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THE FAMILY LIMITED

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MARITAL PROPERTY & ETHICAL CONSIDERATIONS*

BERNARD E. JONES Davis, Ridout, Jones, & Gerstner, L.L.P. 600 Travis, Suite 7070 Houston, Texas 77002-3072 (713) 229-0900 FAX (713) 229-9400

STATE BAR OF TEXAS 23rd ANNUAL ADVANCED ESTATE PLANNING & PROBATE LAW COURSE

San Antonio, Texas June, 2-4, 1999

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*Copyright © 1998, 99, Bernard E. Jones. The author gratefully acknowledges Michael Cenatiempo for his permission to incorporate his portion of Techniques for Preserving the Separate Estate Before Marriage and How to Attack Those Techniques, 23rd Annual Advanced Family Law Course, State Bar of Texas, August 17- 20, 1998, San Antonio, Texas, and Mickey R. Davis and Sarah Patel-Pacheco for their helpful comments and contributions.

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BOARD CERTIFIED, DAVIS, RIDOUT, JONES & GERSTNER, L.L.P. 600 Travis, Suite 7070 ESTATE PLANNING AND Houston, Texas 77002 PROBATE LAW, TEXAS BOARD (713) 229-0900 OF LEGAL SPECIALIZATION FAX (713)229-9400 Education University of Texas, Austin, Texas Juris Doctor, with honors, awarded May 1983 Bachelor of Arts, with honors, awarded May 1980 (Major: Economics) Professional Associations Adjunct Professor of Law, University of Houston Law Center, Houston, Texas, 1995- (course: Estate Planning) Fellow, American College of Trust and Estate Council Member, Texas Bar Association (admitted 1983) Section on Real Estate, Probate and Trust Law (Council member, 1998-; Probate Code Committee, Subcommittee on Revocable Trusts, member, 1991-92, chair, 1993-94; Probate Code Committee, member, 1995-96; and Subcommittee on Transmutation, member, 1995-) Section on Taxation, Chair: Community Property and Family Tax Committee (1992-93) Member: College of the State Bar of Texas; Houston Bar Association and Section on Probate, Trusts and Estates; Disabilities and Elder Law Association, Houston, Texas; American Bar Association and Sections on Taxation; and Real Property, Probate and Trust Law Selected Publications The Family Limited Partnership - Marital Property & Ethical Considerations, University of Texas School of Law Texas Marital Property Institute, October 22 & 23, 1998 (outline and speech) Generation-Skipping Transfer Tax: Trust Severances and Exemption Allocations, 21st Annual State Bar of Texas Advanced Estate Planning and Probate Course, June 4-6, 1997 (speech, outline prepared jointly with Mickey Davis & Jerry Scroggins) Reality Check - Practical Estate Planning Applications, Texas Society of Certified Public Accountants, 1996 Annual Advanced Estate Planning Conference, September 5-6, 1996 Anatomy of a Will, 20th Annual State Bar of Texas Advanced Estate Planning and Probate Course, June 5-7, 1996 (outline prepared jointly with Steve Akers)

Estate Planning for Incapacitated Individuals, 33 REAL ESTATE, PROBATE & TRUST LAW REPORTER 27, July, 1995 (State Bar of Texas) Estate Planning For Incapacitated Individuals; Section 867 Trusts, 5th Annual State Bar of Texas Advanced Drafting: Estate Planning and Probate Course, November 3-4, 1994 Revocable Trusts: Nuts and Bolts, 17th Annual State Bar of Texas Advanced Estate Planning and Probate Course, June 2-4, 1993 Revocable Trusts--Tax Issues, Perpetuities, When and How to Fund, 3rd Annual State Bar of Texas Advanced Drafting: Estate Planning and Probate Course, November 12-13, 1992

Putting Revocable Trusts In Their Place, 129 TRUSTS & ESTATES 8 (September 1990)

Creditors' Rights To Your Retirement Plan, 17 THE TEXAS INDEPENDENT BANKER 22 (April 1990)

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Table of Contents

I. Introduction ...... 1 A. Scope of this Presentation ...... 1 B. Disclaimer ...... 1

II. Family Limited Partnership Basics ...... 1 A. in General ...... 1 1. Governing Law ...... 1 a. Texas Uniform Partnership Act (“TUPA”) ...... 1 b. Texas Revised Partnership Act (“TRPA”) ...... 1 c. Texas Revised Limited Partnership Act (“TRLPA”) ...... 1 2. Creation ...... 1 3. Partner Rights ...... 1 a. Personal Property ...... 1 b. Interest in Partnership v. Interest in Partnership Assets ...... 2 (1) Under TUPA ...... 2 (2) Under TRPA ...... 2 (3) Under TRLPA ...... 2 4. Transfer ...... 2 B. Limited Partnerships ...... 2 1. General Versus Limited Partner ...... 2 2. Statutory Requirements ...... 2 3. Applicability of TUPA and TRPA ...... 2 C. Family Limited Partnerships (“FLPs”) ...... 2 D. The Appendices ...... 2 E. Fundamental Effect of Creating and Funding Partnerships ...... 3 1. At Common Law--The Aggregate Theory of Partnerships ...... 3 2. Under TUPA and TRPA–The Entity Theory of Partnerships ...... 3 a. TUPA Probably Adopted The Entity Theory ...... 3 b. TRPA Clearly Adopted The Entity Theory ...... 3

III. FLP Marital Property Considerations in General ...... 3 A. Partnership Interests ...... 3 B. Marital Property v. Partnership Property ...... 3 1. Generally ...... 3 2. Record Title v. Legal Ownership ...... 4 3. Roach v. Roach ...... 4 C. Partnership Distributions ...... 4 1. Generally ...... 4 2. Marshall v. Marshall and the Return of Capital Argument ...... 4 a. The Facts ...... 4 b. The Ruling ...... 4 c. Comments ...... 4 (1) The Holding Follows the Statute ...... 4 (2) Reliance on Income Tax Rules is Misplaced ...... 4 (3) Partnership Agreement Might Change Result ...... 5 d. Application to FLPs ...... 5 D. Undistributed Partnership Income ...... 5 1. Community Property Partnership ...... 5 2. Separate Property Partnership ...... 5 a. Arguments Against Non-Partner Spouse ...... 5 b. Arguments For Non-Partner Spouse ...... 5 c. The Winning Argument? ...... 5 E. Partnership Management Rights ...... 6 1. Generally ...... 6 2. During Marriage ...... 6 3. Death or Divorce ...... 6 F. Partition of Partnership Interest in Divorce ...... 6

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1. Partnership Interest ...... 6 2. Specific Partnership Property ...... 6 G. Claims of Reimbursement to Community Estate ...... 6 H. Right to Compel Partnership to Satisfy Child-Support Obligations ...... 6 I. Potential Attacks on Partnerships ...... 6 1. Alter Ego ...... 6 2. Fraud ...... 6 3. Failure to Make Distributions ...... 6

IV. Uses and Abuses of FLPs to Alter Marital Rights and Duties ...... 7 A. Avoid Receipt of Community Income from Separate Property ...... 7 1. Generally ...... 7 2. Only Undistributed Income is Protected ...... 7 3. Reimbursement Rights due to Excessively Low Distributions ...... 7 4. Not for Minerals or Other Assets Producing Separate Revenues ...... 7 B. Preserve Separate Character of Receipts with “Built-In” Partition Language ...... 7 C. Transmute Separate into Community ...... 7 1. No Direct Transmutation Under Current Texas Law ...... 7 2. Technique: Create FLP with Community, Augment with Separate and Waive Reimbursement ...... 8 3. Technique: Create FLP with Separate and Distribute Back In-Kind ...... 8 D. Withdraw Partnership Property as Separate Property ...... 8 1. Technique: Straw Man Sale and Redemption ...... 8 2. Technique: Manipulate Capital Accounts to Create “Return of Capital” ...... 8 3. Technique: Multiple Controlled Entities to Create “Return of Capital” or Cross Sale of Interests ...... 9 E. Eliminate Mutual Fund Ambiguity; Render All Returns Community ...... 9 F. Pre-Divorce FLP Creation With Community to Impair Non-Partner Spouse’s Rights and Avoid Child Support Obligation ...... 9

V. Representing and Advising Spouses ...... 9 A. Representing Both Spouses Jointly ...... 9 B. Representing Only One Spouse ...... 10

APPENDIX ONE: FLP “TOP TEN LIST” ...... 11

APPENDIX TWO: FAMILY LIMITED PARTNERSHIP “BASICS” ...... 12

I. Overview of Family Limited Partnerships ...... 12 A. General Concepts ...... 12 B. Differences Between General and Limited Partnership Interests ...... 12 1. Limited Partners ...... 12 2. General Partners ...... 12

II. Advantages of Family Limited Partnerships ...... 12 A. Creditor Protection ...... 12 B. Valuation Discounts ...... 13 C. Other Benefits ...... 14 D. Certain Disadvantages ...... 15

III. Planning Considerations ...... 15 A. The Partnership Agreement ...... 15 B. Management of the Partnership ...... 15 C. Using Trusts as Donees ...... 15 D. Choice and number of general partners ...... 16

IV. Tax Considerations ...... 16 A. Income Tax Issues ...... 16 B. Estate Tax Inclusion Issues ...... 16 C. Income Tax Cost Basis Issues ...... 17

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V. Operational Issues ...... 17 A. Formalities Upon Formation ...... 18 1. The FLP Agreement ...... 18 2. Certificate of Limited Partnership ...... 18 3. Conveyance of Assets ...... 18 a. Deeds ...... 18 b. Oil and Gas Interests ...... 18 c. Mortgages, Notes and Cash ...... 18 d. Stocks and Bonds ...... 18 4. Respecting the Conveyances ...... 19 B. Operating Formalities ...... 19 1. Books and Records ...... 19 2. Partner Meetings ...... 19 3. Votes on Partnership Matters ...... 19 4. Other Operating Formalities ...... 20 C. Formalities Of Transfer ...... 20 D. Tax Formalities ...... 20 1. Partnership Income Tax Returns ...... 20 2. Taxation vs. Distribution ...... 20

VI. Valuation of the Family Limited Partnership ...... 20 A. Obtaining Independent Appraisals ...... 21 B. Valuation Discounts ...... 21

VII. Frequently Asked Questions ...... 21 • How does an FLP reduce gift and estate taxes? ...... 21 • Are these valuation discounts “real”? ...... 22 • What assets can I transfer to an FLP ...... 22 • Can the partnership own life ? ...... 22 • What sort of paperwork is required after the FLP is formed? ...... 22 • Do I really need to get an appraisal? ...... 22 • May I use an FLP to protect assets from creditors after creditor problems arise? .... 22 • What happens to FLP interests in a divorce? ...... 22 • Will the IRS challenge the FLP? ...... 23 • Why doesn’t everyone use an FLP to hold assets? ...... 23

VIII. Summary ...... 23

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THE FAMILY LIMITED PARTNERSHIP MARITAL PROPERTY & ETHICAL CONSIDERATIONS

Bernard E. Jones Davis, Ridout, Jones, & Gerstner, L.L.P.

