARDING OPERATION OF FAMILY PARTNERSHIP
A. Overview
Our objective in setting up your family partnership has been to achieve the desired goals of proper management of the business, succession planning, asset protection, and discounted values, as well as splitting income among family members. The tax goals will not be achieved if the partnership is not operated in the manner in which it is set up. The Internal Revenue Service (the "Service") may take the position that your family partnership does not exist for tax purposes. Therefore, it is very important that the partnership be operated in accordance with these instructions in order to achieve the desired goals. Throughout this discussion the person who sets up the partnership will be referred to as the "donor" and the other partners, usually the children, will be referred to as the "donees" (because they usually receive their partnership interest as gifts).
B. Capital as a Material-Producing Factor
Congress has passed Internal Revenue Code Section 704(e) to set forth criteria for determining whether the donees are real owners of their interests. These criteria are listed below. No one criteria is by itself determinative, but taken together the criteria can result in the partnership not being recognized for tax purposes. Although your partnership agreement will address all of these issues, it is important for the donor to see that they are carried out. Failure to follow the partnership agreement or to ignore it, may result in the partnership being treated as a sham. The following are certain controls which should not be abused by the partner in power.
C. Direct Controls
1. Controls Over Distribution of Partnership Income. The person who set up the partnership (i.e., the donor) should not personally retain control over the timing of income distributions (such as where the person who set up the partnership is the managing partner having authority to control distributions or is a general partner having such powers in a limited partnership). Also, the person who has set up the partnership should not arrange the transactions so that there are contractual restrictions on the current distribution of income (such as where the Partnership agreement requires that all or a certain arbitrary percentage of income be accumulated for a period of time).
2. Limits on the Donees' Right to Dispose of Their Interest Without Financial Detriment. Your partnership agreement may restrict a partner's freedom to transfer their partnership interest or cause a liquidation of the venture. This is all right. The important point is that this can be done "without financial detriment." The partnership then will not be invalidated if it requires a partner to offer his interest to the partnership (or the other partners) at the same price as any bona fide offer from an outside party before accepting that offer. However, a provision giving the partnership the right to purchase a partner's interest for a set price which bears no relation to the interest's actual value could cause a partner financial detriment and would mitigate against a donee's real ownership for tax purposes. Your partnership agreement will be drafted to comply with the regulations, but if the donor substitutes an informal procedure in which the donor makes it difficult for one of the partners to be bought out this would be a problem in recognizing the partnership as a valid one for tax purposes. Please consult with us if you wish to make a change in the buy-out procedure.
3. Retention of Control Over Essential Assets. Your partnership agreement will be drafted so that the donor does not retain control over essential assets. For example, the donor should not lease essential assets to the partnership by a tenancy at will or a short term lease. The donor also should not retain the right to withdraw the essential asset which would cause the partnership to cease business, thereby rendering the donees' partnership interests worthless. If the donor wishes to engage in any of these types of controls or activities it is important that it is discussed with an attorney before doing so.
4. Retention of Management. It is acceptable for the person who set up the partnership to retain control by voting or management since it is consistent with ordinary business practices. The donor's control, however, must be subject to the donees' right to liquidate their interest without financial detriment. The donees will not be deemed to possess this right unless they are both independent of the donor and have sufficient maturity in understanding their rights to be able to exercise them. This criteria requires a factual determination and it is not anticipated it will be a highly scrutinized factor in your case. The partnership agreement will give the majority of the control to the person who set it up, but this becomes dangerous for tax purposes only to the extent that the other partners are immature and not independent of the donor. These factors will be analyzed in setting up your agreement. If you wish to change the agreement after it is operational, please let us know.
D. Indirect Controls
What you cannot do directly, you cannot accomplish by indirect means. That is, the problem of retained controls cannot be avoided by retaining those controls indirectly through an entity controlled by the donor.
This factor should not be a problem in the partnership agreement which will be drafted for you. However, if you anticipate that any of the assets which the partnership will acquire will somehow result in the donor having indirect control, then this needs to be reviewed and analyzed before it is implemented. Also, keep these requirements in mind in your future management of assets and designation of entities (e.g., trusts) to own your assets if any such assets are likely to be assigned to the partnership at a future date.
E. Participation and Management
The donees should participate in the control and management of the business, particularly policy decisions, and not just perform ministerial acts. The Service views this as evidence of the donees' control over their partnership interests. However, in a limited partnership, the donee limited partner must surrender control to the general partner and should not participate.
F. Conduct of the Partnership Business
The following are suggestions for showing that donees are actual owners of their partnership interests. It is the first thing the Service looks at, and compliance with these formalities can avoid further digging by an agent: (1) the partnership name showed that the donees are partners, (2) the partnership should comply with all state partnership and fictitious names as well as business registration statutes, (3) the donees (if general partners) should have some control of business bank accounts, should be recognized (general and limited partners) in distributions of partnership property and profits, and their existence should be noted in insurance policies, leases and other business contracts. The donees should also be recognized in written agreements, records and memoranda. If possible, the donee general partner should have an authorized signature for partnership bank accounts. In sum and substance, they should be treated the same as other partners and should be listed in any documents which show the composition of the partnership. The partnership agreement should be written and the partnership should file partnership tax returns.
