We asked readers to send us questions about their estate transfer problems and we'd try to get answers. Here's how estate tax attorney Elizabeth Crewson Paris, Denver, CO, addresses one of our reader's questions about family partnerships.
Question: We run 3,500 acres of farmland, 3,500 acres of pasture, 500 cows and a 5,500-head feedlot. The operation is in a four-brother partnership and I'm a son of one brother. Being the oldest son and employee of the operation, I'd like to provide for my new family. The brothers (my uncles) have children, too, but they're not yet old enough to farm.
I'd like to someday become an official part of the operation without offending any of my uncles. How do I end up getting to be a part of the estate without waiting too long and letting Uncle Sam wind up with part of it?
Answer: First of all, congratulations on such a successful three-generation operation. Before we consider your future participation in the partnership, let's discuss what should be the concerns of your father and his brothers as the current owners and operators of the family business.
It is my understanding that your grandfather started the operation right after WWII and several decades later he gifted the partnership interests to his sons. Because your grandfather "handed down" the operation as a gift prior to his death, his sons received both your grandfather's business and basis.
Your grandfather's basis would be what he paid for the land, plus the value of any improvements, less any depreciation. Chances are the land did not cost very much 50 years ago, and the basis is very low.
Basis And Capital Gain Basis is important to determine how much capital gain tax your father and uncles would have to pay if they sold their interest in the operation. Capital gain always equals sales price less adjusted basis, less expenses of sale. Sales of assets held more than two years are taxed depending on the type of asset, at rates varying from 18% to 28%.
Basis can be adjusted if your dad and uncles contributed additional cash to the operation. In addition, if one of your uncles were to die owning the interest, then his basis will be "stepped up" to the "fair market value" on the date of death. This would all be considered if they were to sell their interest.
It is important to understand your father's and uncles' tax consequences before you attempt to negotiate your future opportunities. Obviously, the generation in control will find your request to participate in the operation with much more enthusiasm if it has little or no tax consequences to their pocketbooks.
Your family partnership offers a variety of opportunities. First, you should decide if you want a percentage interest in all of the family business or just some portion of the business.
Your father might consider allowing you to purchase some portion of his partnership interest, or possibly he might be willing to gift some portion of his interest, or even a combination and sale is an alternative. Unfortunately, your father's income interest will decrease as his partnership interest decreases. And, even though you may be prepared for the responsibility, your father may not be prepared to give up his income.
As long as the family does business as a general partnership, the value of the partnership is reflected in the value of the partnership assets, which would set the price for any purchase. You could consider purchasing partnership assets instead of partnership interests.
In the alternative, it appears from your letter and the background information that the partnership now owns three different successful operations: farming, ranching and feedlot. Would your family consider spinning out one of the businesses as a stand-alone operation? Obviously, as an employee of the family partnership and with your new family, buying into just part of the business will be less expensive.
Limited Partnership Option Additionally, if your dad and his brothers want to maintain control of the family partnership, but allow for the third generation to participate in an equity position, they could convert the general partnership to a limited partnership. They would continue to control the partnership as the general partners, making all the decisions as they have over the past 25 years, while you and your cousins would be able to participate as limited partners.
As a limited partner, your decision-making authority and additional liability from the operation would be limited, but you would receive your proportional share of the income. The more the partnership thrived, the more income you would earn as a limited partner.
This would allow all of the brothers to be treated equally, and each brother would be able to either gift or sale the limited partnership interest to you and your cousins. This allows the third generation to acquire equity positions in the family partnership under the guiding hand of the second generation.
The limited partnership concept also provides the opportunity to control who can participate (i.e., no spouses or creditors). Because of the variety of control that can be exercised by the general partners, the value of a limited partnership interest is worth something less than the assets owned by the partnership.
This valuation method is substantially different from valuing a general partnership. Because of the potential discounts available, such as "lack of marketability" and "minority interest" in valuing limited partnership interests, you could purchase or receive in gift a much larger limited interest versus what you could afford of a general interest. Additionally, if your uncles were not yet giving up control, they may be more open to your acquisition efforts.
A final benefit of the limited partnership is that as you become the owner of the limited interests, that will decrease the size and value of your father's estate. This eventually limits the estate tax consequences upon your father's death, as the assets have been legally transferred over time to you as owner.