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Using a Family Partnership to Lower Taxes on Your Investments

by

Adam Starchild


One of the most versatile and powerful tools in the ongoing struggle to save taxes and protect your wealth from frivolous or vengeful lawsuits -- not to mention absurd liability claims -- is the family limited partnership (FLP). One common use of FLPs is to reduce your income tax liability. As an estate planning vehicle, FLPs can also help you avoid inheritance taxes.

As an asset protection vehicle, FLPs combine the best of both worlds; they allow you to keep 100% control of your assets while at the same time placing them beyond the reach of creditors. Although usually used by Americans, for foreign investors with U.S. assets or business, a U.S. limited partnership might be the first line of defense against exposure to the lawsuit-happy legal environment in the U.S. Even if a creditor wins a judgment against you, he may not be able to collect a dime from your partnership interest -- a fact that is inclined to make even the most pugnacious adversaries eager to settle.

We'll outline how to use a FLP to achieve each of these advantages in due course. But first, let's establish exactly what we mean by a family limited partnership. A partnership is merely an association of two or more persons (or other legal entities, such as corporations or trusts) in some kind of joint venture.

According to Section 761 of the U.S. Internal Revenue Code, a partnership is "a syndicate, group, pool, joint venture, business, or other unincorporated organization through or by means of which any business, financial operation, or venture is carried on..." In a limited partnership, there are two kinds of participants -- general partners and limited partners.

The general partners have management and control of the partnership's assets and activities. And they are liable for any debts or claims against the partnership. Limited partners generally have no say in the running of the partnership's affairs, and they have absolutely no personal liability.

A typical FLP might have a husband and wife with a general partnership interest of perhaps 10% and children (and perhaps relatives) with limited partnership interests totaling 90%. Such an FLP might contain the family business, or other assets. Note that in this example, the husband and wife, as general partners, maintain 100% control of the FLP, despite owning only 10% of it.

Income and estate tax benefits

For tax purposes, income earned by a FLP is reportable on the individual income tax returns of the partners. (Usually income is allocated among partners according to the fraction of their partnership interest.) This means that you can use the FLP to spread the tax liability for family business among family members -- such as minor children -- who will be in a lower tax bracket.

FLPs can also be used as a simple means of giving the family assets to children in small amounts in order to avoid inheritance taxes. In this case, the FLP would initially be set up with the husband and wife having both a general partnership interest of 10% and a limited partnership interest of 90%.

Each year these parents could give a fraction of their limited partnership interest to their children (and heirs). Each parent can give $10,000 of their limited partnership interest to each child every year without incurring any U.S. gift tax liability.

In this way, the parents' taxable estate can be substantially reduced over a period of years. What's more, even though they may have given away 90% interest to their children, as general partners, they enjoy complete control of all FLP assets.

Asset protection

Suppose you are sued, and a creditor wins a judgment against you. Suppose further that you have your home and other major assets in a FLP. In general, a limited partnership may not be dissolved simply because one partner is sued. In most jurisdictions, a creditor cannot touch any of the partnership assets. At best, he can hope to obtain something known as a "charging order" against your partnership interest. This will entitle him only to any distributions you would receive as a general or a limited partner.

However, you remain the general partner despite the judgment. This means that when and if any distributions are ever paid out to partners remains entirely under your control. As you can imagine, a creditor armed with a charging order, waiting for you to declare a distribution, may have to wait a very long time indeed.

Furthermore, the fact that you have a creditor looking over your shoulder doesn't mean you can't continue to enjoy the benefits of the FLP. For example, general partners often receive a salary for their services to the partnership. You can also receive advances or loans from the FLP.

You just can't receive any benefit that might be classified as a distribution. For this reason, having your assets in an FLP may make you a much less likely target for a lawsuit in the first place.

One word of caution: What we have discussed so far is the asset protection afforded by a FLP to someone who is sued as an individual. If he has his assets in an FLP, he will enjoy the benefits we have described. However, it is important to keep in mind that you as an individual are not the only potential victim of a lawsuit. Your FLP itself could also be sued.

For example, suppose the family business is organized as a limited partnership and the business is sued for malpractice or breach of contract. If the FLP itself loses in court, then the charging order concept does not apply -- and all of its assets are available to creditors for attachment.

For this reason, it is often wise to divide assets with liability exposure among several partnerships or corporations. For example, many taxi companies establish a separate corporation for every single vehicle. That way, a judgment against one part of the business need not necessarily imperil all the others.

Accordingly, the most effective asset protection scheme will almost always make use of several of the structures available -- such as corporations, foreign corporations, and foreign trusts. It is indeed possible to make your financial defenses truly impregnable.

Remember, too, as you read the following sections, that your investments can be further protected by various combinations of family limited partnerships and trusts, depending upon your individual needs. Not every investment needs to be placed in your personal name -- and since the FLP is tax neutral, or even offers tax savings, it may be an ideal vehicle for making some of these investments.

