A partnership is formed when two or more persons agree to share profits and losses in a business. The agreement does not have to be in writing. No approval by the state government is necessary. The terms of the partnership are largely within the control of the partners. Partnership agreements vary widely, depending on when they were drafted, and the purpose for which they are created.
The law recognizes a partnership as an entity that exists separate and apart from its partners. At one time, partnerships were the dominant form of business entity, but because partners were personally liable for all partnership debts, partnerships were largely replaced by corporations, the shareholders of which have no liability for corporate debts. Partnerships have one key attribute that still makes them useful for certain purposes: that is the fact that under U.S. income tax law, partnerships are not treated as an entity that pays taxes. So, partnerships are called “pass-through entities.”
Because partnerships come into existence by agreement of the parties, with no approval by the state required, and because of their pass-through tax attributes, partnerships are very popular for use in estate planning. A limited partnership typically has one general partner (who manages the partnership business) and one or more limited partners (who own an interest but cannot participate in management). An estate and gift tax advantage can be obtained when a ranch, or a business, or an investment portfolio, is placed by the parents into a limited partnership which the parents control, while the children are given limited partner interests. This is because the federal tax is based on the value of the property bequeathed or given, and the limited partner interests are greatly reduced in value because they have no right to control partnership investment decisions or to determine when partnership distributions are made.
Partnerships can create problems in a divorce. If a spouse owns a partnership interest before marriage, the partnership interest is her separate property. If a spouse acquires an interest in a partnership during marriage, as a gift or inheritance, or in exchange for separate property capital contributed, then the partnership interest is her separate property. If a spouse acquires an interest in a partnership during marriage in any other way, then that partnership interest is community property that must be valued and divided in the divorce.
A real problem can be caused where, as part of estate planning, spouses convey their assets into a family limited partnership (FLP). An FLP usually has an entity owned by the parents as the general partner, and the parents themselves and their children are limited partners. The parents then give small percentage limited partner interests in the FLP to the children each year. As explained above, the value of the annual gifts is discounted due to lack of control and lack of marketability. When the parents divorce, they find that the assets comprising their separate estates and their community estate have been put into the FLP, and all they own as individuals is an interest in the general partner and some limited partner interests. Without the FLP, the divorce court would return separate property to its owner, and would divide the community assets between the spouses. However, if those assets have been conveyed to a FLP, the divorce court can only divide the partnership interests, not the underlying assets. Often one or both spouses will want to undo the FLP transaction, but that requires making the FLP a party to the lawsuit, and if successful, an unwinding of the FLP could adversely affect the limited partner interests that have been given to the children, giving them a stake in their parents’ divorce.
Many partnership interests are subject to transfer restrictions contained in the partnership agreement, prohibiting the transfer of an interest in the partnership to the non-partner spouse upon divorce. Some transfer restrictions give the other partners, or the partnership, the right to buy a partner’s interest if she ever wants to sell it. Sometimes the right to purchase is for fair market value, and sometimes for a set amount, or an amount to be determined by a formula. There is a division of case law authority in Texas on whether such transfer restrictions affect the value that is given to the partnership interest upon divorce. The law is tricky on this point, and in a divorce where the value of the partnership interest is great, a fight over the law, both in the trial court and on appeal, is a real possibility. If there is no transfer restriction, and the non-partner spouse receives a partnership interest in the property division, that spouse has a “transferee’s interest,” which includes the right to receive profits if and when they are distributed, but no right to participate in management of the partnership.
When a separate property partnership makes distributions to a married partner, a controversy can erupt over whether those distributions are separate or community property. The correct law to apply to different situations is hotly contested at this time, some case law suggesting that such distributions are separate property and other case law suggesting that such distributions are community property. If the distributions amount to a lot of money, a fight over the law, both in the trial court and an appeal, is a real possibility.
Often, the value of a general partner interest or a limited partner interest owned by a spouse can be hotly contested in a divorce. The question of whether discounts for lack of control, and lack of marketability, should be applied to divorce valuation is a hotly contested issue.
If your divorce involves partnership interests, you likely have complications that will require you to find a divorce lawyer who knows the intricacies of how partnership law interfaces with family law.