Limited Partner Question

[Snaggletooth]

Father F wants to provide financial help to his son S. S owns a used car business.

Rather than loan money to his son, F wants to buy and own the inventory. When S sells a
car, S pays F the cost of the vehicle plus 2% of the selling price. The customer never
knows that F owns the inventory. With a car selling on the average every 90 days, from
a cash flow perspective, F gets an annual return of 6%-8% on his money - much better than
what he would earn from the bank. S turns averages at least 15% margin when a car is sold,
and has to pay 2% of that. In return, he has no financing problems.

The car lot expects to sell at least $500,000 in vehicles next year. F will make $10,000 in
year 1, after putting up $250-$300K.

Note, since there is a profit on each transaction, there are no related party issues.

NOW THE QUESTION: F is involved in merchandising, and these are not capital gain transactions,
so F has to pay self-employment tax on the profit. Can he avoid this by creating a partnership
by being a 99% LIMITED partner, and S being a 1% OPERATING partner? If not, is there a better
way for F to avoid SE tax since he is only providing financing?

To further clarify, F does not shop for or select the vehicles. At no point does is a car title ever in
the name of F.

[MDEA]

Limited partner question

I have engaged in this type of business for years. I treat the income as interest income because I feel it is payment for the use of money. I am not engaged in either the buying or the selling. There is a minimum fee of @100.00 even if the dealer makes no money on the car.

[TXEA]

Couple of questions

1. Why does Father not want to loan the money?

----If he is worried about collateral, then just have a lien filed against each vehicle recorded with the County Clerk just like a bank. It cost a little bit to file the lien is the only drawback. A 4% interest rate on $250,000 will generate the $10,000. Treat it just like floor plan loans....When a car is sold, the lien is released and interest is paid along with principal. Father can reinvest the principal if he desires.

2. I am just wondering how Father owns the car yet the title is not in his name? Just curious. May be possible, just thought ownership meant title.

As to the partnership, Father's status as limited partner does preclude self-employment tax ASSUMING he takes no role in management. The IRS often scrutinizes individual limited partners that own the substantial majority of the partnership especially in situations where related parties are the only partners. (think - income shifting).

There are some drawbacks to consider in the partnership scenario:

1. Father will get 99% of the income no matter what it is. Son will need to take almost all his income in the form of guaranteed payments to avoid Father being taxed on income not in line with the "interest" desired (the $10,000).

2. If the car lot is ever sold, Father will be entitled to 99% of the value. So, there will have to be some planning along the way as the business becomes profitable for Son to purchase some of Father's interest in the partnership (so, regular reasonable valuations will have to be made). Without such purchase of interest, the son will not recognize the growth in value assuming a future sale.

3. If Father passes away, who will inherit Father's share? Are there other siblings that son does not want to be partners with in the future? A buy-sell agreement will need to be implemented and funded with life insurance if possible to avoid such an outcome. Or, father will need other assets to leave other siblings.

4. Planning for the partner draws to generate the $10,000 might be problematic if cash flow is sparse. In my experience cash flow is generally sparse.

If I was advising them, I would first try and work out why Father does not want to loan the money. I think Father's interest is best served by making a loan and treating it just like a bank treats dealer floor plan inventory with all the paperwork and loan agreements. First, it guarantees that Father's cash flow is not absorbed by operations....Second, it eliminates any challenge from the IRS that Father is not a limited partner....Third, it eliminates any possibility that Son might be partners with siblings at the death of Father (they may be creditors but at least not trying to run the business).

[Roland Slugg]

A flooring arrangement like F&S are proposing is going to be complicated enough already. Why complicate it even more by creating a LP?

Payments made by S to F will be interest. S deducts as a business expense, and F reports as income on Schedule B (Form 1040).

Here is a link to a comprehensive article on flooring plans published by the Office of the Comptroller of the Currency:

http://www.occ.gov/static/news-issuances/ots/exam-handbook/ots-exam-handbook-216.pdf

[Snaggletooth]

Excellent Comments - All

Thanks to all who have responded.

The reason F does not wish for this to be a loan is that he has already made loans to beneficiaries in equal amounts and doesn't wish another loan. He has made loans of $50,000 apiece to 4 heirs (including S). The estate settles in such a way that compensates for unpaid balances in the event of death of F. If F dies with this inventory, the partnership dies with him and the inventory value is split 25% to all heirs. The heirs are free to do with the inventory whatever they please but selling via S would be the only realistic economic outlet.

The car lot, computers and equipment are the responsibility of S. The partnership only buys and sells the vehicles.

F regards this as an investment opportunity, and any benefit accruing to S is collateral. The arrangement is not a loan - there is no stated rate or period. The return on investment for F is limited to the inventory turns of the vehicles, and there is risk associated with dead inventory.

The churning of inventory means this is a merchandising operation and therefore I would not file the profit as a Sch D.
I do believe the lack of involvement and management by F allows him to avoid self-employment tax. I understand IRS may wish to scrutinize this, but limited partnerships are sold on the open market with active partners owning a tiny fraction of the whole.

The title may be a problem, as state has special treatment for vehicles. An extra sale from F to S taken through registration would result in extra fees and administrative headaches. If this were some other inventory (like wheat or rare coins), the state would not be in the picture.

If you've read this far, thank you. It is indeed a long-winded post.

[MDEA]

limited partner

If F owns the autos he would have to have a state dealer license. This type of finance is used a lot in the used car business.Since he never owns the inventory I can not see how it would be a Schedule C. I have done this myself and have clients that do this it is always treated as interest.

[Snaggletooth]

Thanks to those who have responded

After the comments, I believe the agreement, although not in the format of a loan, should be reported as interest. I can promise you if the client F is going to have to pay SE tax on the income, he's not going to do the deal. I believe the profit is enough akin to interest that it can be reported as such.

Selling the idea of a "loan" to the other beneficiaries will be more compatible if the others realize it is THEIR asset as well in the event of death.

Most of you are not aware of a quirk in Tennessee. Personal interest is assessed an investment tax of 6%. This is plunked on top of the ordinary income Federal rate. They call it a "Hall" tax, affectionately named after the politician who introduced the tax bill on the floor of the legislature long ago. There may, however, be an exemption if the loan is for "purchase money." I'm looking into that.

Thank all of you for responding.