Asset protection and tax savings

While it is very nice to save on estate taxes, most would be much more interested in saving taxes this year, right now while you are still alive. The "estate plan", when properly implemented has the delightful side effect of making excellent use of your children before they thought they could, or were inclined to be, helpful. Remember that children over the age of 14 have their very own tax brackets which start at 0% and linger at 15% for a time or so, just as yours did, and only after more income than they will make or than you need to give them for their support jump up to the higher tax brackets. It is possible, especially for the self-employed,to cut the total tax bite in half by simply spreading the tax liability among family members.

At this point you say, "Now just a minute, I know what you are about to say, and I assure you that giving assets or income to my children at this stage of their teenage lives is a type of suicide that I do not contemplate." You are right! Let me assure you that no one is foolish enough to suggest that any assets or income should be put under the "control" of children, who at the age of 16 think that a 944 Porsche turbo something or other is an appropriate investment.

The Family Limited Partnerships, and Children's Trusts allow income to be attributed to the children's tax brackets while leaving the "control" and "use" to more responsible parties. In the case of the Family Limited Partnership, the more responsible party would be you. In the case of the Children's Trust, that person would be a trusted other. However, the children and their guardians, and once again, you, would be able to have lower tax bracketed dollars available for luxuries such as family trips, piano lessons, math camp, private schools, college, medical school, etc.

Consider this: Mr. and Mrs. Business Partners set up a Children's Trust for their children and funded it with real estate in which their business was housed. The kids wanted the building to be a retail space suitable for an ice cream parlor, but since they were not in charge of the decisions, the building purchased was an 80,000 square foot steel and block industrial building suitable for the parent's manufacturing business.

The business, which had a good profit picture and cash flow, paid rent to the Children's Trust, thereby writing off the lease payments at a higher tax bracket than the children's tax bracket and accepting the payments in the lower children's bracket. Tax savings were realized each year. In addition, Mr. and Mrs. Business Partners suggest to the Children's Trust, that, with the profits from the lease, it could buy office equipment which it could lease to the business on a "one year renewable lease" for market lease payments, i.e., 75% of the value of the equipment each year. More tax savings were realized.

It is only incidental to this discussion on the advantages of the "estate plan" to mention that when Mr. and Mrs. Business Partners went out of business because the widgets which the parents were manufacturing were replaced by a new super duper better thing, the Children's Trust survived the parent's bankruptcy and with the appreciated value of the real estate and value of the still owned equipment, sold its assets and loaned Mr. and Mrs. Business Partners $500,000.00 to start a new business.

The above examples are illustrative of the old adage, "divide and conquer." If they only file a joint return, no married couple will ever get ahead tax wise. If through a proper estate plan additional entities are created the serve the dual purpose of providing lawsuit and asset protection while dividing income into lower tax brackets. Creating additional entities does itself provide a record keeping and filing burden. It is bad enough facing April 15th each year with one incomprehensible form! However, if you are unwilling to pay attention to the details there are others who will do it for a fee. Failure to care may result in exposure to judgments and the possible greater burden of "starting over."

One major caution must be mentioned, as some of these asset protection techniques are taking on aspects of a fad. The courts can set aside a transaction on the basis that it is a sham, despite what your fancy paperwork says. A family limited partnership formed on the eve of a judgment, with no business purpose and no purpose other than evading the creditor, is likely to be set aside by the court. The same is true of trust arrangements made in the same way.

These problems can be avoided by making such arrangements in advance, having sound and proper purposes other than avoiding ones just debts, and to some extent using foreign jurisdictions to make seizure more difficult.

It is important to stress that there are no "magic bullets" in asset protection, and there is no instant solution. Setting up an asset protection plan -- whether it be partnerships, offshore trusts, domestic trusts, or some combination, requires expert advice.

Preparing your asset protection plan

One of the best ways to protect yourself is to have professionals prepare an asset protection plan in advance of any problems. In the process of doing so, many people are discovering that they can eliminate most income taxes through the proper use of family limited partnerships, offshore trusts, corporations, and annuities.

Creating an asset protection plan is not expensive, and provides a great deal of assurance that you and your family will have the benefit of the money you have built up through years of work. Asset protection plans are a relatively new area of law, prepared by lawyers who specialize in protecting what you own instead of in suing people.

Asset protection is different from traditional retirement or estate planning. It is the systematic and integrated protection of your family and business from risk.

Most financial planning is intended to help you establish wealth so you can retire, and pass on as much of that wealth as possible to your family after death.

Asset protection plans include estate plans but are intended to also help you keep your wealth while you are living. They often involve legal structures such as family limited partnerships, children's trusts, exempt assets, offshore trust arrangements and living trusts.

Asset protection plans are fully legal. It is not something for people who might want to avoid the law or their responsibilities. The law is clear as to what is permissible and what is not. Asset protection simply gives protection against unfair lawsuits and gives a level playing field to operate from.

The goal is to structure the plan so you never have to misrepresent yourself or worry about the legality of the plan.

The family limited partnership approach can be used in conjunction with the corporation strategy mentioned in the previous chapter, by having the family limited partnership own the corporation.

About the Author
For twenty years Adam Starchild has been writing books about these subjects, and they are published by a variety of publishers.

For more information on asset protection, see Asset Protection & Becoming Judgment Proof.

Copyright © 1995 by Adam Starchild
The Investor's Library has reprinted this copyrighted article with the permission of the author.


 
 
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