I. b. Texas Revised Partnership Act (“TRPA”) In 1993, the Texas Revised Partnership Act, INTRODUCTION TEX. REV. CIV. STAT. ANN. art 6132b-1.01 et seq (Vernon Supp. 1998) (“TRPA”), was enacted and A. Scope of this Presentation applies to (i) all partnerships formed on or after This outline contains neither a technical January 1, 1994, and (ii) all partnerships formed discussion of the estate planning applications of before January 1, 1994, as of January 1, 1999, unless Family Limited Partnerships nor a detailed analysis of the partnership elects to apply the TRPA sooner. the numerous federal income and transfer tax issues Considering the very short remaining relevance of relating to family limited partnerships. Instead, this TUPA, this outline will analyze the issues assuming outline presents a summary of partnership law TRPA is the applicable statute, unless otherwise followed by a discussion of Texas marital property specifically indicated. (References in this outline to rights in and to partnerships. It concludes with a TRPA and “sections” of TRPA are to TEX. REV. CIV. discussion of uses and abuses of family limited STAT. ANN. art 6132b-1.01 et seq.) partnerships, all with an emphasis on ethical implications. c. Texas Revised Limited Partnership Act (“TRLPA”) B. Disclaimer In 1987 the Texas Revised Limited Partnership This outline and the accompanying materials are Act, TEX. REV. CIV. STAT. ANN. art 6132a-1 (Vernon intended solely for other professionals and should not Supp. 1998) (“TRPA”), was enacted. Since be relied upon without independent verification. September 1, 1992, TRLPA has been applicable to all Numerous statements in this outline are intended to domestic and foreign limited partnerships doing raise ethical and other issues and provoke in Texas. See TRLPA §13.02(b). consideration of the matter by the practitioner and, as (References in this outline to TRLPA and sections of a result, the opinions expressed in this outline do not TRLPA are to TEX. REV. CIV. STAT. ANN. art 6132a- necessarily reflect the opinions of the author. 1.)

2. CREATION An oral agreement can create a partnership. II. However, it is preferable to set out the agreements of FAMILY LIMITED PARTNERSHIP the partners in writing. The following factors suggest BASICS the existence of a partnership: C Right to receive a share of the profits; A. Partnerships in General C Expression of the intent to be business A partnership is an association of two or more partners; people, as co-owners, carrying on a business for profit. C Right to participate in the control of the See TEX. REV. CIV. STAT. ANN. art 6132b §6 (Vernon business; 1970). Once formed, a partnership is a legal entity C Sharing or agreeing to share in business distinct from its partners. See TEX. REV. CIV. STAT. losses and liabilities; and ANN. art 6132b-2.01(Vernon Supp. 1998). C Contributing cash or other property to the business. 1. GOVERNING LAW See TRPA §2.03. a. Texas Uniform Partnership Act (“TUPA”) In 1961, the Texas Uniform Partnership Act, 3. PARTNER RIGHTS TEX. REV. CIV. STAT. ANN. art 6132b (Vernon 1970) A partner has the following rights in a (“TUPA”) was enacted. (References in this outline to partnership. TUPA and sections of TUPA are to TEX. REV. CIV. STAT. ANN. art 6132b.) Prior to TUPA, partnerships in Texas were governed by common law.

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 C-2 1999 Advanced Estate Planning and Probate Law Course a. Personal Property 2. STATUTORY REQUIREMENTS A partnership interest is personal property. See “To form a limited partnership, the partners must TRPA §5.02 and TRLPA §7.01. enter into a partnership agreement and one or more partners, including all of the general partners, must b. Interest in Partnership v. Interest in Partnership execute a certificate of limited partnership.” TRLPA Assets §2.01(a). “A limited partnership is formed at the time of the filing of the initial certificate.” TRLPA (1) Under TUPA §2.01(b). Thus, if the partners “enter into a Under TUPA a partner has an interest in specific partnership agreement” but never file a certificate, it partnership assets; each partner is “co-owner with his follows that the resulting partnership is a general partners of specific partnership property holding as partnership. tenants in partnership.” TUPA §25. 3. APPLICABILITY OF TUPA AND TRPA (2) Under TRPA TRLPA is silent on many fundamental Under TRPA, a partner has an ownership interest partnership issues, focusing primarily on the issues in the partnership entity itself, not the partnership’s specific to limited partnerships. Under TRLPA specific assets. See TRPA §§2.04 & 5.01. Some §13.03, “the applicable statute governing partnerships commentators have suggested that under TRPA it is that are not limited partnerships . . .” apply in any case no longer possible for a partner to have an interest in not provided for by TRLPA. Thus, TUPA and TRPA, specific partnership assets. However, TRPA §1.03 as applicable, govern numerous aspects of limited indicates that the partnership agreement can vary the partnerships. Almost all marital property issues in provisions of TRPA in any way (except for certain limited partnerships are governed by TUPA and enumerated matters not relevant to this discussion), TRPA, not TRLPA. suggesting that even under TRPA, the partnership agreement could be drafted to specifically give one or C. Family Limited Partnerships more partners an interest in specific partnership (“FLPs”) assets. A family limited partnership (a/k/a, “FLP”) is simply a limited partnership formed among family (3) Under TRLPA members. In the last decade, families have used the Section 7.01 of TRLPA states flatly: “A partner FLP business entity with increasing frequency to has no interest in specific limited partnership assets.” provide additional asset protection and as an estate planning vehicle. The business of the FLP may be 4. TRANSFER nothing more than managing the real and personal Unless prohibited by agreement, a partner may property of members of the older generation or of the sell, convey or assign a partnership interest. The entire family. Often, an older generation member will transfer does not automatically result in the dissolution create an FLP with his or her assets, such as an of the partnership. See TRPA §5.03. However, the ongoing business, stock, real property, etc. The transferee does not step into the role of a partner or younger generations may contribute addition property acquire the transferor’s right to participate in to the FLP or they may obtain their interests in the management. The transferee is merely entitled to FLP by gift. Members of the older generation are receive the transferor’s distributions from the usually the general partners, so they can retain control, partnership if and when made. See TRPA §5.03(b). and members of the younger generation are typically limited partners (although a younger generation B. Limited Partnerships member sometimes serves as a general partner in order to provide asset management for the older generation). 1. GENERAL VERSUS LIMITED PARTNER The limited partners cannot compel a distribution but A limited partnership is a partnership having one are entitled to a share of any partnership distribution or more general partners and one or more limited if and when made. In addition, FLP agreements will partners. General partners in limited partnerships frequently contain significant restrictions on the (like their counterparts in general partnerships) have transfer or assignment of a partnership interest in the right to participate in the management and control order to keep the business “in the family.” the of the business and, as a result, they have unlimited combined effect of these restrictions is to significantly liability with regard to partnership and influence the value of partnership interests both during obligations. Limited partners, on the other hand, have a partner’s life and at death and protect the partnership limited management and control rights. In return, from a partner’s creditors by making the asset less limited partners have for partnership desirable. obligations. D. The Appendices Inasmuch as the preceding single paragraph description of the FLP may leave out too many details,

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-3 two appendices are included in this outline. The first §25, TUPA’s adoption of the entity theory was is a brief “Top Ten List” of FLP observations inartful at best. prepared by Mickey R. Davis. The second is a discussion of the FLP, written in non-technical terms, b. TRPA Clearly Adopted The Entity Theory designed for the client who is interested in With 1993's adoption of TRPA the entity theory understanding the basic principals of the FLP in some clearly became the applicable rule. TRPA has clearer detail. wording as to partner interests in partnerships, eliminating the “tenants in partnership” wording, and E. Fundamental Effect of Creating and flatly states that “[a] partnership is an entity distinct Funding Partnerships from its partners,” TRPA §2.01, and that “[partnership] property is not property of the partners,” TRPA §2.04. 1. AT COMMON LAW--THE AGGREGATE THEORY OF PARTNERSHIPS Common law conceives of the partnership as an From the perspective of the entity theory, the aggregation of its partners, not an entity apart from creation and funding of a partnership is a very them. See Marshall v. Marshall, 735 S.W.2d 587 at significant act. By contributing assets to the 593 (Tex. App.--Dallas 1987, writ ref’d n.r.e.). From partnership, the new partners give up ownership of this perspective a partner who contributes an asset to these assets in exchange for ownership of a wholly a partnership still owns the asset, albeit “through” the new and distinct asset: partnership interests. They partnership vehicle. In the minds of many clients and no more “own” the assets of the partnership than a practitioners alike, this is a rare example of the in General Motors “owns” a Buick common law making common sense; it is probably assembly plant in Michigan. safe to say that most people doing business in partnership form consider the partnership property to Many of the seemingly peculiar rules of be “their” property, albeit jointly owned with their partnership marital property make better sense when partners. this fundamental concept is kept in mind.

From the perspective of the aggregate theory, the creation and funding of a partnership does not cause III. any fundamental change in property ownership rights. It merely pools or aggregates the previously separate FLP MARITAL PROPERTY rights of the partners. The partners still “own” the CONSIDERATIONS IN GENERAL property contributed to the partnership. A. Partnership Interests 2. UNDER TUPA AND TRPA–THE ENTITY A partnership interest can be either separate or THEORY OF PARTNERSHIPS community property. See TRPA §5.02. Generally, a partnership interest is characterized as separate or a. TUPA Probably Adopted The Entity Theory community property under the same general rules of With the adoption of TUPA in 1961, Texas any other interest acquired during the marriage. Thus, statutory law replaced the common law’s aggregate it is necessary to determine whether the partnership theory with the entity theory, under which the interest is acquired before marriage, as a result of a partnership is considered an entity apart from the gift, devise, or decent, or whether it can be traced to individual partners. See Marshall v. Marshall, 735 separate property. See In re Marriage of Higley, 575 S.W.2d 587 at 593 (Tex. App.--Dallas 1987, writ S.W.2d 432 (Tex. Civ. App.--Amarillo 1978, no writ) ref’d n.r.e.). According to the court in Marshall: (partnership interest acquired by husband prior to marriage was separate property). Partnership interest “With the passage of [TUPA] in 1961, Texas acquired during marriage or which does not fit within discarded the aggregate theory and adopted the the statutory definition of separate property is entity theory of partnership. Under [TUPA], presumed to be community property. See York v. partnership property is owned by the partnership York 678 S.W.2d 110 (Tex. App.--El Paso 1984, writ itself and not by the individual partners. A ref’d n.r.e.) (partnership interest acquired during partner’s partnership interest, the right to receive marriage is community property). his share of the profits and surpluses from the business, is the only property right a partner has B. Marital Property v. Partnership . . ..” Property 735 S.W.2d 587 at 594. Whether TUPA really completely discarded the aggregate theory is a matter 1. GENERALLY of personal opinion. Suffice it to say that, by retaining Generally, property transferred to and acquired such concepts as “tenants in partnership,” see TUPA by a partnership is an asset of the partnership rather than any individual partner. Once a specific property

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 C-4 1999 Advanced Estate Planning and Probate Law Course is transferred into the partnership, that property is no partnership as salary and of profits and surpluses are longer capable of being either community or separate community property unless altered by a premarital inasmuch as it becomes partnership property and is no agreement. Marshall v. Marshall, 735 S.W.2d 587 longer property owned by the spouse or the spouses. (Tex. App.--Dallas 1987, writ ref’d n.r.e.). From the See Marshall v. Marshall, 735 S.W.2d 587 (Tex. perspective of the entity theory of partnerships, this App.--Dallas 1987, writ ref’d n.r.e.). Further, rule is entirely consistent with the general Texas law property acquired with partnership funds is presumed rule that income from property (from both separate to be partnership property unless a contrary intent property and community property) is community exists. See TRPA §2.05(c). property.

