A Guide to Family Limited Partnerships
How to Protect Yourself When Investing in Projects with Family
Although stocks and bonds tend to dominate the financial news, many new investors begin by investing in projects such as real estate or small business startups with members of their family. One of the biggest mistakes investors make is being under-capitalized, which can lead to financial stress and increased risk from changes in the economy. Financially savvy families and seasoned investors get around this problem by creating something known as a family limited partnership.
With a family limited partnership, members of your family can pool their money and undertake a project, such as building townhouses, which might not be possible individually.
These partnerships are more common than you might think. Even world-famous investor Warren Buffett got his start by pooling money from family members or close friends.
Sam Walton did something similar when creating Walton Enterprises, LLC, to allow his children and family members to own shares of Walmart Stores, Inc., as well as other investments. Although Walmart may be huge today, it was a tiny five and dime store when the structure was put in place.
General Partners vs. Limited Partners
A typical family limited partnership has two types of partners: general and limited. When one or more members of the family are named as general partners, each person is responsible for the day-to-day management of the family limited partnership. This includes hiring and firing decisions as well as deposits and withdrawals of cash.
General partners are paid according to the partnership operating agreement. Some general partners receive a cut of profits, while others get a fixed annual salary. They also have unlimited liability like they would if they were sole proprietors. In this sense, if the project fails, creditors can go after their personal assets to cover business debts and liabilities.
A limited partner is a family member who contributes money in exchange for ownership in a project but has no day-to-day management responsibilities. They also cannot be involved in executive functions or else they risk losing their protected limited partner status.
Limited partners vote on the partnership agreement, which establishes the rules governing the family limited partnership, and collect dividends, interest, and profits. As a general rule, limited partners cannot lose more than they have invested in the partnership, though there are exceptions, which is why you should discuss any agreement with a qualified attorney.
Family Limited Partnership Example
To understand how a family limited partnership works, an example would be if Robbie wants to build a row of upscale townhouses. He expects the project will cost $1,200,000, including his working capital requirements, and it will generate $200,000 in cash each year before interest on mortgage debt and taxes. To keep the project relatively conservative, he wants a down payment of at least 50%, which would be $600,000. Unfortunately, Robbie doesn’t have that kind of money available, so he calls his brothers, sisters, parents, and grandparents, and they choose to form a family limited partnership.
They settle on the following structure:
- The family limited partnership will issue 6,000 limited partnership units, or shares, at $100 each to raise the required $600,000 in starting capital. These units cannot be sold for at least five years, and the partnership will pay out 70% of cash earnings in the form of dividends.
- Robbie will buy 600 of these shares by contributing $60,000 to the family limited partnership, giving him 10% ownership of the project. He will be named general partner and he will receive the first 5% of pre-tax profits as a management fee for handling the day-to-day operations.
- Other members of Robbie’s family buy the remaining 5,400 shares, each representing fractional ownership in the family limited partnership.
In this example, Robbie controls the family limited partnership with $600,000 cash. He goes to a local bank and gets a first mortgage loan for the remaining $600,000, giving him the $1,200,000 he needs to fund the project. The partnership builds the townhouses, leases them to tenants, and begins to collect rental income.
Each year, as the mortgage is paid down and dividends are distributed to the partners, the family grows wealthier. Without pooling their money through a family limited partnership, this investment wouldn’t have been possible.
Is a Family Limited Partnership Right for You?
While no one but a qualified lawyer and tax accountant can help you answer this question, there are some considerations to factor into your decision. To begin, think about whether pooling your money will allow you to undertake projects that otherwise would not be possible. If so, do these projects offer above-average rates of return? You also don't want to find yourself in a situation where pooling your money causes you to take on too much risk and become financially vulnerable.
If you're a limited partner, trusting the general partner is important because they will have unrestricted access to cash deposits and business assets. If you have any questions about their integrity or business acumen, you may want to avoid the investment.
Good management often makes the difference between investment losses and big gains. If you trust them, find out if the family limited partnership will be formed for a single investment opportunity or as an ongoing investment vehicle that will continue to create or acquire assets.
Issuing limited partnership units is like issuing stock in many respects, and is subject to laws and regulations. Be sure the limited partnership project is big enough to justify the expense of having a lawyer review securities laws so you don’t break any rules.