For many apartment owners, the use of a family limited partnership can be an effective estate planning tool to transfer the apartment to the next generation without any substantial loss of income or control.
To understand the benefits of a family limited partnership, consider the following example: John and Mary Doe, age 60 and 58, own several apartment buildings. One building, a 20-unit apartment, earns about $80,000 in net rental income yearly. The apartment is currently worth $1.2 million and has no debt. The property has almost fully depreciated and its tax basis, mostly land, is $100,000.
John and Mary have four children (all married). They would be willing to give an interest to their four children but do not wish to give up management or reduce their income; nor do they believe that their children are ready yet to oversee management.
John and Mary decide to use a family limited partnership. A family partnership is formed naming John and Mary as the general partners and naming their four children and an irrevocable trust as the limited partners.
In December that year and January of the next year, John and Mary make gifts totaling 27 percent of an interest in the apartment building to an irrevocable trust. The trust is designed to maximize the use of their annual gift tax exclusion and to minimize the estate and gift tax consequences of the gift.
In addition, in January, all but a one percent (1%) interest in the apartment is sold to the children for about $840,000. In exchange, the parents receive a secured, 30-year fully amortizable promissory note. On the same date that this sale is made, all owners, i.e. the trust, the children and John and Mary transfer their interests into the family partnership. The trust and the children become the limited partners in the family limited partnership; John and Mary are the general partners and hold a one percent (1%) partner’s interest.
Even for owners with smaller estates, the family partnership can serve as an effective tool to transition management to children while retaining income for retirement and control.
After these events, John and Mary as the general partners retain complete control over the apartment. Each month, through management fees and payments on the promissory note, John and Mary expect to receive initially roughly the same amount of income, i.e. about $80,000, as they would otherwise receive. Should they ultimately wish to retire and turn over management to their children or to an outside management company, they may continue to receive payments on the promissory note.
In addition, they have begun a process of reducing their estate for estate tax purposes. John and Mary’s gift to the trust has immediately reduced the size of their estate. In addition, because they have traded the apartment building for a promissory note they are able to further reduce their estate each year as the balance of the promissory note is paid down.
As John and Mary look down the road, they realize their children will gradually acquire equity through the principal payments on the note and any future appreciation. Should rental income increase, the children will begin to earn income from the property. This income stream to the children may mean that their children may not need as much support or assistance in providing for their grandchildren.
Flexibility of Planning
The beauty of family limited partnerships is that they are very flexible. Family limited partnerships offer several options with regard to allowing parents to retain or give up control of the apartment building’s management. Family limited partnerships also offer a degree of asset protection from judgment creditors. Particularly, a judgment creditor’s remedy against a partner in a limited partnership for payment of personal debts is limited to a charging order; the creditor cannot seize partnership assets. Under a charging order, the creditor may only be entitled to receive distributions that would otherwise be paid to that partner. In addition, to preclude the judgment creditor from seeking a court order to foreclose on a partner’s interest by way of an execution sale against a partner’s interest, the partnership agreement may provide for a partner buyout provision in certain limited events.
Comparison with Other Options
Family limited partnerships are favored over other types of investment vehicles. Simply using a trust instead of a limited partnership may pose complications if parents retain control over management, the trust may be ignored for both income and estate tax purposes.
Where a corporation is used, there is the risk of double taxation of distributed income and this also may trap appreciation. Corporations also may cause unanticipated tax consequences upon termination. In addition, an election to have one level of tax at the shareholder level through an S Corporation may be unavailable, such as where interests will be held in a trust not qualifying as an S Corporation shareholder.
Other Considerations in Family Limited Partnerships
A family limited partnership should be drafted by an attorney who is familiar with family limited partnerships and who is able to fully inform the apartment owner as to all aspects of partnership ownership. There are many design options, each with their own advantages and disadvantages. Before any transfer is made, the owner should confirm that the transfer will not trigger any “due on sale” clause in the mortgage or a property tax reassessment due to a change of ownership under Proposition 13. There should also be an appraisal of the property by a qualified appraiser. In some cases, a second “business” appraisal is required to value the limited partnership interest to take into account any discount for a gift or sale of minority interest.
Because of the estate tax benefits of a family partnership, they should be considered for apartment owners who have a taxable estate. In addition, even for those owners with smaller estates, the family limited partnership can serve as an effective tool to transition management to children or an outside management company, while retaining income for retirement and control.