| Cash | $ | 100 |
| Cherry Lane Property | $ | 100,000 |
| Desert Hill Partnership | $ | 10,000 |
| TOTAL CAPITALIZATION | $ | 110,100 |
Another calculation that your CPA will make is an adjustment to the capital account(s) of the partner(s) who transferred the asset(s) into the partnership. For example, if John and Jane Doe transferred the three assets listed above to the partnership, their capital account balance would be $110,100. As gifts are made by John and Jane Doe to other partners or as other partners contribute assets to the partnership, their respective capital account balance will obviously change.
A partner has the option of contributing assets and allocating the value of those assets to the capital accounts of other partners. This allocation results in internal gifts to the designated non-contributing partners from the contributing partner. This option is usually outlined in a letter of instruction from the client, which is prepared by the client or by the attorney and submitted concurrently with the transfer document. Copies of the instruction letter should be circulated to the CPA, the attorney, and the client so that all parties are advised.
1.6 Annual accounting. Once the above steps are completed, a yearly accounting is all that is required. This review is usually accomplished at an annual meeting of all the advisors and the clients. The meeting (usually combined with the estate review and, where applicable, the review of the family corporation) normally takes only a couple of hours. All decisions are made so that the annual partnership minutes can be prepared, any annual or lifetime gift documents can be prepared, and the CPA has all the accounting information with which to prepare that year’s income tax returns for the partnership.
2. Is the accounting for a limited partnership complex? Accounting for the limited partnership is not complex. The general partner(s) take money out of the partnership by writing checks to themselves. During the annual meeting at the end of the year, the general partner(s), the partnership attorney, and the partnership CPA review the canceled checks and designate whether the distributions are (1) principal distributions; (2) salary or income distributions; or (3) loans, depending on what is best tax-wise for the general partners and the limited partnership.
The partnership CPA maintains the accounting records for the capital accounts within the partnership and also prepares the K-1’s for general and limited partners’ personal income tax return. Once the tax liability for each partner has been established, the general partners usually distribute enough income and/or principal to cover the limited partner’s income tax liability. Until the last surviving parent/general partner dies, distributions are usually made to cover income tax liability, unless the general partners want to make distributions to their children, the limited partners, ahead of time.
3. If we decide to make annual or lifetime gifts, how is this done? Every year, gifts of limited partnership interests from the family trust may be made to each designated family member, utilizing the grantor’s annual gift exclusion amount ($10,000 by each donor and $20,000 by a husband and wife). These gifts will reduce the gifting partner’s limited partnership interest and increase the percentage interests owned by the various children, grandchildren, and other family members. If the size of the estate warrants it, lifetime gifts can also be made ($600,000 per donor) to skim the appreciation off the estate.
As with other important documents, copies of the gift documents will be circulated to the CPA, attorney, and clients. Once the gifts have been finalized, adjustments are made to the appropriate capital accounts, and the new partnership percentages are calculated. When the CPA has made the new calculations, a partnership amendment is prepared and filed by the attorney. Some states do not require the amendment to be filed. In that case, the partnership amendment is placed in the original partnership minute book.
Once all of the parents’ limited partnership interest has been gifted down to the next generation, a victory party should be given since most of the value and income in the partnership will be attributable to the younger generations rather than to the estate of the older generation, saving the family hundreds of thousands of dollars. The general partner will have 100% control of the limited partnership without suffering the tax burden of 100% ownership. The only amount of income or appreciation attributed to their estate will be that portion equal to the very small percentage of ownership left to the general partner.
Another fantastic benefit of gifting limited partnership interests is that the donor will be making gifts of minority interests in the limited partnership. Therefore, a 30% (safe harbor) discount can be taken on the gifts so that the donor gets more “bang for his buck.” If an appraiser is engaged to appraise a 1% interest in the limited partnership, the donor might receive up to a 55% discount on the gifts of limited partnership interest.
Gifting limited partnership interests allows substantial savings to be enjoyed by the surviving children and grandchildren, depending on the size of the estate. The alternative for the surviving family members is to pay the estate tax liability within 9 months of the date of death, utilizing bank loans, liquidation of family assets, or by other emergency means.
4. Where are the partnership records kept? Two partnership notebooks are prepared concurrently with the preparation of the partnership documents. The first notebook is designated “Original Partnership Notebook” and is generally always kept with the legal file at the attorney’s office. All original documents are put in this notebook.
The second notebook is designated “General Partner’s Partnership Notebook” and is given to the clients or to the general partners. It holds copies of the original documents contained in the “Original Partnership Notebook.” When subsequent documents are prepared by the attorney, copies are sent to the clients as the general partners with instructions on where they should be inserted in the general partner’s notebook.
5. Answers to frequently asked questions. Now that the routine partnership activities have been discussed, we have provided some answers to frequently asked questions relating to the operation of a family limited partnership.
5.1 If I make gifts or transfer assets to a limited partnership, will I lose control? As the general partner, the trust (or the trustees thereof) will have 100% control over the assets in the partnership.
The limited partners (who are silent partners) would be the family revocable trust, owning most of the limited partnership interest, with other family members or their trusts each owning initially a small limited partnership interest.
5.2 Does the partnership provide credit or protection? The limited partnership laws of most states provide an unusual protection for the limited partnership from non-bankruptcy creditors of the partners.
