Family Limited Partnerships in Divorce

A Family Limited Partnership (“FLP”) is another common mechanism used for estate planning purposes that can be used to help achieve multiple purposes. [1] A FLP can be used to help avoid probate.  It can also used to help so that members of a family can jointly own and manage property with one another. [2] On this note, as some family members have less interest in managing jointly help assets, a structure can be put into place to allow other family members to eventually step into the role.  A FLP can help provide asset protection from creditors.  Finally, if put together appropriate, FLPs that are established for legitimate business purposes can provide tax advantages.

In a FLP, a senior family member contributes assets in exchange for a partner interest.[3] For example, a Family Limited Partnership “allows parents to transfer ownership interests to the children (or grandchildren) while still retaining operational control of the assets transferred to the Family Limited Partnership.”[4] FLP is established in the following three steps: (1) determining partners, (2) drafting a partnership agreement, and (3) funding the FLP.[5] The first step, determining partners”, entails choosing which members are “general” partners and which members are “limited” partners.  The goal of the second step, “drafting a partnership agreement”, is to clearly state the purpose, partnership(s), rights, responsibilities, profits and losses of the partners.[6] The final step occurs either via by transferring assets into the partnership “in exchange for all in the FLP” or “each of the prospective partners may transfer assets into the FLP in exchange for proportionate partnership interest.”[7]

There are two kinds of Family Limited Partnership: (1) General Partnership and (2) Limited Partnership.  One way of determining “Limited Partnership” is to look at the degree or level of control that the owner of the interest has over partnership decisions.[8] Furthermore, when establishing a limited control in the partnership agreement, there are two features must be recognized:[9]

1)     Clearly state that the limited partners take no part in and have no control over the partnerships management and operations; and

2)     Sufficiently hinder the limited partners control over day-to-day operations and management, partnership cash flow distributions, initiation of partnership expenditures, hiring personnel for the partnership, and initiation and control over the sale of any of the partnership assets.[10]

In a “limited” family limited partnership, there is: (1) no ability to transfer interests to a third party and (2) there is no right to participate in certain aspects of the FLP’s management.[11] A “general” partnership has control over all the management and investment decisions.  Therefore, in general partnership, a partner is one-hundred percent liable for management and investment decisions.[12]

a. Establishing a Standard of Value

When establishing value in Family Limited Partnership (FLP), three characteristics must be considered.  The three characteristics are: (1) control; (2) marketability; and (3) transferability.

With respect to control, if there is a need to have a specific percentage comprise a majority, it may be wise to gift the smaller interests that do not influence control. A typical FLP arrangement has senior family members contributing assets in exchange for both general and limited partnership interests. This allows retention of reasonable control through exercise of the general partner rights;[13]

 

Two ways to affect the marketability of the interest are by giving the general partner absolute control over the timing and amount of cash distributions and giving the general partner a right to compensation for services. Reduced cash flow to partners will make their partnership interests less valuable; and[14]

 

Typical ways to restrict transferability are to give other partners a right of first refusal on transfer of interests and requiring unanimous consent for transfer of interests.[15]

These discounts, however, can be problematic in dividing assets in divorce.[16] A main reason is because the assets in a FLP can often be significantly undervalued.[17] In other words, fair market value for a piece of real estate might be more valuable outside the FLP, but yet be valued at a fraction of that amount once transferred into a FLP.[18]

Three is also a lack of uniformity amongst courts as it relates to other factors.  For example, in Hertz v. Hertz,[19] it was held that the partnership agreement is dispositive of value. Here, a non-shareholder spouse was bound by the goodwill valuation clause for purposes of establishing the valuation of corporate goodwill in a dissolution action. [20] This insured that the non-shareholder spouse did not receive a greater value than the shareholder.[21] The court stated, “ where a professional spouse’s stock in a corporation was subject to restrictive agreements and the value of the goodwill of the corporation was fixed by the agreements, that value [must be used] to determine the wife’s share in a dissolution action.” [22]

On the other hand, in Drake v. Drake,[23] the partnership agreement has only found to be one factor.  Here, the court said, “ [a] buy-sell agreement for a closely for a closely held corporation which sets or provides a method for setting value on its shares sets or provides a method for setting value on its shares for purposes of distribution is not binding on a spouse in a dissolution proceeding, rather it is to be weighed with other factors in determining value.” [24] This “majority position is sound because [this] approach would produce a value closer to what one could receive in a free and fair market.”[25]

In In Re Marriage of Huff, [26] the trial court held that a trial court could consider various valuation methods, including partnership/corporate buy-sell agreements and capitalization of excess earnings.  Here, the Colorado Supreme Court concluded that the “trial court did not erroneously rely on excess earnings method in valuing husband's partnership interest in law practice ” … and was not bound by the partnership agreement in determining value of law practice, and could use an alternative valuation method. [27]

Goodwill is also an issue that comes up with valuation.  According to In re Marriage of Hall,[28] goodwill can be includable in partnership interest for purposes of division. This court defined goodwill is a “property or asset, which usually supplements the earning capacity of another asset, a business or a profession.” Also, personal and business goodwill may be included when determining the value of goodwill. In considering the goodwill of the spouse’s private medical practice, the court considered the following factors: “… [the] practitioner’s age, health, past demonstrated earning power, professional reputation in the community as judgments, skill, knowledge, and comparative professional success … ”[29]

