CREATING THE FAMILY LIMITED PARTNERSHIP
The first step in creating the Family Limited Partnership is the preparation and filing of the Certificate of Limited Partnership with the Secretary of State in your state. The form asks for the name of the limited partnership. This name should be cleared in advance with the office of the Secretary of State, because the filing will not be accepted if the name is similar to another name already on file. Making sure that your partnership name is available will avoid the inconvenience of having your Certificate of Limited Partnership returned unfiled. You will then have to select a new name and go through the process again. Calling the office of the Secretary of State in advance to confirm the availability of your chosen name will avoid this inconvenience and will expedite the process.
The Certificate of Limited Partnership also asks for the name of a designated Agent for the Service of Process, which is the name and address of a person (or company) who is authorized by the partnership to receive service of process, if the partnership is sued for any reason. Any family member residing in the state can be designated as the agent. There are also companies which will, for a modest fee, act as the designated agent for these purposes.
The form also asks for the names and addresses of all general partners of the partnership. The names of the limited partners are not required. Since this document is a matter of public record, the names of the general partners will be publicly available but not the names of the limited partners. Along with the Certificate of Limited Partnership, each state requires a filing fee which is usually about $85-$125.
When the properly filled out form with an acceptable partnership name is received by the office of the Secretary of State, the Certificate will be filed. At this point, the partnership will be legally formed. You should request that a certified copy of the Certificate of Limited Partnership be returned to you and your copy should be stamped with the filing date. It is essential that you have at least one certified copy for opening a bank account or brokerage account, or, if you buy or sell real estate in the name of the partnership.
The Partnership Agreement
Concurrently with the filing of the Certificate of Limited Partnership, a written partnership agreement must be prepared. This is the document that governs the affairs of the partnership. It sets out the purpose of the partnership; the duties of the general partners; matters on which the vote of the limited partners is required; the share of partnership capital and profits to which each partner is entitled; and all other matters affecting the relations between the partners.
When creating a Family Limited Partnership for estate planning and asset protection purposes, the partnership agreement must also contain certain key provisions designed to accomplish your objectives. Taken together, these provisions must insure that a creditor can never achieve any influence over partnership affairs and that Husband and Wife, as general partners, always maintain absolute control over the assets of the partnership. These provisions are unique and essential to a properly structured Family Limited Partnership.
FUNDING THE PARTNERSHIP
The next step in the partnership formation process is the funding of the partnership. That means you must now decide which assets to transfer and the best means for doing so.
DANGEROUS AND SAFE ASSETS
In making the decision about funding the partnership it is vitally important that you understand the distinction between Safe Assets and Dangerous Assets.
Safe Assets are those which do not, by themselves, produce a high degree of lawsuit risk. For instance, if you own investment securities such as stocks, bonds or mutual funds, it is unlikely that these assets will cause you to be sued. Mere ownership of investment assets, without some active involvement in the underlying business, would probably not cause a significant degree of lawsuit exposure.
Dangerous Assets, on the other hand, are those which, by their nature, create a substantial risk of liability. These are generally active business type assets, or even motor vehicles or aircraft, the ownership of which may cause you to be sued.
The reason for the distinction between Safe Assets and Dangerous Assets is that you do not wish to have the partnership incur liability because of its ownership of a Dangerous Asset. If the partnership does incur liability, it will be the target of a lawsuit and all of the assets in that partnership will be subject to the claims of the judgment creditor. This is exactly the situation you are trying to avoid. Dangerous Assets must either be left outside of the partnership or must be placed in one or more separate partnerships. Dangerous Assets must be isolated from each other and from Safe Assets, in order to avoid contaminating the Safe Assets.
Apartment buildings may be considered to be Dangerous Assets. The liability potential of apartment houses is particularly high. Although liability insurance coverage is usually available, the amount of coverage may not be sufficient. A fire in a densely populated building may cause severe injury or death to many tenants. The potential liability for such a tragedy could easily reach into the millions of dollars, exceeding by far the amount of your insurance coverage.
Apartment owners can also be held responsible for the acts of the resident managers. If the resident manager engages in race or sex discrimination in renting to tenants, or is guilty of sexual harassment, this liability may be imputed to you as the owner of the property. Acts such as these may not be covered under your standard insurance coverage.
If this asset is transferred to the same Family Limited Partnership which holds all of your other assets, that partnership, as the owner of the property would face a high degree of lawsuit exposure and all of your assets would again be at risk.
Instead, the best approach for a Dangerous Asset such as an apartment building would be to transfer that property to its own separate partnership. If a number of these type of properties were owned, each could be placed in a separate entity. Once we formed 19 different partnerships for a client, each holding one apartment building. If a disaster occurred, only the partnership which owned that property would be sued. The other properties and family assets would be safely insulated and shielded from liability under this arrangement.
