Question

A general partner in a partnership has unlimited legal liability but also has managerial control over the partnership. A limited partner has limited liability but does not exercise control over the day-to-day operations. John, your client, owns a machine shop operated as a sole proprietorship. The business is worth $10,000,000. He would like to transfer a portion of ownership to his two adult children, Cindy and Luke, by converting the business into a partnership. How would you structure a partial transfer of ownership in the business to Cindy and Luke to achieve a fair market value of the transfer that is less than Cindy and Luke’s proportionate share of the $10,000,000 value? Are there any penalty concerns associated with the valuation discounts that your proposed transfer takes advantage of, especially if the valuation is found to be inaccurate?

Answer 1

John, who owns a machine shop operated as a sole proprietorship. The business is worth $10,000,000. If he wants to transfer a portion of ownership to his two adult children, Cindy and Luke, by converting the business into a partnership, he will have to go through the procedure of construction of a partnership with whatever portion of his capital of the proprietry to be transfered to his two children. John will have to first close the accounts of his Proprietry business and evaluate the assets and liabilities of the business for its net worth. Then, they will have to go under a legal Parnership Deed to avoid any further posibilities of clash between them. Sharing profit of the partners in the Partnership can be of any type, like it may be equal sharing or on capital basis or it can be any agreed ratio. John being a owner, before formation of Partnership, can take his share of sacrifice, from his profit, from the the capital of the coming members.

Cindy and Luke may achieve a fair market value of their capital in the business by either bringing the cash or withdrawing the cash to of from the business. As the case here is, Fair Market Value is less than their proportionate share, they will withdraw the excess amount.

There will be no panalty, If they have gone through every legal procedures in the formation of partnership. Inappropriation in transfer or in valuation may attract panalty.