Yet, in Travis v. Travis,[30] goodwill was not found divisible in a divorce action. Here, the Court of Appeals affirmed the trial court’s decision to “decline to consider the good will of the husband’s law practice as martial asset.”[31] The court said “in contrast to the physical assets of a law office, the reputation of the lawyer cannot be purchased by another seeking to acquire an established law practice.” [32] Determining “earning capacity is much less speculative than trying to establish a good will value of a law practice.”[33] Also, “ [p]rojected earnings can be considered in establishing support alimony which, unlike property division of good will, may be adjusted upward or downward at a later date.” [34]

b. Preparing Counterarguments (Your Client’s Version of Valuation)

Besides establishing three characteristics (control, marketability, and transferability), the FLP is concerned about abuses of the gift and estate tax system and will scrutinize an FLP for any signs of manipulation of the transferred assets to artificially low levels. Accordingly, the FLP arrangement must be: [35]

·       ​ A bona fide business arrangement;

·       ​ Not a device to transfer an asset to the transferors family for less than full consideration; and

·       ​ On terms similar to those in similar arm’s length transactions.

Through careful advance planning, many of the above risks can be minimized and valuation can be successfully determined:[36]

·       ​ Research applicable state laws;

·       ​ Consider using an assignees interest;

·       ​ Set up a separate FLP bank account;

·       ​ Have assets re-titled in the name of the FLP;

·       ​ Consider gifting smaller interests where specified percentage control attributes

exist;

·       ​ Use a corporate general partner;

·       ​ Consider the LLC option to shelter personal liability;

·       ​ Allow for the potential to compensate the general partner;

·       ​ Use right of first refusal clauses;

·       ​ If possible have all family members contribute assets to the FLP;

·       ​ Do not contribute personal property; and

·       ​ If possible, let the FLP season before making a gift of an FLP interest.

c. “Fair Market Value” Approach on Assessing the Value the FLP Share

Fair Market Value is defined as “the price at which the property would change hands between a willing buyer and willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of relevant facts.”[37] In a “limited” family limited partnership, since there is no (1) ability to transfer interests to a third party and (2) there is no right to participate in certain aspects of the FLP’s management, these two aspects of a “limited” family limited partnership reduce the fair market value of the FLP.[38]

On the other hand, even though a general partnership provides complete management and decision control, there is a possibility that the “general” Family Limited Partnership could be “jeopardized”.[39] For example, consider  if there is one general partner and if something were to happen to this general partner (death, bankruptcy, etc.), then the general Family Limited Partnership could be at a danger of loss.[40] In order to avoid this problem, it is ideal to assign two “general” partners with a written instrument elaborating all “control” each of the “general” partner is authorized.[41]

Lack of marketability is another factor that could reduce a fair market value of a Family Limited Partnership.[42] For example, marketability of an FLP interest could be negatively affected, when there “is the difficulty in finding a third party who wants to own an interest in a closely held family entity.  This is because buyers are wary of the potential problems stemming from the family dynamic inherent in an FLP.”[43]

Lack of “transferability” or “restrictive transfer rights” of is another factor that could reduce a fair market value of a Family Limited Partnership.[44] There are some FLP that contain a provision that bars or restricts from assigning third parties to a FLP.  This restriction “significantly reduces the value of the donor’s partnership interests” by 20-40 percent.[45]

When it comes to making an equitable, or a just division of a FLP interest, where both spouse own an interest, there are really only two options:

(1)   Each spouse retains an interest in the partnership; or

(2)   One spouse retains the entire interest and agrees to buy the other party out of their interest. [46]

As it relates to the first option, this can be problematic for the non-managing spouse.[47]

In most circumstances, one spouse will control the FLP.[48] A minor limited partner is generally not able to participate or interfere in management.[49] This results in that spouse’s interest being diminished due to a lack of marketability and control.  A non-managing spouse would also be unable to control when distributions are made.[50] Yet, as discussed previously, valuing the interest for a buy-out is a problematic endeavor.[51]



[1] Becky Beaver, Rachel M. Baccari, Lee Vanderburg and Haran Levy. Clash of Tax and Divorce Planning, AICPA.AAML National Conference on Divorce, 17-18 (2008).

[2] Id.

[3] Craig Stephanson, How to establish a Successful Family Limited Partnership.  44 No. 6 Prac. Law 41.  September 1998.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id.

[10] Id.

[11] Stephanson, supra at 56.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Beaver, supra at 54.

[17] Id.

[18] Id.

[19] Hertz v. Hertz, 657 P.2d 1169 (N.M. 1983),

[20] Id. at 1174

[21] Id.

[22] Id. at 1175

[23] Drake v. Drake, 809 S.W.2d 710 (Ky. Ct. App. 1991)

[24] Id. at 713

[25] Id.

[26] In re marriage of Huff, 834 P.2d 244 (Colo. 1992)

[27] Id. at 255

[28] In re Marriage of Hall, 692 P.2d. 175 (Wash. 1984).

[29] Id.

[30] Travis v. Travis, 795 P.2d 96 (Okla. 1990).

[31] Id.

[32] Id. at 99

[33] Id.

[34] Id.

[35] Stephanson, supra at 56.

[36] Id.

[37] Lauren Bishow, Death and Taxes: The Family Limited Partnership and its use on estate planning after the third circuit’s ruling in estate of Thompson v. Commissioner, 50 Vill. L. Rev. 1183-1192 2005.

[38] Id.

[39] Id.

[40] Id.

[41] Id.

[42] Id.

[43] Id.

[44] Id.

[45] Id.

[46] Beaver, supra at 54.

[47] Id.

[48] Id.

[49] Id.

[50] Id.

[51] Id.

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