2. RECORD TITLE V. LEGAL OWNERSHIP 2. MARSHALL V. MARSHALL AND THE RETURN OF It is sometime difficult to determine what CAPITAL ARGUMENT property belongs to the partnership versus a spouse or Just as income from separate property is clearly the marital estate. For example, a spouse may allow community property, the proceeds from the sale of a a partnership to use property and hold the property as separate property asset are generally separate a nominee but it is agreed that the spouse will remain property. The husband in Marshall made this the owner of the property. In this situation, it may argument, albeit unsuccessfully, in an attempt to appear to third parties that the partnership owns the characterize partnership distributions as separate property. However, the true owner remains the partner property. spouse. On the other hand, partnership property may be held in the name of the partner spouse, a. The Facts individually. However, the partner spouse does not In Marshall, the husband acquired a partnership have a legal interest in the property but holds it as interest before marriage. Following the marriage, he nominee for the partnership. received several distributions from the partnership which he characterized as withdrawals from his capital 3. ROACH V. ROACH account. The partnership agreement provided that all Because of the potential confusion that can result distributions to the husband were either salary or in the characterization of marital property when profit. In the divorce proceeding, the husband argued transferred to a partnership, the partner spouse should that the distributions should not be included in the clearly delineate in the partnership agreement or other computation of the community estate because they instrument whether the property transferred will were a return, or mutation, of his separate property remain his or her separate property or ownership is interest in the partnership even though he reported being conveyed to the partnership. them as income on his income tax return. The wife On point is the case of Roach v. Roach, 672 asserted all the distributions and withdrawals were S.W.2d 524 (Tex. Civ. App.--Amarillo 1984, no writ). community property. In Roach, the husband and wife each deeded separate real property to a partnership. The wife deeded her b. The Ruling separate real property to the partnership with the The court of appeals agreed with the wife and stipulation that the property could be used by the found that “a withdrawal from a partnership capital partnership but it would remain her separate property. account is not a return of capital in the sense that it The husband conveyed his separate real property to may be characterized as a mutation of a partner’s the partnership but did not request language in the separate property contribution to the partnership and partnership agreement stipulating that the property thereby remain separate.” Id. at 594. Rather, the would remain his separate property. partner spouse’s contribution becomes partnership property (unless expressly agreed otherwise, see Upon divorce, it was determined that the wife’s discussion supra), that cannot be characterized as property, although held in the partnership’s name, either separate or community property. Id. Therefore, remained her separate property; however, the real the court held that the rule that mutations of separate property conveyed by the husband lost its separate property remain separate property when effectively property character when it was transferred and traced, did not apply to partnership distributions from acquired by the partnership. The husband and wife, as a partner’s capital account. Id. partners, were co-owners of the husband’s former c. Comments separate real property. The court characterized the spouses as tenants in partnership. Id. at 524. (1) The Holding Follows the Statute The holding in Marshall is absolutely consistent C. Partnership Distributions with the general rules that (i) partnerships are entities in which partners own partnership interests and have 1. GENERALLY no ownership interest in partnership assets and (ii) Regardless whether the partnership interest is income from separate property is community property. community or separate, all distributions from a The partnership experienced a return of capital but

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Mr. Marshall simply received income with respect to a community property asset held by the partner his partnership interest. spouse. The non-partner spouse, as a partial transferee of the partner spouse’s partnership interest, (2) Reliance on Income Tax Rules is will then have the right to a pro rata share of all future Misplaced partnership distributions, if and when made. Although the husband argued that the withdrawal was principal, not income, he reported taxable income The court cannot, however, compel the with respect to the partnership. The wife (and, partnership to distribute the income. Rather, as a arguably, the court) believed that the federal transferee, the non-partner spouse or ex-spouse is government’s alleged characterization of the forced to wait until the partnership elects to make a withdrawals as taxable income supported the distribution. See discussion supra. argument that the withdrawals were income for community property purposes. The thoughtful 2. SEPARATE PROPERTY PARTNERSHIP practitioner will not rely on this argument because: When the partnership interest is one spouse’s (i) it ignores the distinctions between taxable income separate property, Texas law is arguably unclear on and accounting income, and (ii) it ignores the fact that, the rights, if any, of the non-partner spouse in any under the Internal Revenue Code, partnership income undistributed income. is taxable to the partners without regard to whether there are withdrawals. The wife won because of state a. Arguments Against Non-Partner Spouse partnership law, not federal tax law. Some have argued that undistributed partnership income is not subject to any claim by the non-partner (3) Partnership Agreement Might Change spouse in a divorce proceeding. There is increasing Result support for this argument. As discussed previously, a The partnership agreement in Marshall did not partner’s ownership interest under the TRPA is address the characterization of partnership limited to his or her interest in the partnership as a distributions. Significantly, no Texas case was located whole and not to specific partnership assets, including which considered partnership distributions that were undistributed income and profits. See TRPA §§2.04 deemed to be a return of capital under the terms of the and 5.01. Further, the partner spouse has not partnership agreement. It is unclear whether courts acquired the income or profits because the assets will interpret the Marshall decision to apply to all remain partnership assets and the partner spouse partnership distributions or only those agreed to be cannot, without the joinder of the other partners, income [and treated as such by the partner for tax compel a distribution. Texas cases addressing purposes]. distributions from trusts and lend support to this argument. d. Application to FLPs TRLPA §1.02(13) essentially defines “return of b. Arguments For Non-Partner Spouse capital” as any distribution to a partner to the extent Others, however, have argued that all partnership that, after the distribution, the partner’s capital income and profits, including any undistributed account is less than the partner’s aggregate amounts, are community property. In In re Marriage contributions to the partnership. (For example, if a of Higley, 575 S.W.2d 432 (Tex. Civ. App.--Amarillo partner contributes $100 to a partnership, receiving a 1978, no writ), the husband owned a separate property $100 capital account credit balance, and then receives partnership interest. In dividing the marital estate, the a distribution of $20 that leaves his capital account court awarded the non-partner spouse a share of the balance at $80, the $20 distribution would be a “return anticipated net income of the partnership for the year of capital.”) This section of TRLPA appears to of the divorce. See Higley, 575 S.W.2d at 434. support the argument that all distributions from a Further, the unique taxation of partnership interest partnership of profit and surplus are community, but lends support to this position. Recall that all that distributions made by “dipping in” to a partner’s partnership income and profits flow through to the separate property capital contribution may be partners for tax purposes even if the partnership separate. retains these earnings. Each partner must include his or her share of any income and profits in calculating D. Undistributed Partnership Income their taxable income and pay any related income taxes.

1. COMMUNITY PROPERTY PARTNERSHIP If the partnership interest is community property, c. The Winning Argument? it is said that both spouses have an interest in the To date, the Texas Supreme Court has not undistributed partnership income and the court can resolved this issue. The few cases that have addressed partition the right to the income in the divorce decree. this issue were decided when TUPA’s inartful entity It is perhaps more accurate to say that the court may theory of partnerships provided that a partner partition the actual partnership interest--being as it is generally had an interest in specific assets as a tenant in partnership. See Higley, 575 S.W.2d at 434.

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However, effective January 1, 1999, all general 2. SPECIFIC PARTNERSHIP PROPERTY partnership will be governed by TRPA which more A divorce court cannot partition specific clearly sets forth an entity theory of partnerships. It partnership property to either spouse. See McKnight seems highly likely that the provisions of TRPA will v. McKnight, 543 S.W.2d 863, 868 (Tex. 1976); result in the courts finding that a non-partner spouse Roach v. Roach, 672 S.W.2d 524 (Tex. Civ. App.-- has no community property right in the undistributed Amarillo 1984, no writ). partnership income. G. Claims of Reimbursement to E. Partnership Management Rights Community Estate The community estate is entitled to be 1. GENERALLY reimbursed for distributions used to satisfy one Under TRPA §4.01(e), “each partner has equal spouse’s separate obligations. See Marshall, 735 rights in the management and conduct of the business S.W.2d at 587. In Marshall, the husband acquired a of the partnership. However, “[a] partnership interest partnership interest prior to marriage. At the time of does not include a partner’s right to participate in the marriage, the husband owed $125,375.50 in management.” TRPA §1.01(12). That is to say, the income taxes. The partnership subsequently paid the right of management is not a property right per se but husband’s income tax and charged it as a is a right personal to each partner. As to limited distribution from the partnership. The couple included partnerships, the right of management is vested in the the distribution in their income. The Dallas Court of general partners. See TRLPA §4.03. Appeals held that the community estate was entitled to reimbursement equal to the amount of taxes satisfied 2. DURING MARRIAGE by the partnership. Id. at 596. A partner’s management rights, if any, are not community property. See TRPA §4.01(d). The The community estate will also be entitled to a partner spouse has the right to participate in the right of reimbursement for any income taxes paid by management and control of the partnership according the community estate relating to one spouse’s separate to the terms of the partnership agreement. The non- property partnership interest when the associated partner spouse does not have comparable right even profits and income were not distributed during the though the partnership interest may be community marriage. property. H. Right to Compel Partnership to 3. DEATH OR DIVORCE Upon the death or divorce, the non-partner Satisfy Child-Support Obligations spouse will be deemed a transferee of any interest Unlike a trust, no statute exists which requires partitioned or acquired by the non-partner spouse. See that a partnership make distributions to satisfy a TRPA §5.04. As such, his or her sole right is to partner’s child support obligation. receive distributions if and when made. See TRPA §5.03(b). I. Potential Attacks on Partnerships F. Partition of Partnership Interest in 1. ALTER EGO Just as with any other entity, a spouse may assert Divorce that the court should disregard the partnership because it is nothing more than the alter ego of the partner 1. PARTNERSHIP INTEREST spouse. A divorce court can partition a community property partnership interest as it determines to be just 2. FRAUD and right. However, the partition of a partnership The non-partner spouse could claim that the interest to the non-partner spouse will not result in him partner spouse transferred community property to a or her becoming a partner in the partnership. The non- partnership to defraud the community estate. See partner spouse is deemed a transferee or assignee of TEX. REV. CIV. STAT. ANN. art 6132b §28-A-- the partitioned interest and is only entitled to comment (Vernon 1970). partnership distributions, when made, by the partnership. See discussion supra. The non-partner 3. FAILURE TO MAKE DISTRIBUTIONS spouse is not entitled to participate or interfere in Some partnership agreements provide that the partnership management. See TRPA §5.03. As a profits will be distributed at a certain time or based on result, the non-partner spouse’s interest in the a formula, taking into account reasonable reserves to partnership is diminished and frequently unmarketable provide for anticipated partnership expenditures and because of his or her inability to participate in the obligations. Generally, partnership distributions must management and control of the partnership. be made pro-rata to the partners. Review the terms of the partnership agreement to determine if the partner has a right to compel and receive distributions. Also

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-7 verify that the partner spouse has received a extent that the partner spouse receives distributions proportionate share of any partnership distributions attributable to partnership income and profits, there made during the marriage. will be community income (in the absence of a marital property agreement). IV. 3. REIMBURSEMENT RIGHTS DUE TO EXCESSIVELY LOW DISTRIBUTIONS USES AND ABUSES OF FLPS TO It is arguable that a non-partner spouse could ALTER MARITAL RIGHTS make a valid reimbursement claim to the extent that partnership distributions are unreasonably low and the AND DUTIES partner spouse contributes personal time, talent or effort to the partnership. This risk will be more Depending on one’s personal ethic, each of the significant in partnerships owning assets requiring following techniques is either a useful tool to clarify, significant management efforts and less of a concern control and retain valuable property rights, or a in more “passive” partnerships (those holding cunning device to perpetrate fraud, evade fundamental or other assets not requiring a significant marital duties and defy public policy. However, the contribution of time from the partner spouse). Also, techniques are presented with only limited ethical taking withdrawals for [community] living expenses commentary because, in my view, it is the recognition can probably minimize the reimbursement claim and discussion of the issues that leads to an ethical without much risk of creating a significant community practice. Ethics cannot be taught by an outline’s estate. designation of “ethical” or “unethical.” Rather, ethics are learned by each practitioner’s making his or her 4. NOT FOR MINERALS OR OTHER ASSETS own decision. PRODUCING SEPARATE REVENUES The technique is not for assets that produce A. Avoid Receipt of Community Income separate property revenues, such as: (i) royalty and from Separate Property other fee mineral interests (note that interests in oil & gas partnerships produce community property income, 1. GENERALLY not separate property royalties), (ii) non-income The FLP (or any other partnership entity) producing real estate held for long term appreciation, essentially creates a brick wall between the property of and (iii) other “growth” assets. These assets already the partner spouse and the property of the partnership. avoid creation of community property without regard Assets inside the partnership do not belong to the to actual receipt of the revenues. Placing them into an partner spouse. Neither the appreciation of nor the FLP effectively converts their separate property income earned by those assets belongs to the partner revenues into community property income, to the spouse. Instead, the partnership itself owns the assets, extent withdrawn from the partnership. Planning with appreciation and income, and the partner spouse owns these assets should revolve around a careful only his or her partnership interest in the to preserve tracing arguments, not FLPs. entity. B. Preserve Separate Character of So long as the partnership makes no distributions Receipts with “Built-In” to the partner spouse there can be no income with Partition Language respect to his or her partnership interest; the An FLP agreement to which both spouses are partnership interest may increase in value (due to the parties could effectively double as a limited scope partnership’s retained earnings) but increases in the marital property agreement by including language value of separate property are clearly separate providing that all distributions to either partner spouse property. Thus, a spouse or future spouse who will are his or her separate property. This could be useful not need personal access to the income from separate where the spouses both wish to invest separate property assets can place those assets in an FLP and, property in a single enterprise but wish to avoid so long as the income from those assets is retained creation of community property. It could also inside the partnership, that income will never be the facilitate non-pro rata treatment of the spouses to the partner’s property, much less the community property extent that one of them is given compensation, of the partner and his or her spouse. Without the guaranteed payments or other similar distributions. joinder of the non-partner spouse, the partner spouse Obviously, in order to be effective, any partnership will have effectively converted the income from his agreement (or other instrument) which doubles as a separate property assets into separate property. marital property agreement would have to satisfy the general requirements for a valid marital property 2. ONLY UNDISTRIBUTED INCOME IS PROTECTED agreement (disclosure or waiver, voluntariness, etc.). The technique is only effective to the extent that earnings are retained inside the partnership; to the

