Articles
|
Publications
IN PLAIN ENGLISH: Why You Should Be Using Family Partnerships.
By David M. Cohen
So much has been written on the topic of Family Partnerships, from the impenetrably complex to the extravagantly exaggerated, that confusion is practically unavoidable. Unless you understand what a family partnership is and how you might benefit from one, you cannot employ them as part of your estate planning in any meaningful way. To that end, this brief article will identify those areas in which family partnerships can be extremely valuable to you, as well as some problems to avoid.
By way of example, consider a local building company owned by a husband and wife, Mom and Dad. Mom and Dad are both 55 years old and have 2 children: Daughter, who works in the business (an "inside child") and is being groomed to become President, and Son, who has no connection to the business (an "outside child"). Mom and Dad have a $5 Million net worth, little of which is outside of the business.
Mom and Dad have a number of goals, which fall within three basic categories:
- Business Succession: transfer control over the business to Daughter when she is prepared to accept it and Mom and Dad are prepared to yield it; guarantee financial security for themselves after control is passed; and treat Son fairly, financially, to offset or protect him against Daughter's control of the business.
- Asset Protection: protect individual assets from business risks and protect business assets from personal and unrelated business risks.
- Estate Planning: accomplish the foregoing at minimum gift, estate and income tax cost.
For purposes of this article, the term "partnership" is used in the generic sense, i.e., a business entity owned exclusively or principally by family members. The forms which predominate in the real estate industry are Limited Liability Company (LLC), Partnership (General, Limited or Limited Liability) and S or C Corporation. Each offers certain advantages and disadvantages, and a discussion of these would exceed my page allocation. Suffice it to say that once the goals and the approaches to meeting those goals are set, counsel will advise as to the correct form.
A key to effective succession planning, defined as planning to pass the business to the next generation without losing it to a forced tax sale or other liquidity crisis--as opposed to preparing the business for sale, which is a different type of exit strategy--is the bifurcation of operational control and equity. A critical element in cutting transfer (i.e., gift and estate) tax is the development of a strategy to pass wealth at the minimum possible valuation. When the wealth is in the business, we shall see that the strategy generally anticipates inter-vivos giving of business interests. Yet, at the same time, effective succession planning as well as the security of the older generation requires that the parents maintain control at least until the next generation is "ready" to assume that control (and the parents are ready to relinquish it). The timing of these two events rarely coincides.
There is, of course, a complication in Mom and Dad's planning: what to do about Son, who will not be actively involved in the business? Is it fair to transfer equivalent equity to both children if only the "inside" child will eventually take control? Is it feasible to do so? Should the "outside" child be given something else of value to offset the planned control premium that the other is to receive? Assuming that Mom and Dad's net worth is substantially tied up in the business, that "something else of value" must come from the business, perhaps in the form of disproportionate equity or perhaps a priority return on equity (in effect, a distinct economic class of equity similar to preferred stock).
Thus, Mom and Dad could begin now to pass non-voting equity to Son and Daughter currently, possibly providing disproportionate equity or income for Son who will not receive voting equity later. See Figure 1.
Proper asset protection planning must be multi-directional. Traditionally, such planning concentrated on protecting principals against the liability of the business. Hence, real estate development activities have long been conducted in a corporation or corporate-like entity to shield the principals.
A variation on this theme, one that the lending community has endorsed, is the single-project entity. Each business entity owns a single project (residential or commercial) and, thus, not only are principals protected against business liabilities (barring guarantees or other assumptions of personal liability) but each project entity has a measure of insulation against loss because of a problem at another site, barring cross-default or cross-collateralization agreements. The lending community favors single-project development because lenders wish to focus their underwriting efforts only on the project in question and are somewhat insulated from problems at projects with which they are not involved.
Every type of entity identified above, except the general partnership (and the limited partnership, as to the general partner), will provide effective protection of personal assets from business liabilities, if the business entity is adequately capitalized by reasonable industry standards (to avoid the "piercing" of the protective veil). And even general partners may be effectively protected in several ways:
- The law in most jurisdictions will protect the general partner until the assets of the partnership have been exhausted;
- A well-planned business insurance program will cover most potential liability; and
- The general partnership interest is often transferred to a corporation or other entity so any potential liability is encapsulated in that upper-tier entity, thus protecting the true principal.
- Registration of the partnership as a Limited Liability Partnership.
