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For couples with a net worth of over three million dollars and for individuals with a net worth of more than one million, five hundred thousand dollars, who own real estate other than their home, a family limited partnership is a way to make gifts to family members without giving up complete control of the asset or assets and to save estate taxes at death.
Under the federal gift tax structure an individual can make gifts of up to $11,000 per year per recipient. This amount is not deducted from the person's estate tax exemption at death. A couple can double this amount and give $22,000 per year per recipient. If a couple has three children, they can transfer assets with a value of $66,000 per year to the three children. At death each of the spouses then has an estate tax exemption of $1,500,000 to $3,500,000, depending upon the year of death.
A partnership is a legal entity established under state law. In a limited partnership there is a general partner or partners who manage and control the assets in the partnership. There are also one or more limited partners who are investors and receive benefits from the partnership but have no control or management of the partnership assets. General partners have unlimited liability in connection with the partnership assets. The limited partners may lose their partnership investment but have no liability beyond their interest in the partnership.
A "family limited partnership" is a standard limited partnership which has various family members as partners.
The IRS allows a discount to be taken when a fractional interest is given in real estate or some other non-divisible asset. Additionally, another discount is allowed if the interest is in a limited partnership and there are limitations on the transfer of the partnership interest. This discount usually ranges from 20-40% but occasionally is higher. Generally, the IRS will accept a discount of approximately 20% but will look at larger discounts rather closely and may disallow a portion of the discount.
If a couple has three children, sets up a limited partnership in which they put real property, and then gives a share of the partnership to each child, they are making a gift. Upon valuing the partnership assets, they determine that their $22,000 gift is 2% of the partnership value. However, since the partnership only owns real estate which is not capable of being divided and since there are restrictions on the transfer of the limited partnership interest, a 33% discount is taken and the couple give a 3% interest in the partnership, worth $33,000 to each child. By discounting the value they claim they are only giving away $22,000 per child because of the one-third discount. The parents as general partners continue to manage and control the real estate.
It is possible to place securities and cash in a limited partnership but real estate, other than a residence, makes a good choice, since the discount is less for traded securities and cash.
Establishing the partnership
To establish a limited partnership in California it is necessary to select a name. The proposed name can be checked with the California Secretary of State to see if it is available. A "Partnership Agreement" is prepared setting forth the terms and conditions of the partnership. It is signed by all of the general and limited partners. A one page form, Certificate of Limited Partnership, together with a filing fee of approximately $100, is then filed with the California Secretary of State.
Frequently, a husband and wife will be the initial general partners, holding a 1-2% interest. The living trust which they have established will be the limited partner, holding the remainder of the partnership interest.
After the partnership is established, the real estate is transferred by deed into the partnership name. There is no reassessment for real estate tax purposes on the transfer of the property to a partnership.
Tax Considerations
There is no income tax on the establishment of the partnership. The assets keep their same income tax value after transfer. A tax identification number is obtained and annual federal and California partnership income tax returns are filed. The partnership pays no federal income tax and only $800 annually to the State of California, but the partnership return is required as an information return. Each partner then reports on his or her personal income tax returns the proportionate share of income, deductions, depreciation, etc. This amount is based on the partner's percentage interest in the partnership.
The general partners can take a salary for management of the partnership assets if they choose. This salary is taxable income and is considered self-employment income (subject to social security, Medicare, etc.) for the general partners. The salary is paid out of the income of the partnership and each partner gets his or her deduction for this amount.
The partnership is usually set up to last for a period of years, but can continue beyond that date if the partners agree. Upon termination of a partnership and transfer of assets to the partners, there may be some income tax.
If more than 50% of the partnership interest is transferred during the existence of the partnership, then all of the real property in the partnership is subject to reassessment for real estate tax purposes.
Operation
The general partner or partners establish a partnership bank account, transfer the appropriate assets into the partnership name, change insurance policies, leases and other items to reflect the name of the partnership. The general partners then manage the partnership assets and can sign leases, sell assets, purchase assets, make exchanges, and take other action without the consent of the limited partners.
If a general partner dies or becomes incapacitated, the partnership agreement frequently provides for a successor general partner.
Gifts of Partnership Interest
To make a gift of a partnership interest, the limited partner (couple or their living trust) assigns a percentage to each child, son-in-laws and daughter-in-laws (if desired) and grandchildren. To determine the amount or percentage given, it is necessary to value the assets in the partnership and to have a qualified appraiser or accountant determine the amount of the discount. If the value of the partnership assets was $1,100,000, and a 30% discount was being used, a transfer of 3% of the partnership (equivalent to $33,000 minus the $11,000 discount) would be made to each party jointly by husband and wife.
The couple or trustees of their living trust complete a form "Assignment of Partnership Interest" for each gift. The partnership records are then changed to reflect the interest each partner has in the partnership.
If gifts are made to grandchildren who are minors, the gifts can be made until age 21 under the California Uniform Transfers to Minors Act, or can be made to an irrevocable trust, although such a trust can be rather complex.
If one spouse dies, the surviving spouse usually is the general partner and can continue to make gifts from the survivor's share.
Protection Against Creditors
A general partner of a limited partnership has personal liability for the debts of the partnership if the partnership assets are insufficient to pay these debts. Creditors can, in some cases, even reach the personal assets of a general partner. As previously stated, limited partners have no personal liability.
If a limited partner is sued in connection with another matter and the creditor attaches the limited partner's interest, the creditor cannot terminate the partnership or receive any partnership assets. Generally, the creditor can only obtain a "charging order" against the limited partner's interest and receive any distributions from the partnership that would have gone to the limited partner who was sued.
Family limited partnerships are not for everyone. With couples or individuals with "large" estates over the estate tax exemption, these partnership can be used to transfer assets each year without physically giving up the assets, and increase the amount of the gifts because of the discount used.
A couple with four children and six grandchildren could give $22,000 to each party each year and increase this amount by applying the discount to $33,000 per year per party. This amounts to $330,000 per year, or $1,150,000, over a five year period. If the couple is in the maximum estate tax bracket of 45%, this will amount to a future estate tax savings of $792,000.
Anyone considering establishing a limited partnership should discuss the advantages and disadvantages with an accountant and attorney.