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C. Transmute Separate into Community in-kind and liquidating distributions--if they prefer to own the partnership’s assets directly. In either case, 1. NO DIRECT TRANSMUTATION UNDER the property owned will arguably be community CURRENT TEXAS LAW property. Under current Texas law spouses can convert community property into separate property but cannot 3. TECHNIQUE: CREATE FLP WITH SEPARATE directly convert separate property into community AND DISTRIBUTE BACK IN-KIND property. Rather, community property is Another technique is for a spouse to create the constitutionally defined and can be caused to exist FLP with the separate property to be converted into only in compliance with the Texas constitution. community property and then take the property back However, there may be spouses who desire to “opt-in” via one or more non-liquidating in-kind partnership to the community property system; e.g.: distributions. To the extent that all partnership distributions are in fact “income” and therefore C migrant spouses desiring to eliminate community property, all of the property (except, ambiguity as to their separate and arguably, the final liquidating distribution) will be community estates; community. C spouses desiring to undo a prior partition of community property or an inadvertent This technique seems riskier than the other partition (such as one effectuated by a joint because of the possibility that the distributions would brokerage account agreement including old be treated as a “return of capital” and characterized as “two-step” partition/survivorship language a separate property mutation or return of the initial in the boilerplate); separate property partnership interest. See the C non-citizen spouses desiring to reduce or discussion supra. avoid the need for a Qualified Domestic Trust in their wills (necessary to obtain a D. Withdraw Partnership Property as marital deduction for bequests to a Separate Property surviving non-citizen spouse but irrelevant as to the surviving non-citizen spouse’s 1. TECHNIQUE: STRAW MAN SALE AND retention of his or her ½ of the community REDEMPTION estate); If the partnership interest is the separate property C spouses with non-taxable estates wishing to of one spouse and that spouse desires to withdraw obtain a larger “step-up” in basis on the funds from the partnership as separate property, he or death of the first spouse (the deceased she could sell a partial interest in the partnership to a spouse’s separate estate and ½ of the third party and the third party could then redeem the community estate and the surviving interest (sell it back to the partnership) for the same spouse’s ½ of the community estate all get price (plus a little something extra for his trouble). a step-up but the surviving spouse’s The proceeds from the sale of the separate property separate estate does not); and partnership interest would be separate; however, the C spouses with substantial but unequal wealth unhappy non-partner spouse would probably have a who wish to “equalize” their estates without good chance at characterizing the proceeds as requiring the wealthy spouse to make an community by arguing that the sale to the intermediary outright gift and thus lose all management should be ignored (this “step transaction” argument is rights over the gifted property. often used by the Internal Revenue Service in tax cases). 2. TECHNIQUE: CREATE FLP WITH COMMUNITY, AUGMENT WITH SEPARATE AND 2. TECHNIQUE: MANIPULATE CAPITAL WAIVE REIMBURSEMENT ACCOUNTS TO CREATE “RETURN Either or both spouses can transfer community OF CAPITAL” property to a newly formed FLP and the partnership Another option for the partner spouse desiring a interest received in return will be community property separate property withdrawal from his or her separate under general principals of tracing and inception of property FLP relies on effective exploitation of the title. The spouses can then make additional return of capital argument. Under that argument, contributions of separate property to the FLP without withdrawals are separate property to the extent they receiving any additional partnership interests. This reduce a separate property capital account to an will enhance the value of the previously obtained amount less than the aggregate capital contributions. community property partnership interest and will With careful timing and coordination of distributions probably create a reimbursement claim; however, and partnership receipts, community property reimbursement claims are easily waivable. The withdrawals (which could be applied to living spouses can retain the partnership interest or take one expenses) could be used to reduce the capital account or more distributions from the partnership--including to the amount of the initial contribution; then, the next

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-9 withdrawal would be separate. Likewise, withdrawals FLP–with or without the joinder of the other spouse-- could be made prior to the date the partnership as a pre-divorce planning technique. It is quite anticipates a particular receipt of profit (which, when possible that the attorney drafting the FLP agreement realized, would increase the capital accounts and thus will not be aware of the spouse’s motive. In the event increase the likelihood of subsequent withdrawals of a future divorce the court will be able to award the being characterized as community). non-partner spouse no more than a non-voting, non- marketable transferee interest in the FLP and will have 3. TECHNIQUE: MULTIPLE CONTROLLED no authority to order the FLP to make distributions to ENTITIES TO CREATE “RETURN OF CAPITAL” satisfy child support obligations. Depending on the OR CROSS SALE OF INTERESTS extent to which the motive of the partner spouse can Alternatively, the partner spouse with a separate be proved, the non-partner spouse may or may not property FLP could establish multiple partners which have good arguments to attack the FLP. are owned by him or her, e.g.: one or more revocable trusts, corporations, etc. The partner spouse could make non-pro rata allocations of profit to the capital V. accounts of these different entities, always ensuring REPRESENTING AND ADVISING that at least one of them has a capital account that is SPOUSES less than or equal to (or only slightly larger) than the aggregate contributions. Then, whenever the partner Having before us an extremely powerful tool--the spouse desired to take a separate property withdrawal FLP–the question is: what do we tell our clients? he or she could take it from that entity’s capital account. An even more aggressive position would be to have one of those entities sell all or a portion of its A. Representing Both Spouses Jointly partnership interest to another, enabling the partner Representing both spouses jointly in an estate spouse to claim that the proceeds of sale were planning engagement is both historically accepted and, separate. in my view, absolutely ethical and proper--not to mention economical--in the vast majority of cases. The non-partner spouse would probably point to Representing both spouses in a divorce or in pre- (i) the very precise manipulation of capital accounts divorce planning is ethical in only a very small by the partner spouse and (ii) the fact that, both before minority of the cases. Distinguishing between the two and after all the dust settled, the partner spouse had situations can be problematic. total control of the partnership, as evidence that the transactions were either shams or were made with Obviously, the attorney’s “people skills” and fraudulent intent. ability to read between the lines when conferring with the spouses are crucial; the attorney who is able discern that what is ostensibly estate planning is really E. Eliminate Mutual Fund Ambiguity; viewed by either or both of the spouses as pre-divorce Render All Returns Community planning will have the opportunity to terminate the Mutual funds initially funded with separate representation promptly--with luck, before any property of either or both spouses can present difficult damage is done. Thus, e.g., when a spouse with no tracing problems. The ambiguity can be resolved with children from prior relationships shows interest in a partition agreement, making the entire fund (and all using an FLP to avoid child support obligations, the income) separate; however, the loss of the basis step- prudent attorney may wish to withdraw. up (discussed supra) may be a high price to pay when growth stocks are involved. Placing mutual funds in Potential conflicts can also be ferreted out with a an FLP arguably converts all returns into community good joint engagement agreement which clarifies that property--to the extent withdrawn from the all statements one spouse makes to the attorney may partnership. This eliminates the ambiguity without be shared with the other spouse. I do not believe that sacrificing the basis step-up or forcing the spouses to a spouse with an ulterior agenda can be stopped take the sometimes divisive step of executing a marital merely by an attorney with a good engagement property partition agreement. (Not all spouses agreement; however, if that spouse is clearly informed desiring to avoid ambiguity desire to maintain separate that the attorney intends to keep no secrets from the finances.) other spouse, it significantly reduces the chances of the attorney becoming an unwitting accessory to a F. Pre-Divorce FLP Creation With fraud or otherwise violating his or her ethical duties to Community to Impair Non-Partner both spouses. Spouse’s Rights and Avoid Child Assuming the attorney is satisfied that joint Support Obligation representation is otherwise permissible, equal A spouse can place his or her separate property treatment of the spouses is extremely desirable where and sole management community property into an FLPs are involved:

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Almost all of the marital property and ethical problems with FLPs can be eliminated if only community property is placed into the FLP and both spouses receive and retain identical general and limited partnership interests.

This eliminates the separate/community issue, perpetuates a circumstance of joint management, and ensures that neither spouse will be stuck with a non- voting, non-marketable transferee interest when the marriage terminates either by death or divorce. In this situation it is very difficult to find any ethical problems with entering into a joint representation situation.

When equal treatment is not possible, either because separate property will be funded into the partnership or because the spouses or circumstances dictate that either spouse (or both spouses) not have a general partner interest, the attorney has the more difficult task of advising the spouses as to all the relevant legal consequences of the FLP--and documenting that advice. In some circumstances this can be very upsetting to the spouses even when discussed in hypothetical terms. (For example, if clients want to use an FLP to “transmute” separate property into community property, the attorney should be sure they understand: the potentially increased exposure to the claims of the other spouse’s creditors, as well as the court’s authority to divide community property but not separate property in a divorce.) Any lawyer--including an estate planning lawyer--who does not feel capable of giving advice that might be upsetting to his clients simply needs to find another profession. B. Representing Only One Spouse When only one spouse is to be a client the joint representation issues of confidentiality and conflict of interest are replaced by one easy to ask (and difficult to answer) question: where is the line between practicing law (albeit in a fashion that pushes the law to its limits), and joining your client in unethical, fraudulent, or illegal conduct. As is the case with joint representations, I believe it is incumbent on the attorney to ascertain the client’s wishes and be sure those wishes are consistent with the attorney’s standards of ethical and legal conduct. It is certainly my hope that this outline will help the reader to develop and maintain a set of standards that reflect well on all practitioners.

