How to Use Limited Liability Companies & Limited Partnerships. Garrett Sutton
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over a business debt and seeks to hold the general partner liable. If the general partner is a Corporation or LLC that is where the liability ends. While the assets within the corporate or LLC entity may be exposed to a creditor’s claim, a useful and popular strategy is to hold few or no assets in the corporate general partner. In this way the personal assets of the owners of the corporate general partner are protected and not at risk.
As such, many, if not most, Limited Partnerships are organized using corporate or LLC general partners. In this way, both the limited and general partners achieve limited liability protection.
Restrictions on Transfer
By definition, limiteds may not participate in management, therefore the general partner maintains complete control. In many cases, the general partner will hold only two percent of the partnership interest but will be able to assert 100 percent control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted Limited Partnership interests to his children.
Retained Management
The ability to restrict the transfer of Limited or General Partnership interests to outside persons is a valuable feature of the Limited Partnership. Do you want to keep unknown parties or undesirable ex-spouses out of your company? Through a written Limited Partnership Agreement, rights of first refusal, prohibited transfers and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by Limited Partnerships.
Protection from Creditors
Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner. Thus if, for example, you and your family owned three separate apartment buildings, it may be prudent to compartmentalize these assets into three separate Limited Partnerships, using one separate corporate general partner. If a litigious tenant sued over conditions at one of the properties, the other two buildings would not be exposed to satisfy any claims.
Creditors of the individual partners can only reach that person’s partnership interest and not the partnership assets themselves. Assume you’ve gifted a Limited Partnership interest equal to 25 percent in one of the apartment building partnerships to your son. He is young and forgets to obtain automobile insurance. Of course, in this example he gets in a car accident and has a judgment creditor looking for assets. This creditor cannot reach the apartment building asset itself because it is in the Limited Partnership. He can only reach the money earned by your son’s 25 percent Limited Partnership interest, and then only, in many states, through the charging order procedure. Charging orders, which do not offer an easy path to payment, are discussed more fully in Chapter Seven, and are not favored by creditors.
Family Wealth Transfers
With proper planning, transfers of family assets from one generation to the next can occur at discounted rates. As a general rule, the IRS, at the time of this writing, allows one individual to give another individual a gift of $14,000 per year. Any gifts valued at over $14,000 are subject to a gift tax, but may also be counted as a lifetime gift, which allows $5.34 million in gifts during your life and at death. As such, you have two tracks of gifting: the annual (currently $14,000 per year) and the lifetime (currently $5.34 million per spouse). In the estate-planning arena, senior family members may be advised to give assets away during their lifetimes so that estate taxes of up to 40 percent are minimized. Please note that Congress is always prone to change these rules so stay current with your advisors.
Estate planning will be discussed in greater depth in Chapter Nine.
Flexibility
The Limited Partnership provides a great deal of flexibility. A written Limited Partnership Agreement can be drafted to tailor the business and family planning requirements of any situation. And there are very few statutory requirements that cannot be changed or eliminated through a well-drafted Limited Partnership Agreement.
Taxation
Limited Partnerships, like General Partnerships, are flow-through tax entities. The Limited Partnership files an informational partnership tax return (IRS Form 1065, United States Partnership Return of Income, the same as a General Partnership) and each limited receives an IRS Schedule K-1 (1065), Partner’s Share of Income, Credits and Deductions, from the Limited Partnership. Each limited then files the K-1 with his or her individual IRS 1040 tax return. The issue of taxation will be discussed more fully in Chapter Four.
Limited Liability Company
A Limited Liability Company is a new form of entity introduced into the United States in 1977. The LLC combines certain advantages of partnerships and Corporations and has been called an “incorporated partnership.”
Genesis of the LLC
The Limited Liability Company can be traced to a German entity known as the Gesellschaft mit beschranker Haftung (GmbH). Created in 1892 and combining limited liability with flow-through taxation, this entity soon found converts in a number of Latin American and European countries, including Portugal (1901); Panama (1917); Brazil (1919); France (1925); Chile (1929); Argentina (1932); Uruguay (1933); Mexico (1934); Belgium (1935); Switzerland (1936); Italy (1936); Peru (1936); Columbia (1937); Costa Rica (1942) and Honduras (1950).
As United States businesses engaged in international commerce after World War II, many became exposed to the benefits of these foreign LLCs. Finally, Hamilton Brothers, an oil exploration firm that had used LLCs throughout Latin America, saw the benefits of the United States offering such an entity. They lobbied the Wyoming legislature to enact LLC legislation and effective June 30, 1977, Wyoming became the first state to offer LLCs. Florida followed in 1982, and by 1994 all 50 states had enacted permitting legislation.
One of the primary advantages of an LLC is that no one has personal liability, as in a Limited Partnership. As discussed, the general partner of a Limited Partnership is personally liable for the debts of the partnership. The way to minimize this is to form a separate Corporation or LLC to serve as the general partner, thus encapsulating personal liability within a protected entity.
However, with an LLC, both managers and members (akin to the directors and officers and shareholders of a Corporation) are free from personal liability. This LLC feature removes the need to form a separate Corporation or LLC manager.
LLCs also offer the previously mentioned Limited Partnership features of restrictions on transfers and protection from creditors. LLCs are also useful for family wealth transfers, although some CPAs and estate planning professionals are more comfortable using Limited Partnerships for this purpose.
Flow-Through Taxation
As has been mentioned throughout, one of the most significant benefits of the LLC, and a key reason for its existence, is the fact that the IRS recognizes it as a pass-through tax entity. All of the profits and losses of the business flow through the LLC without tax. They flow through to the business, real estate, or asset-holding owner’s tax return and are dealt with at the individual level.
Again, a C corporation does not offer such a feature. In a C corporation, the profits are taxed at the corporate level and then taxed again when a dividend is paid to the shareholder – thus the issue of double taxation. In a Sub S corporation, profits and losses flow through the Corporation, thereby avoiding double taxation, but may only be allocated to the shareholders according to their percentage ownership interest. As described below, LLC profits and losses flow through the entity and may be allocated in a flexible manner without regard to ownership percentages. As such, the LLC offers the combination of two significant financial benefits that other entities do not.
Flexible Ownership
In 1997, the IRS abandoned its creaky rules on tax classification, allowing for single-member LLCs. State legislatures immediately followed suit and amended their statutes to allow for single-member LLCs.
As a result, you can now form an LLC and be the sole member. You can enjoy the benefits of limited liability and flow-through