You've worked hard building your business, but like many busy entrepreneurs, you probably haven't spent much time planning for what will happen to the company when you're no longer around. Enter the family limited partnership, a popular estate-planning device that may be just what you need to keep your company in the family and avoid painful tax consequences.
Planning for a business transfer is never a cake walk, but to ease the burden on your family, it's necessary--and the sooner you do it, the better. This is especially important if you operate a family business and want the company to stay in the family when you decide to step down or if some unexpected event transpires. Estate taxes can hit family businesses hard because the full value of a parent's business can be included in the parent's estate when he or she dies.
Estate tax is one of the highest taxes levied on individuals. The first $600,000 of a person's estate is exempt from federal estate tax, but amounts above the exempt portion are subject to a graduated tax ranging from 37 percent to a whopping 55 percent. One thing to keep in mind is that you can give up to $10,000 per year during your lifetime ($20,000 if your spouse joins in) to as many individuals as you wish without incurring gift taxes. Tax experts recommend you make use of this benefit to transfer wealth and, ultimately, tax liability.
A similar strategy is employed when you use a family limited partnership to transfer a business. With a family limited partnership, the business owner remains in control of the business while giving away portions of the company to family members, resulting in significant tax savings, says Mark Stutman, a partner in the Philadelphia office of accounting firm Grant Thornton LLP.
For example, if you started your business with a $10,000 investment many years ago and it's now worth $1 million, you'll pay a hefty capital gains tax if you try to sell it. And if you pass away with no succession plan in place, your heirs will be hit with sizable estate taxes. But with a family limited partnership, the same $1 million business, with a discount of 40 percent (the average allowable amount, which will vary depending on industry, percentage of ownership and what kind of secondary market exists for the type of business), would have a net value of $600,000. If you transfer half the business during your lifetime, you would have transferred $300,000 worth of value, which would have been $500,000 without the discount, explains Stutman.
To set up a family limited partnership, the owner transfers the assets of the company to the partnership, says Howard R. Gladston, an estate-planning attorney with New York City law firm Ballon Stoll Bader & Nadler. The owner, as general partner, maintains control over the limited partnership as well as the overall business, and immediately gives partial ownership of the partnership to his or her children.
Once the partnership is in place, the operation of the company doesn't have to change. "As a general partner of the family limited partnership," says Gladston, "the [business owner] still receives a salary and can make all the management decisions in the business."
A family limited partnership allows the business to be transferred to the younger generation at substantially less than its value, thus reducing the size of the estate and the federal tax bite. "These discounts can run anywhere from 30 to 50 percent of a business's value,' says Stutman.
The discounts are possible, according to Stutman, because closely held businesses generally don't have selling opportunities in the public markets. "As a result, various tax authorities and courts have allowed discounts,' he says.
An additional discount for the transfer of a minority equity interest is permitted, reflecting the lack of management or ownership control the transferee has. It would be difficult, for example, for someone who owns 10 percent of a $1 million business to sell his or her ownership position for $100,000.
Another benefit of limited partnerships is that creditors don't have access to the partnership's assets. So if the children or grandchildren get into financial difficulties down the road, the company remains intact.
As an alternative to family limited partnerships, consider creating a limited liability company (LLC), which can be used to accomplish the same estate-planning objectives, Stutman says. An LLC provides the benefits of a corporation with the tax treatment of a partnership. Unlike a partnership, however, no member is individually liable for the company's debts and liabilities.
Taking Care Of Business
Should you decide to use a family limited partnership for an ownership transfer, do so with care. These partnerships send up a red flag with the IRS and are often targets of audits, cautions Seymour Goldberg, an estate-planning lawyer in Garden City, New York. The IRS is on the lookout for abuses, especially attempts to take too great a discount on the business's value. Nonetheless, Gladston and Stutman say this should not deter business owners from considering a limited partnership.
To avoid any snags with the IRS, strictly follow all the necessary steps to set up the family limited partnership. The first step is to have the business appraised by an experienced professional.
"It's important to get a reputable valuation because it's likely that if the IRS does look at the transaction, it will look closely at this,' says Stutman.
Getting your business appraised and setting up the partnership can be expensive, costing anywhere from $2,000 to $50,000, depending on the intricacy, size and asset value, says Gladston. To locate an experienced appraiser, contact the American Society of Appraisers at (800) 272-8258. In some cases, two appraisers are needed, one to value the business and one to formulate the discount.
Once these calculations are completed, the owner transfers the stock to the partnership. He or she can then begin an annual gift-giving program that passes portions of the business to family members.
No Time Like The Present
If you decide you want to reorganize your business as a family limited partnership, the sooner you do so, the better. Why? The IRS doesn't condone business owners attempting to use this vehicle solely for tax-savings purposes. To illustrate this point, Stutman cites a recent memorandum from the IRS concerning a business that wanted to set up a family limited partnership.
In this case, a terminally ill business owner tried to form a limited partnership a few days before his death to take advantage of the tax benefits. His business was worth about $2.5 million, and he was attempting to take a 40 percent discount on the business's value. The IRS found this effort inappropriate and disallowed it.
So when is the best time for a business owner to establish a family limited partnership or an LLC for business transfer purposes? "When there has been a buildup of substantial value in the business and the older generation has a substantial amount of liquidity,' says Stutman.
To make sure you get the timing right--and follow all the rules--check with your tax advisor. He or she can set you on the proper course and come up with the best way to accomplish your goals.
Ballon Stoll Bader & Nadler, 1450 Broadway, New York, NY 10018, (212) 575-7900;
Seymour Goldberg, c/o Goldberg & Ingber, 666 Old Country Rd., #600, Garden City, NY 11530, (516) 222-0422;
Grant Thornton LLP, 2 Commerce Sq., 2001 Market St., #3100, Philadelphia, PA 19103, (215) 561-4200.
PAGE 70: LEADING EDGE
Bain & Co., 2 Copley Pl., Boston, MA 02116;
GoldMine Software Corp., 17383 Sunset Blvd., #301, Pacific Palisades, CA 90272, (800) 654-3526, (310) 454-6800.