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APPENDIX ONE: FLP “TOP TEN LIST”

10. FLPs are not an Olympic dive with a 2.8 degree insurance, which is 100% includable in the estate of difficulty. (Estate planning attorneys will tell of the insured if he or she owns more than 50% you that the degree of difficulty is more like 3.4.) of the stock, partnership-owned life insurance is included only to the extent of the insured’s 9. If an FLP works to decrease your client’s net percentage ownership of the partnership. If he or worth for gift and estate tax purposes, it also she has give away 95% of the limited interests, decreases it for other purposes as well. You but retained control by retaining the 5% general should be sure that your client’s lender knows partnership interest, only 5% of the insurance what is going on if, for example, your client is proceeds should be included in the insured’s guaranteeing the debt of his or her closely held estate. business. 3. Although the argument seems strained, the IRS 8. FLPs really can do many of the things they are is apparently making an effort to apply the rules promoted to do--dissuade creditors; avoid out-of- of Section 2703 of the Internal Revenue Code to state probate; get the younger generation FLPs, saying that the agreements are really only involved in family decisions; elaborate “buy-sell” agreements. To come within consolidate undivided interests in family the safe harbor exception to Section 2703(b), the investments; simplify annual gifting with parting agreement must (1) be a bona fide business with cash; etc. arrangement; (2) not be a “device to transfer property to members of the decedent’s family” 7. For an FLP to work, you need an appraisal. (or, under the Regs, to the “natural objects of the Often, depending upon the nature of the property decedent’s bounty”); and (3) be comparable to contributed, your need two appraisals--one for similar arrangements entered into by persons in the value of contributed property, and another of an arms’ length transaction. Although tests (1) the value of the resulting partnership interests. and (3) are fairly easy to satisfy, test (2) is might This area is not one to scrimp on. Most FLP be pretty tough. litigation boils down to a question of value. Your appraiser must be prepared to testify 2. FLPs are just one tool in the tool box. Despite convincingly that his or her valuation is well claims to the contrary by their proponents, they reasoned and supportable. are not the solution for every estate planning situation. They work in a variety of contexts, 6. If your client has a closely held business and however, and seem to work especially well when: wants to contribute it to an FLP, watch out: (1) if (1) The senior generation has diverse investment the business is an S corp.--a partnership is not a assets; (2) the children have assets of their own permitted S corp. shareholder; and (2) if the (perhaps acquired by earlier gifts from the senior business is a C corp. and the transferor retains generation), which they want to consolidate; (3) voting control of the stock owned by the the senior generation wants to retain control, or partnership, the IRS may try to tax the value of they want control consolidated in one or more of the stock under Internal Revenue Code Section the children; (4) the client has the tolerance for 2036 (transfers with retained control)--the safer the complexity and fees associated with the course is to recapitalize the with a technique. nominal amount of voting stock (retained by the founder), transferring only non-voting stock to 1. FLPs simply make assets “ugly”, and thus the FLP. decrease the value of the assets for gift and estate tax purposes. 5. Internal Revenue Code Chapter XIV and the Regs thereunder, far from killing FLP’s, give us useful guidelines by providing that restrictions imposed by the Texas Revised Partnership Act will be given effect. Plain vanilla limited partnerships can get some pretty substantial discounts (if they last for a term of years) simply because of these state law restrictions.

4. An FLP may be used to shift life insurance out of the insured estate. Unlike corporate-owned life

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APPENDIX TWO: FAMILY LIMITED PARTNERSHIP “BASICS” I. Limited partners are usually not required to make contributions to the partnership, and they are not OVERVIEW OF FAMILY LIMITED responsible for partnership liabilities (i.e., they are not PARTNERSHIPS personally liable if the partnership is sued). State law restricts the rights of a person to whom a limited A. General Concepts partnership interest is transferred. Unless the other As indicated by its name, a family limited partners agree to treat the transferee as a limited partnership (“FLP”) is a limited partnership, the partner, the person will normally have only the rights partners in which are members of the same family. of an “assignee” which are described below. Typically, the founders are senior-generation family members who transfer assets into the partnership and 2. GENERAL PARTNERS receive both general and limited partnership interests Like limited partners, general partners are in return. They usually hold only a small interest entitled to share in partnership profits based on their (often as small as a 1% interest) as general partners-- percentage ownership in the partnership. However, the remaining partnership interests are structured as the general partners have complete management limited partnership interests. Despite the small authority and control over the partnership and percentage represented by partnership assets, including the power to decide if interests, these interests represent control of the FLP; and when to distribute partnership profits. They the limited partnership interests, which are usually typically receive reasonable compensation for nonvoting, represent the bulk of the ultimate value of performing their management duties. However, the the partnership. The founders of the partnership price under Texas law for having management usually retain their general partnership interests. They authority and control over the partnership and its then often make gifts of some or all of their limited assets is that general partners are personally liable for partnership interests to younger-generation family partnership liabilities that are not paid out of members. Sometimes, younger-generation family partnership interests. In other words, if a general members contribute some of their own assets to the partner makes a bad management decision and, as a FLP in exchange for a limited partnership interest. result, the partnership is unable to pay its liabilities, The founders frequently own the general partnership the general partners may have to pay those liabilities interests in their own names, individually. In some out of their own pockets. circumstances, the general partnership interests are owned by a trust, a , or a limited liability company controlled by the founders. II. ADVANTAGES OF FAMILY B. Differences Between General and Limited Partnership Interests LIMITED PARTNERSHIPS Under Texas law, general partnership interests and limited partnership interests differ in several ways. Family limited partnerships offer numerous tax The most significant differences between general and non-tax advantages to their founders and to partners and limited partners are as follows: members of the founders’ families. To a certain extent, however, the benefits to be obtained depend in 1. LIMITED PARTNERS part on the motives of the founders in creating the Limited partners are entitled to share in FLP. In most cases, the founders of the partnership partnership profit distributions on a pro rata basis. In are seeking a variety of benefits from the FLP. It is addition, if the partnership is liquidated, the limited frequently helpful in future dealings with third parties partner receives his or her pro rata share of liquidation (such as potential creditors and the IRS) to spell out proceeds. For example, if partnership profits are the objectives and business reasons for forming the distributed, a limited partner owning a 10% limited FLP in the partnership agreement, while emphasizing partnership interest would receive 10% of the the continuing, ?going concern” nature of the distributed profits. If the partnership were liquidated, partnership. The following discussion highlights some that partner would receive 10% of the assets of the of the effects of transferring assets to an FLP. partnership. However, limited partners do not take part in partnership management (e.g., they cannot vote A. Creditor Protection on whether to buy or sell a particular investment and If a creditor wins a lawsuit against a debtor and cannot vote to liquidate the partnership). They are obtains a judgment, the creditor may take possession subject to the control of the general partner and have of certain assets of the debtor. Family limited no assurance that distributions will be made to them. partnerships provide asset protection from potential

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-13 creditors of a partner because a partner’s creditor the price at which the property generally cannot seize the partnership interest and would change hands between a thereby become a partner. Instead, the remaining willing buyer and a willing seller, partners continue to control the partnership and the neither being under any creditor typically receives only a ?charging order” compulsion to buy or to sell and against the debtor-partner’s interest. A charging order both having reasonable knowledge gives a creditor the rights of a mere ?assignee” of the of relevant facts. The fair market partnership interest to the extent of the debt. In this value of a particular item of position, the creditor receives only the partner’s share property . . . is not to be of income (as determined by the general partners) plus determined by a forced sale price. the right to inspect the books of the partnership. The Nor is it determined by the sale creditor gets no voting rights, control, or any other price of an item in a market other power in the partnership. The creditor cannot sell than that in which such item is partnership assets, liquidate the partnership to satisfy most commonly sold to the public, the debt, or force a distribution of profits. Although taking into account the location of the creditor cannot require a distribution of profits, the item, wherever appropriate. the creditor is required to pay income tax on its pro rata share of any income received by the partnership. A “willing buyer” of a partnership interest does This feature of partnership law makes an interest in an not become a partner under Texas law. Rather, like a FLP an ?ugly” asset to creditors. Consequently, most creditor, the buyer is treated as an “assignee,” unless creditors would rather negotiate a settlement favorable the other partners agree to admit the buyer to the to the debtor than become an assignee of the partnership as a partner. No buyer can be certain that partnership interest. he or she will be so admitted (in the context of a family partnership, the prospects for admission of a The asset protection benefits of an FLP might third party as a partner would appear especially induce a creditor to raise an allegation that the initial remote). Therefore, the prospective buyer has no transfer by the partner to the partnership was made to guarantee of any voice in partnership matters. This “defraud” the creditor. Texas law provides certain feature of the law regarding transferred partnership protections to creditors from debtors who attempt to interests substantially diminishes the price that a transfer property to defraud creditors. If the transfer willing buyer would pay for an interest in the is found to be “fraudulent,” a creditor may persuade a partnership. Suppose for example that a partnership court to undo the transfer to the extent needed to contained assets valued at $1,000,000. The buyer of satisfy the claim. Generally, however, as long as 10% of the assets generally would be willing to pay transfers to the FLP are not made with an actual intent $100,000. A buyer of a 10% interest in the to hinder, delay, or defraud creditors, the transfer to partnership owning those assets, however, likely the FLP should not be voidable. Therefore, persons would pay much less, since the buyer, as an assignee, forming an FLP should retain sufficient assets outside gets no voting rights, control, or any other power in the FLP to enable them to satisfy any outstanding (and the partnership, and cannot sell the partnership assets, reasonably anticipated future) debts and claims. require a liquidation of the partnership to receive the assets, or even require a distribution of his or her “share” of partnership profits. This price-depressing B. Valuation Discounts feature of limited partnerships substantially lowers the Valuation of FLP interests is important: if assets value of the property transferred by the founders of an are transferred to an FLP, estate and gift taxes are FLP, and as a result, lowers overall gift and estate tax measured based upon the value of the partnership exposure. interests given during lifetime or retained at death. Because a founder exchanges contributed assets for Restrictions set out in the partnership agreement FLP interests, the value of the contributed assets are may also affect the valuation of a partnership interest not taxed in the founder’s estate. Valuation of cash, because they prevent the partners from freely stocks, bonds, and other readily tradeable assets is a disposing of their interests. Historically, the ability of relatively simple matter. When no public market family members to include severe transfer restrictions exists for an asset, however, its valuation becomes in the partnership agreement provided an opportunity somewhat subjective. Since there is no public market to obtain discounts on the value of partnership for interests in an FLP, the tools used to value interests. Since 1986, however, Congress has unmarketable assets can contribute to a favorable provided that in a partnership controlled by family valuation for estate and gift tax purposes. members, restrictions set forth in the partnership agreement are ignored for valuation purposes to the The Internal Revenue Code provides that estate extent that they are more restrictive than state law. and gift taxes are measured by the “fair market value” Ironically, the limitations imposed upon partnership of transferred assets. Fair market value is defined as: interests described above are imposed not by the partnership agreement but by state law. These

