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I Come to Praise the Partnership, Not to Bury It

9/11/2016

 
   I routinely use partnerships in my business, estate planning and investment management practices.  Please call me at 832.330.4101 if you'd like to learn more.
                                          
  Recently released Treasury Department regulations specifically target estate tax valuation discounts for limited partnership interests in family limited partnerships, or “FLPs.”  It’s widely argued that these new rules eliminate these discounts.  While I feel certain that most in the estate planning community are diligently working to find a viable structure circumventing the new rules, I also believe that the Service will use these new provisions as justification for a new anti-FLP pogrom, placing any attempts to circumvent these new rules squarely in the IRS’ litigation crosshairs. 

     But the estate planning community is missing the forest for the trees.  Even without valuation discounts, partnerships – be they general, limited or in some other form such as an LLC – offer tremendous benefits that we should consider when weighing the option of which entity to use for an estate planning transaction. 

     A single tax layer: this benefit alone is worth the price of admission.  I’ll show the benefit using an admittedly extreme example.  Assuming a maximum corporate tax rate of 35% and a maximum personal rate of $77,485 + 39.6% of all income over $250,000, it’s conceivable that more than 50% of a company’s income could be paid in taxes before ending up in the shareholder’s bank account.  This example doesn’t take deductions and other benefits into account.  But that’s not the point: instead, it simply shows that 2 layers of tax mean a fairly large amount of money will move from the business to the government before ending up in the client’s hands. 

  In contrast, there is only one layer of tax with a partnership.  Using the above example, we see a maximum rate of $77,485 + 39.6% of all income over $250,000, eliminating the 35% entity level tax, sending a larger amount of money to the partners.  This example explains why, after its introduction in the 1990s, the LLC became the most popular business structure.  And it’s also a primary reason why using a partnership tax based entity for a family business entity makes tremendous sense.   

     Finally, a partnership looks very enticing when compared
to the greatly compressed tax rates associated with trusts.

  An Entity Governed by Contract: corporations are statutory creatures: owners must follow – and painstakingly document their adherence too -- many rules and regulations.  In contrast, contract law governs the relationship between the partners and limited partners, granting the parties tremendous latitude to determine how they will interact with each other.  Save for base partnership concepts such as the duty of loyalty and duty of care, partners are free to construct their affairs however they see fit.  This benefit lowers the compliance burden placed on the owners.

     Disproportionate Participation and Distributions: Let’s assume that a father and son want to form a partnership.  The father can contribute 60% of the original capital with the son contributing the other 40%.  This type of allocation is part and parcel of pass-through entities, where partners routinely have different interests in the entity. 

     But it gets better.  Let’s assume that a father forms a family LLP and includes his children as limited partners.  Because he’s in a higher tax bracket, he wants the tax free income from the portfolio’s municipal bonds while his children, being younger, need some or all of the portfolio’s capital appreciation.  Using a tool called “disproportionate allocations” it’s possible to achieve this type of allocation so long as they have “substantial economic effect” – a term of art in the partnership tax world.  While an explanation is far beyond the scope to this article (and, in fact, is the subject of at least one long chapter in most partnership tax text books), suffice it to say that customized internal cash flows at the partnership level are very common.

     There is no denying that, should these new regulations survive the public comment period, a powerful estate planning tool will be lost to the legal community.  But that doesn’t mean planners should stop using partnerships.  This brief article touches on 3 of the most commonly known benefits of pass-through entities.  There are many more.

A Look at the Landmark Spendthrift Trust Case, Nichols v. Eaton

9/5/2016

 
     Trusts are a core entity that I use in my estate planning, business succession and investment management practice.  Please call me at 832.330.4101 if you'd like to learn more.   

Sarah Eaton had three boys and one girl.  To provide for them after her death, she divided her assets into 4 trusts, allocating the income to the children for life and then to their respective offspring.  She also gave each trustee discretion to stop all income payments if any child declared bankruptcy or assigned their income interest to a third party.  This provision was the 1800s equivalent of a spendthrift provision.  Her son Amasa “failed in business” sometime in the mid to late 1860s.  He assigned his income interest to Charles Nichols in order to satisfy Amasa’s creditors.  Nichols attempted to sue the trust for payment, leading to this ground-breaking spendthrift trust suit.
 
