 About the author: Mira J. Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas, and Southern California. She specializes in succession planning. (303) 298-9600
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Partnerships Are Still an Excellent Vehicle Increased scrutiny does not make the technique obsolete by Mira J. Finé Business owners who face succession and estate tax issues should not be scared off from using partnerships as a legitimate tax management tool. Partnerships are a simple, flexible way to pass assets on to successors at a lowered tax rate. They allow you to retain control over the asset you transfer to the partnership, be it raw land, a building, or a business. In addition, there are techniques to make low- or no-tax distributions to the partners. Tax code, like any other law, evolves. A decade ago, partnerships didn’t attract much attention from regulators. There weren’t as many rules on discounts, transfers and distributions as there are today. The IRS has begun using U.S.C. 2036 to attack the misuse of limited partnerships for succession purposes, but it does not spell the death knell for legitimate uses of the creative vehicles. Most of the cases the IRS has pursued involved situations in which the estate holder dumped nearly all the assets into a partnership but retained all control and use of the assets. That is going to pull the IRS’s chain - so is transferring an asset into a partnership and then discounting the value of it more than 50 percent in order to avoid or substantially reduce the estate tax. However, if you avoid the obvious abuses, you can still save substantial amounts under normal estate taxes. How to use partnerships This article will discuss the different ways you can use a partnership to lower inheritance taxes. The best way to illustrate this is through using a mythical family… let’s call them the Hensleys. The Hensleys own a large ranch in Northwestern Colorado. The ranch still produces hay, alfalfa, cattle, and sheep profitably, but most of the family’s wealth is tied up in the 500 acres of land just down valley from Steamboat Springs and its ski area, golf courses, and other recreational pursuits. The Hensleys – father William, mother Ann, and their four children – are classically asset rich. Ann and William have set-up a limited partnership with their children to lesson the inheritance tax impact that the significant rise in land values will cause when the estate passes hands. The partnership can help the family in a variety of different ways. Partnerships are used when assets are involved, such as real estate, investments, and ownership in a business, but there could also be reoccurring royalties in such things as patents, books, movies, plays, software, or oil well interests. The first and most basic benefit involves the transfer of a portion of the Hensleys’ chief asset, the ranch itself. Let’s presume the land is potentially worth $10 million on today’s market. The parents transfer the full value of the land into the partnership. The children invest comparable amounts for their respective percentages into the partnership. The partnership interest which holds the land is discounted for inheritance tax purposes under two standards: 15 percent for lack of marketability, and another 15 percent for lack of control. When the Hensleys die, the partnership interest will be valued at $7 million for estate purposes instead of the full $10 million. The partnership, generally, has to be run like a business with its own set of books. Distributions to the partners have to be accounted for and rules apply as to what distributions are allowed. Discounts have to be justified by independent appraisal. Gone are the days when the parents could retain total control and have all use of the assets without any financial reporting. While they are alive, parents can maintain some control of the ranch but the limited partners do need to have some influence in the partnership’s affairs, for example, through a board vote or serving on an advisory committee. In a partnership, the majority partner, or grantor, can transfer a “profits interest” in any income that may be earned in the future by the partnership’s assets. At the time of transfer, the profits interest has zero or low value because there is no guarantee that the asset in a partnership will be profitable, and the profits interest transferee will not receive any interest in the asset’s value generated in the past. The transfer, which can be used with liquid or non-liquid assets, will not result in immediate income or a gift and won’t be taxed. If a partnerships profits interest is used, the recipient of the interest receives a share of profits on a going-forward basis. So, if, at the receipt of the profits interest, the value of the partnership is $100, the recipient does not share in the $100, he just shares in the profits on a going-forward basis. So, if the entity profits have generated a value of $500 going five years from now, the partner has his percentage of the increase of $400. There was no shift of the past value and the partner only shared in the future value increase from that point on. Why do it? It’s an alternative to outright gifting that allows the limited partner to share in the appreciation of the asset but not the current value of the asset. You shift the income out of the parent’s tax bracket and into the kid’s or limited partner’s bracket. It’s great for funding college education or a new business. Consider capping the profits interest Another technique available is to set your partnership up with segregated asset classes, each of which would provide different future profits percentages. This would allow the partnership to appropriately allocate different risks and returns – and different assets – to specific limited partners based on their individual risk/return profiles. For example, those children actively involved in running a business might warrant a different future profits percentage than passive family members. Another way to accomplish the same goal would be to divide assets into separate partnerships. One note about the taxation of profits interest: currently, appreciation is treated as a capital gain, which is lower than regular income tax. Congress is likely to push to tax appreciation of the partnership as regular income tax where partners contributed labor to the partnership. Some prominent private equity firms will not be enthusiastic about the change. Sale of a partnership interest to a defective trust Another option is to sell a partnership interest to a defective trust. A defective trust is similar to a regular grantor trust. If I form a trust and have control, I’m a Grantor. All income is mine. The same can be said with a defective trust, except there is a specific clause that makes it defective and allows it to be treated as a grantor trust for income tax purposes only. For all intents and purposes, it’s still an irrevocable trust, so the assets are not taxed in an estate situation. When the defective trust is formed with assets from the grantor, owner or parents, the assets are sold to the defective trust in the form of some cash and a note or loan. The trust then makes payments to the parents/grantor on the note. The value of the assets is frozen and any appreciation goes to the beneficiaries. It should be noted that this technique might not be allowed in the future. Congress is considering legislation that would restrict private equity and hedge funds from using it. Nonetheless, entities using these techniques set up before the new law is enacted would likely be grandfathered. |
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