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 C-14 1999 Advanced Estate Planning and Probate Law Course restrictions have the most dramatic impact on the as limited partnership interests are gifted, the value of value of the partnership interests; they give the underlying assets held by the partnership are partnership interests a value much lower than their effectively removed from the donor’s estate, thereby value upon the liquidation of the partnership. decreasing the amount of federal estate taxes that otherwise would be payable at the donor’s death. C. Other Benefits Once gifts of partnership interests are made, not only Family limited partnerships provide a number of a percentage of the underlying property, but also a benefits beyond those associated with creditor corresponding percentage of any appreciation in the protection and estate and gift tax minimization. For property is effectively removed from the donor’s example, an FLP allows the founders to keep control estate. of the assets as general partners. When property is gifted outright, the donee gains control over the gifted Other FLP advantages are as follows: property. In contrast, with an FLP, when the founder makes a gift of a limited partnership interest while C A person in a high income tax bracket retaining the general partnership interest(s), he or she holding income-producing assets can gift retains control over all of the underlying partnership limited partnership interests to a person property. An FLP also allows a simplified mechanism who is in a lower income tax bracket, which to make gifts of assets that might otherwise be hard to may permit income to be reallocated among divide.1 Some donors view gifts made through the use family members and, thereby, decrease the of an FLP to be an excellent way to enable them to overall income tax burden.3 make gifts which are “fair” to everyone. A particular asset is not set aside for a particular person. Rather, C At death, fewer assets are subject to probate everyone is treated equally, since everyone receives a court jurisdiction. As a result, partnership pro rata portion of the same property. Family limited real estate located in a state other than partnerships provide senior family members a Texas avoids what might otherwise be an convenient mechanism to take advantage of the expensive “ancillary” probate proceeding. $10,000 annual gift tax exclusion.2 At the same time, C Because many different types of assets can be placed in one entity, accounting and management of family wealth can be 1 Real estate is a good example of an asset for consolidated. which gifting is simplified through the use of an FLP, especially if annual gifting is desired. Rather than C The partnership allows flexibility, since the terms of the partnership agreement can be having to prepare separate transfer deeds and pay modified as needed (subject to any filing fees to record the deeds of fractional interests restrictions on amendment that the family each year, only one deed transferring the land to the chooses to place in the partnership FLP is required. Thereafter, the founders can execute agreement). a simple instrument assigning limited partnership interests to family members each year. The partnership assignments need not be recorded. At the same time, management of the real estate, instead of to any person in any year exceeds the annual gift tax being fractionalized among co-owners, remains in the exclusion, gift tax returns are required. No gift tax is hands of the founders, who hold the general actually paid, however, until the total of all such partnership interests. excess gifts exceed $650,000. The $650,000 “exemption equivalent” shelters property from estate 2 The Internal Revenue Code permits each and gift tax until total taxable transfers, whether person to gift up to $10,000 per donee per year during life or at death, exceed this threshold. without any gift tax implications. Parents utilizing this $10,000 “annual exclusion” are each treated as 3 To avoid perceived abuses in shifting income donors, enabling married couples to make gifts of up among family members, the Internal Revenue Code to $20,000 per year. Gifts of FLP interests enable provides that the donee of a partnership interest will founders to make these gifts without parting with cash, be taxed on partnership income computed after an or with control of the FLP assets (as long as they allowance for reasonable compensation to be paid to retain the general partnership interests). In addition, the donor partner for any services provided by the because the valuation of the property is reduced by donor to the partnership. In addition, net profits, in having been placed in a partnership entity, more value effect, must be allocated based on the percentages of can be transferred than if the donor had instead gifted partnership property that the partners would receive the partnership’s assets outright. If the value of gifts upon liquidation of the partnership.

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C Some donors use the FLP entity to teach FLP can alter the character of property donees to work together while gaining (from community to separate or from business skills. separate to community, depending on the circumstances), and this can impact on the C Transfer restrictions can be placed on the divorce court’s ability to make a meaningful limited partnership interests to prevent property division. transfers to outsiders. These types of restrictions effect a type of ?spendthrift” provision because they act as a restraint on III. a partner disposing of his or her interest. PLANNING CONSIDERATIONS C Unlike other entities, FLPs are not currently A. The Partnership Agreement subject to Texas franchise taxes. The principal document needed to establish an FLP is the partnership agreement. In conjunction with C The FLP form can help preserve the Texas law and federal law, the partnership agreement separate property character of a partner’s governs the formation and management of the FLP. interest in the underlying property. After the partnership agreement is properly executed, a one-page informational “Certificate of Limited C The senior generation may choose to focus Partnership” is placed on file with the Texas Secretary control in one or more younger-generation of State, and a one-time filing fee is paid (currently family members, while providing equal $760). Thereafter, the founders transfer property to value to all younger-generation family the partnership. These transfers are accomplished members. For example, a couple might through deeds, assignments, opening of new bank or transfer a 25% limited partnership interest brokerage accounts, and other similar steps. to each of three children, giving the fourth child a 24% limited partnership interest and The partnership is established to continue for a a 1% general partnership interest. While specific term, typically 25 to 50 years. Limited each child receives one-fourth of the value, partners cannot withdraw before the end of the control is effectively given to only one partnership term unless the partners unanimously child. agree to liquidate the partnership. Limited partners are not entitled to mandatory distributions until the D. Certain Disadvantages end of the partnership term. FLPs, like every other estate planning tool, have both advantages and disadvantages that must be B. Management of the Partnership considered and compared before deciding whether the The partnership agreement can designate FLP is right for a particular client. someone to serve as the “manager” of the partnership. The manager acts somewhat like the “president” of a FLP disadvantages include the following: corporation, taking charge of the day-to-day operations of the partnership to the extent required. C FLPs can be costly. Creating an FLP Frequently, the manager is one of the founders of the generally involves lawyers, accountants, partnership. The general partners of the partnership appraisers and other professionals, all of are typically given the power to remove and replace whom charge fees for their services. the manager by their unanimous vote. The manager is Additional ongoing professional fees are typically entitled to receive reasonable compensation generally necessary to maintain the FLP. for services rendered on the partnership’s behalf. C The discounts are real; creating an FLP will C. Using Trusts as Donees reduce your net worth. This may make it Frequently, instead of transferring limited more difficult to obtain credit and may even partnership interests to children or other family violate the terms of existing loan members directly, donors choose to establish trusts for agreements (which frequently require that a the donees’ benefit. They might select a trustee to certain minimum net worth be maintained). assist younger family members. They frequently provide that, at some specifically-designated time in C An FLP can significantly alter the the future, each younger generation family member consequences of a divorce. Although the can become a co-trustee or the sole trustee of his or divorce court can divide community her trust. If a trust is utilized, the trustee owns the property interests in an FLP between the partnership interests that are intended to benefit the spouses, a spouse who was not a general donor’s family members. To the extent there is cash partner will typically never have a vote in flow from the partnership, the trustees then use that partnership matters. Also, the use of an cash flow to provide for the health, support,

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 C-16 1999 Advanced Estate Planning and Probate Law Course maintenance, and education of the donee family members and their descendants during their lifetimes. IV. If the partnership is ultimately liquidated, the TAX CONSIDERATIONS underlying partnership assets pass into these trusts, and the assets are again available through the trust to A. Income Tax Issues provide for the health, support, maintenance and Under the terms of the Internal Revenue Code, education of the intended donees. The family partnerships are not taxpayers. Rather, the partners members who are the beneficiaries of these trusts themselves are taxed on the income recognized by the often are given the power in their respective Wills to partnership, whether or not the income is actually designate who is to receive the property in his or her distributed to the partners. As a result, the general trust. The advantages of using lifetime trusts to hold partners or manager of an FLP must be aware of the the partnership interests include the following: income tax effects of the partnership’s income upon the various partners. Frequently, the manger will C An exemption of $1,000,000 per distribute at least enough cash from the partnership “transferor” (thus, $2,000,000 total for a each year to enable the various partners to pay any married couple) is available to minimize increase in their income tax bills caused by having to estate taxes when property passes from the report their respective shares of partnership income. donor’s children to their grandchildren. Another income tax issue of which founders of an C Even if the partnership is liquidated some FLP must be mindful relates to the tax effect of day, the assets held in the trusts are not contributing property to the partnership. Generally, subject to claims of a donee’s creditors; no gain or loss is recognized on the transfer of therefore, a large judgment will not cause property to a partnership. There are, however, some the donee to lose the benefit of these assets. important exceptions to this rule. For example, if two or more persons transfer non-identical assets to a C Holding assets in trust can preserve their partnership, and more than 80% of the partnership’s exemption from creditors’ claims and keep assets are readily marketable stocks or securities held them beyond the reach of a divorce court’s for investment, the effect to the partners may be that property settlement powers. their respective securities portfolios are thereby diversified. Under those circumstances, the so-called C Management assistance can be made “investment company” rules of the Internal Revenue available to donees through the use of Code may cause the partners contributing appreciated trustees or co-trustees. securities to recognize gain at the time the securities are contributed to the partnership. For most Texas D. Choice and number of general married couples forming an FLP, these rules should partners not apply, since contributions are typically from the The decisions of choosing general partners and couple’s community property (in which the spouses the number of general partners go hand-in-hand. hold identical interests). If more than 80% of the Under Texas law, a partnership dissolves upon the partnership’s assets will be in the form of marketable death or withdrawal of its sole general partner. A securities, however, these rules should be carefully lapse in control of the FLP can cause adverse tax reviewed with your counsel. Certain other types of consequences at the time of the lapse of the partner's assets have income tax characteristics that are rights. Therefore, it is important to avoid a lapse in dependent upon their being owned by qualified control of the FLP upon either a general partner's individuals. These assets (notably, annuities and stock death or withdrawal from the partnership. Several in closely held corporations that have elected to be options are available to avoid this occurrence, treated as S corporations) generally are not suitable for including having multiple general partners, successor contribution to an FLP. general partners and/or having an entity such as a trust, corporation, or limited liability company serve B. Estate Tax Inclusion Issues as one of the general partners. Determining which One important consideration in the formation of approach is best in any given situation depends on an FLP is the treatment of the partnership assets and numerous factors, including the number, age, and interests upon the general partner’s death. One of the health of the founders; the nature of the activities to be advantages of an FLP is the ease of gifting the undertaken by the partnership; and the overall estate partnership interests. Gifted partnership interests planning objectives of the founders. have the effect of removing the value of the partnership’s underlying assets (and any post-gift appreciation) from the donor’s estate. Accordingly, careful planning must be done to prevent the value represented by the assets contributed to the

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-17 partnership from being inadvertently included in the By using an FLP, some portion of the partnership general partner’s taxable estate. interests usually will have been transferred to a donee during the lifetime of the senior generation family For example, special estate tax rules provide members. Since neither the gifted partnership that--if a donor gives away an asset while retaining too interests nor the partnership’s underlying assets will much control of the possession or enjoyment of the have been transferred from a decedent at death, a step- asset (or the right to income from it)--it will be taxed up in basis is lost to the donee. In addition, since the in the donor’s estate. In the partnership context, the partnership interests retained by the senior generation founder’s retention of control through the general at death are subject to estate tax valuation discounts partner interests is subject to an obligation to maintain from the value of the partnership’s underlying assets, a fiduciary relationship with the other partners and to the cost basis of those assets in the hands of the act in the best interest of the partnership. This beneficiaries similarly will be discounted. In weighing fiduciary duty generally has been held to prevent the these divergent tax effects, most people conclude that gifted partnership interests from being included in the the current potential gift and estate tax savings founder’s taxable estate under those special estate tax obtained by using an FLP outweigh prospective future rules. As discussed above, only the value of capital gain taxes in the hands of younger generation partnership interests still owned by a founder at death, family members. This conclusion is bolstered by the subject to various discounts in value, will be included fact that estate and gift tax rates (which effectively in the partner’s gross estate. range from 37% to 55%) exceed capital gain tax rates (currently capped at 20%). When transferring One important exception to the rule discussed appreciated assets to an FLP, however, the advantages above applies to stock in a “controlled corporation.” of valuation discounts and annual gift tax exclusions If a general partner owns an interest in a closely held should be balanced against potential capital gain taxes corporation which he or she transfers to the FLP, associated with the loss of basis step-up. while retaining the right to vote the corporation’s stock, either directly or indirectly, the transferred interest in the corporation will be included in the general partner’s gross estate. To avoid this result, we V. advise persons who hold, alone or with their family, OPERATIONAL ISSUES 20% or more of the voting interest in a closely held corporation to recapitalize the corporation prior to An FLP is more than just a set of words on paper. transfer to the FLP, so that only nonvoting stock is Regardless of one’s motive for forming the FLP, it transferred. If voting stock in a controlled corporation will accomplish its objectives only if its form is is transferred to the FLP, we advise the inclusion of respected. If the goal is consolidation of investments, language in the partnership agreement that prevents the investment assets must actually be conveyed into the contributing partner from voting the stock; rather, the partnership. If one hopes to facilitate gifting, then the other general partners (or if there are no other partnership interests have to be given to family general partners, the limited partners) would then vote members. Using the FLP to teach investment policies the stock. and values to the younger generation works only if the partners actually meet and discuss investment C. Income Tax Cost Basis Issues philosophies, strategies and goals. If the idea is to Property which is inherited from a decedent ensure that the FLP is respected not only by the generally receives a so-called ?step-up” in basis in the family, but also by third parties, then undertaking hands of the estate’s beneficiaries. This means that these steps alone is not enough. It is equally important the cost basis of an asset in the hands of an estate’s to establish and maintain an adequate record, which beneficiaries is equal to the asset’s estate tax value shows that partnership formalities have been (normally, the asset’s fair market value at the observed. The founders of an FLP should hardly be decedent’s date of death). The “step-up” is usually surprised that the IRS or a creditor may ask a court to advantageous to the beneficiaries because, if the ignore the existence of an FLP if the family has done inherited asset is later sold, the beneficiaries will avoid so. The courts cannot be expected to give more all capital gain taxes attributable to any appreciation credence to the existence of the entity than do those in the value of the property during the decedent’s who have formed it and are expected to benefit from lifetime.4 it. To paraphrase an old saw, if you walk like a duck, quack like a duck, fly like a duck, and are constantly

4Although commonly referred to as a “step-up” in basis, the asset’s basis may actually “step-down” if of the decedent is simply ignored. The beneficiary’s the value of the property at the time of the decedents’s cost basis is the estate tax value of the asset, whether death is less than the decedent’s original cost basis. In that value is more or less than the decedent’s cost general, the former cost basis of the asset in the hands basis.