     The court upheld the spendthrift provision.  The decision contains three distinct lines of legal reasoning supporting their decision.

     The court first noted that at least 8 English cases supported the discretionary power’s specific wording.  From the decision: “the cesser of income upon alienation or upon the bankruptcy of the [beneficiary] are unquestionably valid.”  A second case that prevented a court from supplanting their discretion for that of the trustee bolstered the court’s holding.  This was an important addition to the English cases: it prevented a creditor from indirectly attacking the spendthrift provision by asking for the court to substitute their discretion for the trustee’s.

     State law also upheld the provision.  The Supreme Court cited 11 cases from at least 4 different jurisdictions (New York, Connecticut, Pennsylvania and Kentucky) that supported the discretionary power.  This demonstrated that spendthrift provisions were already allowed within the U.S. at the state level.    

     Finally, the creditor argued that allowing a trustee to have this power was against public policy.  In response, the court first noted that all creditors engage in their own due diligence before extending credit, indicating that the creditor should have not only found this clause but understood that they would not be able to reach trust assets in the event of a bankruptcy:

This distinction is well founded in the sound and unanswerable reason, that the creditor is neither defrauded nor injured by the application of the law to his case, as he knows, when he parts with the consideration of his debt, that the property so exempt can never be made liable to its payment. Nothing is withdrawn from this liability which was ever subject to it, or to which he had a right to look for its discharge in payment. The analogy of this principle to the devise of the income from real and personal property for life seems perfect. In this country, all wills or other instruments creating such trust-estates are recorded in public offices, where they may be inspected by every one; and the law in such cases imputes notice to all persons concerned of all the facts which they might know by the inspection. 

Second, the court cited many individual asset protection statutes from across the country that were already in existence:

It is believed that every State in the Union has passed statutes by which a part of the property of the debtor is exempt from seizure on execution or other process of the courts; in short, is not by law liable to the payment of his debts. This exemption varies in its extent and nature in the different States. In some it extends only to the merest implements of household necessity; in others it includes the library of the professional man, however extensive, and the tools of the mechanic; and in many it embraces the homestead in which the family resides. This has come to be considered in this country as a wise, as it certainly may be called a settled, policy in all the States. To property so exempted the creditor has no right to look, and does not look, as a means of payment when his debt is created; and while this court has steadily held, under the constitutional provision against impairing the obligations of contracts by State laws, that such exemption laws, when first enacted, were invalid as to debts then in existence, it has always held, that, as to contracts made thereafter, the exemptions were valid.[1]

Here, the court is putting the creditor on notice that numerous statutes already exempt certain property from their claims.  To argue that public policy is somehow offended by the spendthrift provision clearly ran against numerous already in-force laws.

  By the late 1800s, a strong common law foundation, derived from England and implemented by several individual states, supported spendthrift powers.  The Restatement of Trusts, §58 explains its philosophical underpinnings:

The spirit of the times was of individualism, at least of individualism for the man of property. What a man owned was his own; with it he could do as he liked. If he desired to give his property to another in such a way that the donee could not transfer it and his creditors could not reach it, that was a matter which concerned the donor alone.

Various bankruptcy and then inchoate asset protection laws also supported this concept.  In the event of default, both areas of law attempted to make creditors at least partially whole while also granting debtors sufficient post-judgement assets that allowed them to continue contributing to their community.  Most importantly, the court considered creditors sophisticated, meaning they should have been aware of this common law and statutory support.  And finally, the idea that an individual should have the right to somehow limit the impact of life’s misfortunes was a central philosophy of the times.  In the decision’s words:

Why a parent, or one who loves another, and wishes to use his own property in securing the object of his affection, as far as property can do it, from the ills of life, the vicissitudes of fortune, and even his own improvidence, or incapacity for self-protection, should not be permitted to do so, is not readily perceived.

​That sentiment still provides the backbone of current spendthrift law.
 


[1] Nichols, Assignee v. Eaton Et Al, 91 U.S. 716, 23 L.Ed. 254 (1875)   
 

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