The reason for this protective statute is that the limited partnership is and has been used as an investment vehicle, involving the purchase of interests by innocent members of the public. As such, the investors are exposed to problems if a general or limited partner has creditor problems and some stranger, whom the partners do not know, forecloses and becomes a partner in place of the debtor partner with whom the investors originally agreed to be associated.
For whatever reasons, our esteemed legislators have enacted laws which prohibit creditors who levy on a limited partnership from getting anything more than a “charging lien.” The term “charging lien” means that the creditor may levy on a general or limited partnership interest only to the extent that he becomes the equivalent of an “assignee of a limited or general partner who is not officially a general or limited partner.” In other words, if I, a creditor, levy on a limited partnership interest of yours, whether it be general or limited, all that I am entitled to receive is a charging lien which gives me the right to receive only the distributions of income made by the general partners to themselves and the limited partners, all in accordance with the partnership agreement. The partnership agreement usually provides that the distribution of cash or property from the limited partnership is discretionary with the general partner. In other words, the general partner could continue to operate the partnership even though there were creditors with charging liens, make “oodles and scads” of profit in the limited partnership, reinvest those profits, and never, ever give any cash or property distributions to the creditors who have charging liens against the limited partnership.
This charging lien position puts the creditor in a unique situation tax-wise. The creditor is “attributed” his share of the partnership income and must pay the income tax on that attributed income. This phenomenon is sometimes called “phantom income.” Imagine a creditor, year after year, being taxed on income in a partnership, but never receiving any cash to pay taxes on the income. This is like investing in a prison where you receive a whipping every year – wistfully hoping that the general partner will decide to make a cash distribution or waiting years until the partnership terminates according to its articles.
If the general partner or limited partner had creditors levy on an interest in the partnership, the trust as general partner could still “wheel and deal” with the partnership property as long as the general partner did not make cash or property distributions to the general and limited partners, one of whom might be a creditor with a “charging lien.
We also included another provision in the partnership which discourages creditors from being too aggressive – Paragraph 6.9 (Involuntary Withdrawal Resulting from Creditors Proceedings, Levies, or Bankruptcy). This provision allows the partnership to buy back the interests that are levied upon at 50 percent of the fair market value with 10 percent down and the balance paid over 10 years at prime plus 1 percent interest.
An exception to these general guidelines is where the general partner of the partnership goes bankrupt. In this case, the trustee of the general partner’s bankruptcy “steps in the shoes” of the general partner, becoming the acting general partner. There are additional steps which can be taken to prevent this scenario which can be discussed with an attorney if there is the possibility that a bankruptcy of the general partner could occur.
5.3 How does the limited partnership help the limited partners before the parents or the general partner die? As previously stated, the gifts of limited partnership interest reduce the parents estate tax liability. The limited partnership also protects the partnership assets from third parties or from creditors, serving as a “porcupine” against their claims.
In addition, the limited partnership serves as a “family bank.” The limited partners, with the consent of the general partners, can receive salary and income or principal distributions from the partnership. Further, the family can require that any monies received be treated as loans with proper documentation and adequate interest and security as part of the terms of the promissory note and security documents.
5.4 What happens when both parents or the general partners die? Since the general partnership interest is normally owned by the family trust, the designated successor trustees of the trust act on behalf of the general partner, and the interests in the family limited partnership owned by the children are administered according to the dispositive provisions of the family trust. For example, if the estate is to be split equally among the children, the children could decide to keep the partnership in existence in their generation or they could agree “to take their marbles and go home.” This would mean that they would split their interests equally, or as otherwise set forth in the family trust, by taking what is in their respective capital accounts and then dissolve the limited partnership. Either way, they have gotten assets across the line free of estate taxes.
5.5 If I put assets in a limited partnership, will I become “cash poor”? We have developed a technique to prevent “cash claustrophobia.” This technique involves the use of Line of Credit Promissory Notes between the limited partnership as maker and the revocable trust or the donors as payee. This promissory note is properly secured. The result of this transaction is that, at any time, the donor can have access to any amount of money up to the maximum loan amount designated on the promissory note itself. This is an arbitrary number and must be reasonable. The loan amount is one chosen by the clients and professionals depending on the needs of the clients.
5.6 Are there any other benefits of a limited partnership? Yes. There are even more benefits from the limited partnership that you do not have with your family trust. There is the Internal Revenue Code § 6166 tax deferral treatment on all assets owned by the partnership on your death, assuming that the partnership has been treated as a “trade or business” and that proper records have been kept. Section 6166 tax deferral treatment means that you will have 14 years to pay any estate taxes due on the partnership properties. The estate tax is paid in the following manner:
For 5 years, the taxpayer pays interest only (4% on the first $1 million dollars). Anything above $1 million dollars is at the standard interest rate. After 5 years, the taxpayer pays interest and principal prorated over the remaining 9 years.
This means that the family can avoid liquidating assets right after the death and can have the option to pay any amount due over a period of years instead.
5.7 Will the family limited partnership affect my relationship with the bank? Having assets in a family limited partnership will not affect your relationship with the bank. If you need to establish lines of credit, the general partners can guarantee all loans on behalf of the partnership. Limited partnerships have been around for a long time so financial institutions are familiar with them.
If you have further questions, telephone us right away. As the attorneys who drafted your partnership agreement, our job is to ensure that you completely understand how to operate your family limited partnership. Otherwise, it would be like buying a Mercedes without a key.