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 C-18 1999 Advanced Estate Planning and Probate Law Course seen in the company of other ducks, then it is reasonable to suppose that you are a duck. By the 3. CONVEYANCE OF ASSETS same token, if you expect others to treat the entity that Until assets are transferred to a limited has been so laboriously formed as a true partnership, partnership, the partnership exists in name only. It is then it should “walk, talk and act” like a partnership. the actual transfer of assets from the partners to the partners that breathes life into the entity. As a result, A. Formalities Upon Formation it is critically important that appropriate conveyance FLPs are formalized by the execution of an instruments be prepared and filed. Conveyance agreement which sets forth the rights and duties of the instruments may take the form of deeds; mineral deeds various partners, and specifies the relationship or division orders; stock powers (or endorsement of between general and limited partners. In addition, the stock certificates); opening of partnership bank or partnership must formally register as a limited brokerage accounts into which checks or brokerage partnership with the office of the Secretary of State of assets of the partners be convey; etc. Texas, and the partners must actually contribute assets to the FLP. a. Deeds A deed from a partner to the partnership ensures 1. THE FLP AGREEMENT that the partnership is properly identified as the owner The partnership agreement designates the of any real estate in the official real property records. original partners, describes their initial contributions, Recording this deed thus adds an important link in the sets forth whether and how additional contributions chain of title. It serves to establish ownership, and will be made, and describes how profits are to be fixes liability for future property taxes. Occasionally, allocated among partners. It also frequently sets forth partners execute only special warranty deeds (or even limitations on transferability of interests, and sets our deeds without warranty). However, some title such technical information as the formal address of the reportedly argue that execution of a special partnership, and its “,” who acts to warranty deed does not transfer insurance protections receive official notices on behalf of the partnership. in the partner’s policy of title insurance, since it The agreement may describe in detail how books and warrants only actions by the partner, and not others in records are to be maintained, what partnership matters the chain of title. may require a vote, whether more than a simple majority vote is required for any matter, how and when b. Oil and Gas Interests partnership meetings are to be conducted--in short, Oil and gas interests constitute interests in real any information relevant to describe how partnership property. When partner wishes to convey minerals, business is to be conducted. Many clients view these those minerals are generally transferred by mineral matters as mere “boilerplate,” which requires little deed. Where a retained royalty is at issue, the royalty attention on their part either during the formation of is typically transferred by execution of new division the partnership or after its operation. On the contrary, orders (or issuance of letters in lieu of division orders) however, and FLP is a business, and should be provided to the payor of the royalty. operated in a businesslike fashion. These provisions of the agreement outline exactly how those business c. Mortgages, Notes and Cash operations are to be undertaken, and should be Transfers of cash are generally undertaken by adhered to in the operation of the partnership. issuing checks from the partners, which are then deposited into a bank account established for the FLP. 2. CERTIFICATE OF LIMITED PARTNERSHIP As to mortgages and notes payable to partner, the In Texas, no partnership may qualify as a limited original instruments representing those notes should partnership unless and until it has filed with the be transferred. Promissory notes are typically Secretary of State of Texas a certificate of limited assigned by endorsement. If the note is secured by partnership. This instrument sets forth the name of real estate, then in addition to the endorsement of the the partnership, its address, the name and address of note, an assignment of the lien should be recorded in its registered agent and registered office, and the name the deed records where the real property is located. In and address of each general partner. The certificate any event, the contributing partner should notify the must be signed by each general partner, and filed, maker of the note to ensure that future payments are together with the payment of the appropriate filing fee made directly to the FLP. (currently, $750.00). Until the certificate of limited partnership is filed, third parties without knowledge of d. Stocks and Bonds the limited nature of the limited partners’ liability may Partners frequently transfer stocks and bonds treat them as general partners. As noted above, it is held by them in a brokerage account held in “street the unique features afforded limited partners under name.” Subsequent transfers of stocks and bonds Texas law that provide many of the benefits of an registered in the street name are substantially simpler FLP. As a result, it is imperative that the certificate be than the process required if original stock certificates filed as soon as the partnership is formed. are owned by the partner, and then reissued to the partnership. Typically, the manager of the FLP

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-19 creates an account in the name of the FLP with the Contributions, distributions to partners, sales of same brokerage firm or financial institution that holds partnership assets, purchases of new assets, the founding partners’ stock, so that a simple journal partnership income and expenditures, all should be entry can be utilized to transfer securities. If the stock documented. Frequently, the partnership maintains a issued is not publicly traded, the partners must relatively few number of bank and brokerage accounts determine what steps are necessary to transfer the whose monthly statements can form the basis of these shares. In the case of a closely held business in which accounts. A formal set of “double entry” journals is the partner is a shareholder, the partner (or perhaps his not required. Many partnerships utilize simplified or her counsel or accountant) likely has possession of accounting software such as Quicken or Microsoft the corporate minute book and stock transfer ledger. Money. In any event, the partners in charge of the Old stock certificates in the partner’s name should be partnership should keep adequate records to report to canceled, and new stock certificates should be issued the partners on the status of the partnership and the in the name of the FLP. The stock transfer ledger results of its operations. The manager or general contained within the corporation’s minute book should partner should give regular reports of partnership be appropriately updated. financial information to the partners. These same records are critical in enabling the FLP to prepare its 4. RESPECTING THE CONVEYANCES tax returns, which are discussed below. A common mistake made by persons who form FLPs is to forget that they no longer own the assets 2. PARTNER MEETINGS that have been conveyed to the partnership. For Regular meetings of the partners are usually example, they undertake such careless actions as required by the partnership agreement. Even if the paying personal expenses directly from partnership agreement doesn’t specify that the partners must meet, accounts. They prepare financial statements for good business practices suggest that they do so, at lenders which list the partnership's assets as their own, least annually. Partners’ meetings are a good instead of listing only the partnership interests that opportunity for the family to gather together to discuss they themselves retain. These types of actions give the operations of the FLP. Although such meetings rise to claims by third parties, such as creditors or the tend to be less formal than the meetings of corporate IRS, that the FLP is a mere sham. They argue that boards of directors, they nonetheless should be carried neither they nor the court should give the partnership out with a similar sense of importance. Partnership any more credence than did the founder. books and records should be reviewed at the meeting. Important actions undertaken by the FLP since its last B. Operating Formalities meeting, such as acquiring or disposing of partnership Formalities of formation and conveyance are usually assets, should be review. The partnership’s goals and overseen by the attorney that assists with establishing objectives, both in the short run and for the long term, the FLP. Once the partnership has been set up, it is should be discussed. As important as holding regular not unusual for the attorney to take a much less active meetings is documenting each meeting, and recording roll. This reduced involvement helps keep legal fees the important points discussed. Minutes like those low. It is important to remember, however, that the maintained for corporate ’ or directors’ formalities of operating the partnership are just as meetings should form a model for the record of partner important as the formalities involved in the formation meetings. process. Most clients prefer not to incur the costs associated with keeping their counsel on retainer to 3. VOTES ON PARTNERSHIP MATTERS ensure that operating formalities are followed. They The managing partner or general partners attend feel that they are able to take whatever steps are to the day-to-day business affairs of the FLP, and required to document the fact that the partnership is most matters requiring a vote of the partners are being operated in a businesslike fashion. When the undertaken by the agreement of the general partners. partnership regularly employs an accountant to If the general partners are unable to agree, the undertake the keeping of partnership books and the partnership agreement frequently sets forth the manner preparation of partnership tax returns, those steps help in which partnership interests are to be voted to document the partnership’s status as a separate entity. resolve the dispute. The partnership agreement may But preparing financial statements and tax returns are provide that some matters require the approval of the only part of the formalities that should be maintained. limited partners, or a vote of all of the partners. It is And even in the case of partnership financial important that the managers of the partnership review information, many clients prefer to adopt a “do it the agreement to ensure that they understand what sort yourself” approach so that the professional oversight of vote is required for each matter that must be that an independent account might bring is foregone. submitted to a vote of the partners. Equally important, the managers must hold and record votes of 1. BOOKS AND RECORDS partners as required by the agreement to ensure that The partnership should keep a regular record of partnership matters are being tended to in a its assets and its receipts and disbursements. businesslike way.

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4. OTHER OPERATING FORMALITIES 1. PARTNERSHIP INCOME TAX RETURNS The FLP can observe a number of other Despite the fact that an FLP does pay taxes, it formalities to show that the partners respect the nature must nevertheless file an income tax return (Form of the entity. For example, some FLPs maintain their 1065) which reports to the IRS: (i) each item of own separate business offices from which their affairs income, expense, deduction and credit incurred by the are operated. Frequently, the FLP establishes a partnership during the year; and (ii) the identity of the separate mailing address or post office box to receive various partners, and how each item of income, mail for the partnership. The FLP might have its own expense, deduction and credit is allocated among the stationary printed (or might use current computer partners. The FLP must also deliver to the partners technology to design and print correspondence on its the information necessary to enable them to report own “letterhead”). their respective shares of partnership income, etc. This reporting is undertaken through a Form K-1, C. Formalities Of Transfer delivered to each partner, which sets forth that Most FLP agreements limit the transfer of partner’s share of partnership tax attributes. The partnership interests, so that interests are not Form K-1 also tracks partnership contributions, transferred to non-family members. In addition, under distributions, and capital accounts. Texas law, the transferee of a partnership interest does not become a partner unless admitted as a partner 2. TAXATION VS. DISTRIBUTION under the terms of the partnership agreement and the As noted earlier, each partner must pay tax on Texas Limited Partnership Act. Therefore, partners in his or her share of partnership income, whether or not an FLP must be mindful of the limitations on transfer, the income is actually distributed. Actual distributions and the formalities to be observed, to document a valid from the partnership have no tax impact on the gift or other transfer of a partnership interest. Most partners (unless distributions exceed a partner's total corporations issue certificates representing stock in the contributions plus profits). As a result, the general company. This stock is often freely transferable by partners or manager of an FLP must be aware of the endorsing the stock certificate. In contrast, most FLPs income tax effects that the partnership’s income will do not issue certificates representing partnership have upon the various partners. Frequently, the interests. Instead, partnership interests are transferred manger will distribute at least enough cash from the by written “assignments” whereby the assignor agrees partnership each year to enable the various partners to to transfer a specifically described interest in the pay any increase in their income tax bills caused by partnership, and the assignee agrees to accept the having to report their respective shares of partnership assignment, subject to the terms of the partnership income. If no distributions are made, the partners may agreement. Unless the partnership agreement have to use other outside sources of cash to pay the otherwise so provides, the assignee is not income taxes associated with their share of partnership automatically admitted to the partnership as a partner income. In most cases, the partnership agreement until the requisite vote of partners approve the transfer permits, but does not require, the distribution of and agree to admit the transferee as a substitute enough partnership cash to pay resulting tax liabilities. partner. Thus, a valid transfer of a partnership interest Potential buyers of partnership interests would likely and the admission of the transferee as a substitute pay less for a partnership interest if the agreement partner requires at least two pieces of formal does not require distributions, since they could not documentation, one reflecting the assignment and ensure that they would be able to compel distributions another reflecting the vote to admit the assignee as a in amounts sufficient to pay taxes arising from their partner. Some partnership agreements permit the ownership of the acquired interest. partnership to demand further documentation, such as an opinion of counsel that the transfer will not violate VI. federal or state securities laws or result in adverse income tax consequences to the remaining partners. VALUATION OF THE FAMILY All required documentation should be prepared and LIMITED PARTNERSHIP signed prior to treating any transferee as a new partner in the FLP. The documentation should be maintained Valuation of FLP interests is a vital part of the as part of the permanent books and records of the process in creating an FLP. As noted above, valuation FLP. begins with determining the price that a willing buyer would pay to a willing seller for the partnership D. Tax Formalities interest. For estate tax purposes, value is determined As indicated above, under current tax laws, at the date of death. For gift tax purposes, value is partnerships are not treated as taxpayers. Instead, the measured by the value of the property passing from partners are taxed on the income recognized by the the donor on the date of the gift. Although the Internal partnership. Likewise, partnership credits, deductions, Revenue Code has endeavored to provide guidance for and expenses are reported directly by the partners. determining value, different methods of valuation have developed based on that guidance. Consequently,