G. Trustees as Partners
If the partnership is to be formed with minors, sometimes there are separate trusts (sometimes called 2503(c) trusts) created for the minors' interest, and sometimes the partnership agreement creates a trust to hold the interest of the donees. Using a trust avoids the necessity of appointing a guardian for the minors. Furthermore, if an independent trustee is used, the Service should recognize the trustee as a partner, provided the donor is not retaining unacceptable controls. The donor should not be the trustee if this can be avoided. If you feel it is necessary to replace the trustee (you should not personally have the power to do this), it is better to replace the trustee with an independent trustee. One case does sanction the donor serving as trustee where it can be shown that the donor actively represents the interest of the beneficiary. Despite the advantages of using a trust, they involve special problems. If you intend minors to be donee partners, you need to discuss with us more fully the implications and ramifications of creating trusts for them.
H. Allocation of Family Partnership Income
As a general rule, the income should be allocated in accordance with the partnership capital. Therefore, if you or any other partner own 10% of the capital of the partnership you or the other partner should get 10% of the income. The first exception to this rule requires departing from the partnership agreement if the donor performs services for the partnership, then enough partnership income must be allocated to constitute reasonable compensation for those services before allocating the remainder according to the partnership agreement. Therefore, if you are the individual who set up the partnership and are the managing general partner, (the donor) then you must be allocated a reasonable amount for your services. If you are hesitant or in doubt as to what constitutes a reasonable amount for your services, you might find out by questioning people who are compensated for the same type of services and see if your compensation agrees with theirs. Or, you can discuss this matter with us.
The second exception to the general rule is applicable where the portion of the partnership income allocated to donated capital is proportionately greater than the share of the donor attributable to the donor's capital. Therefore, if you allocated a disproportionately large portion of income to donated capital, the law requires a reallocation in accordance with capital interests. This rule only applies to donated capital. There is no prohibition against a disproportionate allocation in favor of the other capital. Therefore, if you arbitrarily change the partnership agreement or start allocating income to someone who has been given his or her capital interest and its allocation is disproportionately large, you can expect it to be reallocated by the Service. If you anticipate a change in the allocation of the income from that drafted in the partnership agreement, it should be something that you discuss with us. In no event should you ever
arbitrarily allocate a disproportionately larger share of income to yourself.
Normally, however, the partnership agreement (or attached schedules) sets forth the percentages for allocation of income.
I. Special Allocations
While special allocations are allowed under the Internal Revenue Code under the special situation of a family partnership, they should be carefully discussed and reviewed before you undertake them. Therefore, if you sell a property and decide to make a special allocation to one of the donees (but in no event to yourself), you should contact us before doing so.
J. Estate Planning Considerations
With regard to the operation of the family partnership and estate planning considerations, it is mandatory that the terms of the partnership agreement be followed to the letter. The General Partner has a fiduciary obligation to follow the terms of the agreement, otherwise, he or she risks being sued by the other partners for a breach of that duty. As a part of the General Partner's fiduciary obligation, income must be distributed to the partner in proportion to their ownership interest (except as noted previously in this memorandum). Failure to follow these requirements may result in the IRS arguing that the donor has retained the right to all of the income of the gifted property and therefore all of the property will be included in the estate of the donor, notwithstanding that valid gifts of the limited partnership interests have been made. For this to happen, all that is required is that the IRS perceives an oral agreement among the family that the donor has the right to all the partnership income.
In short, with respect to the estate planning issues, the partnership agreement as drafted should achieve your desired goals, but if you amend the partnership agreement or change it in any way to give the donor more control, to set up a buy-sell agreement, or to change the allocation provisions, you need to contact us or an attorney before doing so. Small changes can have profound affects in the estate tax results of your partnership.
V. CONCLUSION
The above is a synopsis of a very complex area in management planning and tax law. If you do not understand any of the issues raised above, or wish further clarifications, or simply have additional questions, please feel free to call us so that we can discuss them.
Notes:
(1) See Le Van, Passing the Family Business to the Next Generation: Before Estate Planning Begins, 14 Probate notes 257 (1988).
(2) Please note that the issues are complex and that this memorandum is only a general discussion to acquaint you with these issues. THIS MEMORANDUM IS NOT MEANT TO BE RELIED ON FOR LEGAL PURPOSES.
(3) See Treas. Reg. sec. 20.2031-1(b).
(4) "Handbook" at section 7(11)6.
(5) See also Estate of Mary F. Bright, 81-2 USTC para. 13,436 (5th Cir. 1981).
The contents of this publication are for information purposes only and are not meant nor should be construed to be legal advice. Note, also, the date of the document. Laws are constantly changing, and are subject to differing interpretations. We, therefore, urge you to do additional research or to contact your own legal or tax counsel before acting on the information contained herin.
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