Statement of purpose is important
By Steve Penrose
Q: I am considering creating a family limited partnership, or
family limited liability company. Should I use the word
”
family
”
in the name of my family entity?
A: The word
”
family
”
when attached to the name of your limited partnership (LP) or
limited liability company (LLC) has become a red flag to the IRS
and should be avoided. Limited partnerships and limited liability
companies whose partners or members happen to be related by blood
or marriage are thought to top the list of revenue-generating
possibilities for federal estate and gift tax auditors. Since the
word
”
family
”
has no legal meaning different from its colloquial meaning,
dropping the offensive word from LP names and agreements and LLC
names and operating agreements is widely recommended.
Statement of purpose is important
By Steve Penrose
Q: I am considering creating a family limited partnership, or family limited liability company. Should I use the word “family” in the name of my family entity?
A: The word “family” when attached to the name of your limited partnership (LP) or limited liability company (LLC) has become a red flag to the IRS and should be avoided. Limited partnerships and limited liability companies whose partners or members happen to be related by blood or marriage are thought to top the list of revenue-generating possibilities for federal estate and gift tax auditors. Since the word “family” has no legal meaning different from its colloquial meaning, dropping the offensive word from LP names and agreements and LLC names and operating agreements is widely recommended.
One of several issues on the mind of an estate tax attorney as he thoroughly examines an estate or gift tax return which discloses the existence of a “family” LP or a “family” LLC, is whether the organizational documents reveal a business purpose (as opposed to a tax-avoidance purpose) for the existence of the entity. Lack of a business purpose allows the IRS to argue that the entity can and should be disregarded as a sham under certain sections of the Internal Revenue Code that are devoted to federal estate and gift tax. If successful, the argument can result in partnership assets being included in a descendant’s federal gross estate and taxed at up to 45 percent of their date of death value, despite having been legally transferred, perhaps years earlier, to children or grandchildren.
Here is a typical statement of purpose from the operating agreement of an LLC invested in hypothetical assets:
The company is organized for the long term investment of assets including stocks, bonds, and mutual funds, as well as the owning, developing, leasing, managing, and selling of real property owned by the Company, or as the Managers may elect to purchase on behalf of the Company, and to engage in the conduct of any other business which shall be lawful for a limited liability company organized under the laws of the State of X.
It is not possible to glean from this statement of purpose whether the Company was organized solely for estate tax planning purposes and/or for a non-tax and purely “business” purpose or purposes existing at the time the entity was formed. Certainly if the entity was formed to conduct any operations at all, apart from the holding and/or investing of assets, it is difficult to imagine a court making a finding of no business purpose whatsoever. However, in many, if not most cases a much expanded statement of purpose of the Company or Partnership, to express the many inherent purposes of such an entity that are indisputably “business” purposes, should be included in the organizational documents.
Examples of traditional business purposes of so-called “family” entities which arguable serve only legitimate business concerns included: providing a centralized management structure for the property transferred to the entity, as well as management succession on behalf of all of the partners. Real property, whether farm or ranch land, apartment buildings, or single-family rentals, is frequently the subject of such centralized management. Entity organizational documents nearly always provide a means for the family partners to elect successor management from among family members upon the death, registration or incompetence of initial family management. They usually also restrict transfer of ownership so that no interests pass outside the family. These are strictly and fundamentally business concerns – who can be a partner, and who or what group will exercise the executive function.
Another business purpose of the entity is to provide a way that all family members can own a part of each family asset. Without the entity, some asset types might not otherwise be divisible into separate undivided interests capable of ownership by several individuals. Examples include equipment, stock and bond portfolios, inventory, art, collectibles, etc. Allowing for percentage, unit or share ownership of such assets by family members is another important business purpose of FLPs and LLCs, as is allowing the sale or gifting of interests in the entity to younger generation members.
Another legitimate, strictly “business” purpose for forming an FLP or FLLC that should be stated in the organizational documents is the protection of family assets from creditors. The assets of limited partnerships and limited liability companies cannot be attached by a creditor of a partner. The creditor can obtain a “charging order” and force the entity to pay the creditor income that would otherwise go to the partner, but the creditor cannot foreclose on a partnership asset to pay his judgment. Regardless of whether the partners or any one of them ever have had or might ever in the future have to worry about judgment creditors, this natural asset protection feature of these entities, when properly formed and maintained according to law, is a legal fact. Taking advantage of this legal fact is a legitimate business purpose for formation of the entity, and one that has no conceivable relationship to estate or gift tax planning.
Good practice dictates that all of these business purposes, where applicable, should be stated in the LP agreement or in the LLC operating agreement.
This column is the work product of Lombardo & Gilles, PC, which has offices in Hollister and Salinas. Steve Penrose is a lawyer with Lombardo & Gilles, PC, and can be reached at 888-757-2444. Mail your questions to Jeff Gilles, It’s the Law, c/o The Pinnacle, 380 San Benito St., Hollister, CA 95023 or contact Jeff at 888-757-2444 or [email protected].