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-21 discrepancies may exist as to the value of an asset inability of the partners to freely withdraw from the depending on who is seeking and who is making the partnership or transfer their partnership interests). valuation. In addition, several methods may exist for Appraisers frequently focus their analysis on two valuing the same property. And the method used may prominent factors in fixing the discounts available for vary, depending on the specific type of property an interest in an FLP–the lack-of-control discount and involved. the lack-of-marketability discount. A. Obtaining Independent Appraisals A lack-of-control discount is based on the Due to the complexities involved in valuing FLP concept that the holder of a minority or nonvoting interests and applying appropriate discounts, the interest lacks control over the management and choice of an appraiser is very important. With top operations of the entity. The holder of such an interest estate and gift tax rates at 55%, the stakes can be high. cannot compel distributions from, or a liquidation of, The importance of obtaining a thorough appraisal is the entity. In the context of an FLP, a hypothetical illustrated by several court cases involving disputes buyer of a partnership interest becomes a mere between taxpayers and the IRS regarding the value to “assignee.” Assignees of partnership interests place on partnership interests. The courts often look generally have no voting rights whatsoever, unless to the reports of the valuation experts of the parties. admitted as substitute partners. Since no buyer can They focus in detail upon the qualifications of each ensure that he or she would be so admitted, a buyer expert, including general experience, background, and would not be willing to pay an amount equal to the experience in the particular industry at issue. In liquidation value of the partnership interest. Instead, addition, courts frequently note the various factors and the buyer would pay only the value of an assignee’s approaches used by each expert in reaching an opinion interest, discounted to reflect its lack of control. on valuation, including the extent of investigation of the company and comparable companies, assumptions A lack-of-marketability discount applies when made by the expert, and valuation of the underlying there is no current market for the interest being sold, assets. making it difficult for a hypothetical buyer to convert the purchased interest into cash. In other words, the Because an appraisal is the evidence supporting value of the assets is discounted because it would be the valuation and corresponding discounts for the difficult to find a hypothetical buyer to purchase the FLP, it is important to consider several factors when interest in light of the restrictions placed on ownership hiring an appraiser. These factors include: (1) of the interest. Although there is a market for certain qualifications of the appraiser, (2) prior experience of publicly traded limited partnerships, FLP interests are the appraiser with similar assets or industries, (3) not registered to trade on public securities markets. prior experience with similar appraisals, (4) potential As a result, they have no ready market. Even if an conflicts of interest, (5) the appraiser as a credible exception from federal and state securities laws is witness, (6) successes and failures of the appraiser in identified, sales of privately held limited partnership prior valuation work, and (7) the general valuation interests are rare. A hypothetical buyer of a limited approach of the appraiser. Courts are not bound to partnership interest would naturally take this lack of choose one expert’s valuation. In fact, a court may liquidity into account in placing a price on the adopt only part of a valuation as determined by an purchase of an interest in an FLP. expert, or a court may find that none of the experts came to the correct conclusion and adopt its own VII. valuation. However, it is apparent from a review of the cases that courts frequently will adopt a valuation FREQUENTLY ASKED QUESTIONS made by an appraiser when the appraisal is well researched and supported by relevant facts. • How does an FLP reduce gift and estate taxes? B. Valuation Discounts Valuation of FLP interests is really a two-step An FLP simply makes assets less attractive to process. Most appraisers start the FLP valuation by potential third party purchasers. The buyer of a valuing the assets owned by the FLP. Once a value is partnership interest (as opposed to a buyer of the placed on the assets contributed to an FLP, appraisers partnership’s assets) forfeits a substantial degree may apply various discounts in valuing the partnership of control and marketability. Because estate and interests themselves. Valuation discounts vary gift taxes are based on the “fair market value” depending on factors such as the intent of the partners that a hypothetical third party buyer would be to continue the business, the type of assets contributed willing to pay for assets, placing them in an FLP to the partnership, and restrictions placed on the decreases the value of the assets for gift and partners under state law (such as lack of management estate tax purposes. control over the partnership, lack of unlimited access by the partners to the assets of the partnership, and

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• Are these valuation discounts “real”? • What sort of paperwork is required after the FLP is formed? Yes. If an FLP works to decrease your net worth for gift and estate tax purposes, it also decreases For an FLP to be respected by others, those who it for other purposes as well. For example, if you form the FLP must follow proper formalities. must maintain a certain net worth for commercial Thus, they should maintain separate accounts for borrowing purposes, or for purposes of the FLP, keep partnership books and records, guaranteeing the debt of your closely held hold partners meetings, record votes on business, you should discuss the impact that partnership matters, and otherwise treat the FLP valuation discounts may have on your net worth as a separate business. In addition, proper in dealing with your lender and other third documentation should be prepared and signed parties. each time a partnership interest is transferred. And, of course, partnership income tax returns • What assets can I transfer to an FLP? must be filed each year, with each partner reporting his or her share of partnership profits Most people transfer income-producing assets to and losses. the FLP. These include real estate, securities, investments, business interests, and the like. • Do I really need to get an appraisal? Special precautions need to be taken if a closely held corporation is transferred to an FLP. If the If you plan to make gifts of FLP interests, you corporation has elected to be taxed as an S need an appraisal. Often, depending on the corporation, transferring it to an FLP will nature of the property contributed, your may need terminate its S corp. status because a partnership two appraisals--one for the value of the property is not a permitted S corp. shareholder. In contributed to the partnership, and another for addition, special precautions need to be taken the value of the resulting partnership interests. before transferring stock in a corporation in Investment in a quality appraisal is money well which you and your family own 20% or more of spent. Most fights with the IRS regarding FLPs the voting control. The IRS may try to tax the boil down to a question of value. Your appraiser value of contributed stock in your estate unless must be able to provide convincing testimony you part with voting control. The safer course is that his or her valuation is well reasoned and to recapitalize the company with a nominal supportable. amount of voting stock (retained by the you), transferring only nonvoting stock to the FLP. • May I use an FLP to protect assets from Other assets that warrant special scrutiny include creditors after creditor problems arise? annuities and property with debt in excess of the contributor’s cost basis. Because Texas courts protect creditors with a concept known as the “fraudulent conveyance” • Can the partnership own life insurance? statute, the creation of an FLP will be of little or no use with respect to existing and reasonably An FLP may be used to shift life insurance out of anticipated claims against a debtor. If a transfer the insured’s taxable estate. Unlike corporate- is found to be “fraudulent,” a creditor may owned life insurance, which is 100% includable persuade a court to undo the transfer to the extent in the estate of the insured if he or she owns more needed to satisfy the claim. Therefore, persons than 50% of the stock, partnership-owned life forming an FLP will have to retain sufficient insurance is included only to the extent of the assets outside the FLP to enable them to satisfy insured’s percentage ownership of the any outstanding (and reasonably anticipated partnership. For example, if the insured has future) debts and claims. given away 95% of the limited partnership interests while retaining control by keeping a 5% • What happens to FLP interests in a divorce? general partnership interest, only 5% of the insurance proceeds should be included in the An FLP can change the character of property insured’s estate. While a life insurance trust can owned by married persons--from separate to act to remove all insurance from an insured’s community, or from community to separate, taxable estate, it has the disadvantage of being depending on the circumstances. In addition, if, irrevocable. Some FLP owners are willing to risk for example, only the husband is a general estate tax inclusion of a portion of the life partner (if the wife either has no partnership insurance proceeds to maintain the flexibility and interest in her name or has only a limited control that an FLP offers. partnership interest), then even if the court awards a substantial interest in the partnership to the wife, she will be in essentially the same

G:\ALLPDP\ARTICLES\9ADEPP\WPFORMAT\JONES.C\\6/24/99/09:20:49 The Family Limited Partnership - Marital Property & Ethical Considerations C-23 situation as a creditor who becomes an “assignee” (as the founders have a certain tolerance for the discussed above): she will have no voting power nor complexity associated with the formation and any effective ability to sell her interest but will, subsequent operation and management of the instead, be forced to rely on her ex-husband’s FLP. willingness to treat her fairly. These (and other) aspects of the FLP can make it a valuable tool when carefully coordinated with a marital property VIII. agreement. On the other hand, the careless use of an SUMMARY FLP can dramatically shift the spouses’ legal rights, with unintentional consequences if there is ever a The family limited partnership is an increasingly divorce. popular estate planning and gifting tool. By contributing assets to a family limited partnership and • Will the IRS challenge the FLP? gifting limited partnership interests instead of the underlying assets, the value of the assets transferred As you might guess, the value-depressing (and related gift tax cost) is reduced. At the same features of the FLP have been the source of time, the family limited partnership enables senior considerable frustration to the IRS. They family members to retain control over the underlying originally tried to argue that family members can assets through retention of general partnership be expected to act together, and therefore, the interests. The family limited partnership also has IRS should be entitled to assume away some of advantages in minimizing operational costs, the discounts that appraisers apply to FLPs. The simplifying annual gifting, providing investment courts, however, have been unsympathetic to the flexibility, and protecting assets from creditors. IRS on this issue, and the IRS has announced Through proper and careful planning, the family that it has abandoned its “family attribution” limited partnership can be an ideal asset transfer tool. theory. Having lost that battle, the IRS recently has tried to apply a new argument to FLP valuations, saying that FLP agreements are really only elaborate “buy-sell” agreements among family members. A special statute restricts the use of buy-sell agreements among family members for estate and gift tax valuation purposes. Although their argument seems strained, this effort shows the frustration of the IRS with the success of FLP discounts, and indicates their resolve to continue to challenge the technique.

• Why doesn’t everyone use an FLP to hold assets?

FLPs are just one tool in the estate planning tool box. Despite claims to the contrary by some FLP proponents, they are not the only solution for every estate planning situation. They are very effective in a variety of contexts, however, and seem to work especially well when: (1) the senior generation has diverse investment assets; (2) the senior generation wants to retain control of gifted assets, or they want control consolidated in one or more of the younger generation family members; (3) the founders have assets that are difficult to divide (such as real estate), or assets difficult to part with in the form of annual gifts; (4) younger generation family members have assets of their own (perhaps acquired by inheritance or earlier gifts from the senior generation) which they want to consolidate; (5) the senior generation has a general concern about potential future creditors who might seek to attach the assets of the founders or the children or other family members of the founders; and (6)

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