Another form of asset protection, that may be described as the reverse of the first, however, is more effectively attained with the LLC or partnership structure than with the corporate structure. As Mom and Dad need to protect personal assets from business liabilities, so they need to protect their business assets (i.e., their retained ownership in the business) from uninsured personal creditors. Generally, the difference between owning corporate stock (with its associated control) and partnership (including LLC) interests is that the former are subject to attachment by a judgment creditor while the latter are subject to the more limited charging order.
A charging order allows the creditor to attach the economic rights associated with the interest, i.e., cash and property distributions when made and, of course, the share of income and loss allocable to the interest, but not the control rights.
Depending on the particular facts, levying on a charging order could be a mistake, as when the interest generates taxable income but, through bad luck or design, there is little if any cash distributed. In such a case, of course, the opportunities for a favorable workout with the creditor are far greater. See Figure 2.
Of paramount importance to a successful succession plan is that the business survive the death (or retirement) of its founders, in this case Mom and Dad. Survival can be a function of several factors, certainly including continuity of competent (or better than competent) management and whether there is sufficient liquidity to pay any taxes on the estate of the founders without the necessity of a fire sale of the business or critical assets.
With a combined net worth of $5 million the estate tax bill on the death of the survivor of Mom and Dad could exceed $2 million if no planning has been done, a sum which would trigger a tax sale. What should they do? The answer may well be found in the nature of the family partnership. By choosing to own the family business in corporate or partnership form, Mom and Dad have changed the nature of what they own, of what assets make up their estate. In one sense, the very use of a family partnership or corporation is a type of estate planning.
Why? Because when one owns an operating business rather than the underlying assets, the asset owned is personalty--stock or partnership interests--and a new method of valuation has been introduced, the going concern value of the business, as an alternative to the underlying asset value, or liquidation value of the assets themselves. Going concern value is often calculated as a multiple of cash flow or operating income, and the value one might place on the equity in the business may differ very significantly from the value one might place on the underlying assets. Indeed, valued on a going concern basis, a real estate business is often worth less than the liquidation value of the individual assets.
But whatever baseline value is established for an interest in the company, a real advantage to the family partnership is the ability of the taxpayer to substantially discount the value, however established, of an equity interest transferred to the next generation.
Assume that Mom and Dad choose to give each of their children a 40 percent interest in the family corporation or partnership. For now, Mom and Dad will retain 20 percent of the equity and all of the control (by giving the children non-voting stock or limited partnership interests, as the case may be). See, again, Figure 1. If a supportable appraisal determined the going concern value of the business to be $4 million, would the gifts to each child of 40 percent be valued at $1,600,000 for purposes of assessing gift tax? Probably not, though the precise value is subject to interpretation and, if the numbers are sizable enough, to possible dispute with the IRS.
It is well established that a minority interest in a non-publicly traded business is worth less than a proportionate share of the value of the whole. Generally, the value of such an interest is subject to discounts owing to a lack of marketability and to minority status. The justification for these discounts is that the holder of a restricted, non-controlling interest faces the very real prospect of absolute illiquidity, restrictions on transferability and distributions, and possible capital calls.
Although it is true that these discounts may be available to a minority tenant-in-common of the underlying assets, the combined discount for a minority interest in a private company is likely to be steeper for the reason that the minority partner generally has no right to cause the partition of the underlying property, a right the tenant-in-common or joint tenant generally enjoys. Various reported cases have upheld combined discounts of 10% - 60%, with 30% - 45% considered realistic.
With the prospect of significant transfer tax savings by use of the going concern value and valuation discounts, Mom and Dad may be encouraged to make gifts of business equity to their children rather than wait for transfer-by-inheritance, especially since to do so will keep any (or 80 percent, in our example) appreciation in the value of the business, as well as income allocable to that equity out of Mom and Dad's estate altogether.
A word of caution. The IRS is not happy with the tax planning which can be accomplished with well-planned family partnerships and, in its 1998 proposal to Congress, the Administration did propose (unsuccessfully) to do away with valuation discounts. For now, a few guidelines are in order. Avoid the last-minute creation of family partnerships where Mom or Dad is on his or her deathbed. Avoid establishing family partnerships from which any immediate real economic benefit to the next generation is purely illusory. And, finally, avoid if possible trying to set up for tax purposes partnerships holding solely publicly traded securities.
Although family partnerships are not a magic elixir, there are compelling reasons for their use in family enterprises. They provide a mechanism for orderly business succession and fair treatment for both inside and outside children, to varying degrees they strengthen asset protection efforts, and they provide significant gift and estate tax savings potential.
|
