Given the current tax rate structure and the double tax nature of corporations (unless an S corporation), the partnership vehicle has become the preferred entity of the'90's, especially in the case of real estate holdings. A variation of the partnership, with the same pass-through income tax advantages and retained control, is the limited liability company, not yet part of California law.

Because of flexibility and tax benefits, partnerships have many uses, including research and development, real estate investment and development, start-up ventures, property conservation and management, asset protection and estate planning.

The partnership as an entity has two basic types, namely, general and limited.

• General partnerships have only general partners, with equal rights of management and control and potential unlimited liability.
  
  
• Limited partnerships have at least one general partner to manage the partnership and one or more limited partners with limited liability and a limited role in day-to-day partnership management and other decisions respecting the partnership.

Like C corporations (which are income tax entities), limited partnerships can have various classes of equity, within certain limitations such as insuring economic reality in special allocations (I.R.C. Section 704(b)) and meeting new 1990 tax law requirements for valuing preferred equity in a dual capital partnership (I.R.C., Section 2701). Unlike C corporations, however, partnerships involve only a single level income tax which is at the partner level. Now, with the higher income tax rates included in OBRA '93, partnerships can be used to effectively shift income to lower bracket taxpayers. But, more importantly, with estate tax rates ranging from 37% to 55% (after the $600,000 asset value of the unified transfer tax credit), the family partnership is an effective planning tool.

Valuation is the key to successful family partnership planning. At death, the decedent's estate is taxed based on the fair market value of the decedent's estate. The value of cash, publicly traded stock, and even real estate (if owned 100% by decedent) is easily determined. However, the value of a portion of a real estate partnership is much more difficult to determine. In fact, due to the nature of the partnership arrangement involving co-ownership, lack of marketability, and perhaps a non-controlling interest, a significant discount from the value of the underlying property is proper. Within certain special limits a family partnership can even receive cash and marketable securities to utilize in the estate fractionalization plan. IRC Sections 721(b) (limiting securities diversification on partnership contributions) and 2036(b) (estate tax trap if contribute stock to partnership where family owns over 20% control) illustrate pitfalls to be avoided in family partnership planning.

Discount Partnership. Under I.R.C. Section 2701, effective October 9, 1990, special valuation rules apply to certain partnerships. By its terms Section 2701, however, does not apply to identical classes of equity or classes of equity which would be identical but for voting rights and liability differences. Thus, Section 2701 is not applicable to family limited partnerships where all interests participate pro-rata in income, loss and distributions. Recognizing the value of a general partner's services (mandated by Section 704(e) for income tax purposes) under IRC Section 707(c) poses no problem. The fractionalized ownership, lack of marketability and minority discounts are available for this type of partnership. Hence, the name used here is discount partnership, the vehicle mostly used in playing the valuation game.

Freeze Partnership. In 1987, Congress did away with certain traditional estate freezing techniques such as the freeze partnership having preferred equity features. However, this change was retroactively repealed and replaced with the Chapter 14 special valuation rules. I.R.C. Section 2701 now specifically permits freeze partnerships under certain circumstances. A freeze partnership typically has two classes of equity, namely, common units and preferred units.

The preferred unit holders must receive currently, or at least within 4 years following the distribution accrual debt, a fixed cumulative return and they will have a preference on liquidation as well as usual voting control. The preferred unit values in the holders' estates are interest-sensitive and thus could then be valued at premium or a discount. However, generally, the value of the preferred units remains constant (or frozen) and increases in value of partnership assets will accrue to owners of the common units. Typically, the preferred units are voting and the common units are nonvoting. Thus, the preferred units, carrying the vote and frozen as to value, are held by the senior family members, while the common units are held by or for the benefit of children and other junior family members.

Normally, the parents want to retain control (voting rights), would like to retain much of the income (e.g., preferred distributions) but would prefer that the asset value not continue to escalate in their hands (and ultimately be taxed at a 50% or higher estate tax rate). The freeze partnership accommodates these goals and thus is the preferable vehicle, if the underlying assets are high in equity value and produce sufficient income to cover the cumulative preferred return. As stated, in order to be effective, the cumulative return must be paid out within four years or else a tax disaster occurs, i.e., compounding of gifts which add to the transfer tax burden. Often a partial freeze, e.g., 50% of the units as preferred, can be structured so as to permit the senior family members to preserve capital, receive all the current income, and shift 100% of future growth to their heirs.

Family Partnership Plan. Assuming proper business purpose, management control and asset valuation in the family partnership context, either the discount partnership or the freeze partnership can result in substantial estate tax savings. Leveraging the available $600,000 estate tax-free asset value during lifetime, using discounted value $10,000 annual exclusion gifts, achieving a substantially lower estate value and avoiding all transfer tax on post-death appreciation truly can allow a family to achieve its wealth preservation goals. While, as always is the case under our tax system, there are pitfalls to be avoided, the planning effort with a willing client and competent and communicative advisor team will produce dramatic results.

What has been discussed in this memorandum relates principally to inter-vivos asset distribution within the family. We have concentrated on the family partnership by reason of our significant experience in assisting clients to fractionalize capital. Of course, where a family-controlled corporation is involved, valuation discount and control retention is available there as well. We suggest that developing and accomplishing family goals, including equity transfers, management succession and tax savings, should involve a family strategic plan. Our law firm's focus is to assist families and their other advisors in designing and implementing such a plan.

Valuation discount analysis and the use of entity envelopes, including trusts, corporations and partnerships, is the core area for planning. Other areas, namely compensation planning, life insurance and even charitable trusts, should also be considered as part of the Family Wealth Planning process.

The attorneys and staff of Quillinan & Luce, LLP are prepared to assist families in their planning and wealth preservation efforts.