Some types of commercial real estate may also constitute Dangerous Assets. Office buildings, hotels, restaurants, night clubs or any other building where many people work or gather, all have the potential to produce stratospheric liability in the event of some type of disaster. These properties must be kept separate from other types of assets.
Safe Assets, with a low probability of creating lawsuit liability can be maintained in a single partnership.
For most people the family home is their single most valuable asset. Fortunately, a house is a good candidate for asset protection in a Family Limited Partnership. It is unlikely that a house would create a substantial uninsured liability. Homeowners insurance provides protection against liability associated with ownership of the home and if someone is injured on the property, the amount of coverage should be sufficient to satisfy any claim.
The house can be transferred to the partnership by use of a simple quitclaim deed. Endorsements reflecting the new ownership should be secured from the liability and casualty insurer and the title insurance company.
Local law must be consulted in order to avoid triggering a property tax reassessment of the home. Some states, such as California, do not increase taxes on the assessed value of property unless there has been a change of ownership. But even if there is a change of ownership, property transferred from individuals to an entity controlled by those individuals is usually exempt from reassessment. Your own state law must be reviewed in order to understand the property tax implications of a transfer.
In addition to preparing a quitclaim deed to transfer the house, you may wish to obtain the consent of lender. If you have a loan on your home, the terms of the loan usually contain what is known as a "Due on Sale" clause. The Due on Sale clause states that the lender has the right to declare the loan due and payable if the property is transferred to another person or entity.
This is not quite as ominous as it sounds. The law in most states provides that a lender cannot exercise the Due on Sale clause, unless the security for the loan has been jeopardized by the transfer. If, for example, the property is transferred to a less creditworthy buyer, the lender may argue that its security has been impaired by the transaction. A transfer to a partnership, in which the borrowers on the loan are the general partners, should not be viewed as impairing the lenders security since the same persons as before are responsible for making the monthly payments. All the same, depending upon the law of your state, at least discussing the matter with your lender, prior to the transfer, may be the prudent course of action.
A tax issue which arises with respect to the transfer of the family home into the Family Limited Partnership concerns the availability of the income tax deduction for home mortgage interest. Section 163 of the Internal Revenue Code permits a deduction for "qualified residence interest." A "qualified residence" is defined as the " principal residence" of the taxpayer. The only requirements appear to be that (1) the house is the principal residence of the taxpayer; (2) interest is paid by the taxpayer; and (3) the taxpayer has a beneficial interest in any entity which holds legal title to the property. Based upon the language of the statute, the deduction for mortgage interest would, therefore, not seem to be adversely affected by a transfer into the Family Limited Partnership. However since the outcome of this issue obviously has great significance to you, you will need to discuss this with your personal tax advisor in order to reach a firm conclusion on this matter.
Similar tax issues concern the ability to rollover the gain from the sale of your home and the one time exclusion of gain available for individuals over age fifty-five. In order to avoid the possible loss of these benefits it appears that mere legal title could be transferred to the partnership while maintaining the beneficial ownership within the Asset Protection Trust. This arrangement would preserve all of the tax benefits while accomplishing the desired level of asset protection.
A popular alternative to the FLP for protecting the family home is the Personal Residence Trust. For those who are concerned about the potential tax consequences of a transfer the FLP, the Personal Residence Trust provides the protective benefits of the FLP while maintaining all of the tax advantages available for home ownership.
Bank and Brokerage Accounts
These type of accounts do not create any potential liability and should be transferred into the Family Limited Partnership. In order to open these accounts in the name of the partnership, you will present the financial institution with a certified copy of the Certificate of Limited Partnership. The institution will also require the Employer Identification Number issued to the partnership by the Internal Revenue Service.
Interest In Other Entities
The Family Limited Partnership is an excellent vehicle for holding interests in other business entities. The reason that we mention these other business entities is that the Family Limited Partnership must not ever be engaged in any business activities. You do not want the partnership to buy or sell property or goods or to enter into contracts. If the partnership does business then the partnership can get sued. And if the partnership gets sued and loses, all of the assets that it holds can be lost.
For example, a client of ours entered into a contract to purchase a shopping center. Previously, we had set up for him a Family Limited Partnership. Without our knowledge, the "Buyer" under the purchase contract was the Family Limited Partnership. During the pre-closing escrow period, financing became unavailable and the client failed to complete the deal. The seller sued the partnership for damages for breach of contract and was awarded $600,000 wiping out a substantial portion of our clients assets. The seller sued the partnership because the partnership was the named party to the contract.
This transaction should not have been handled in this manner. The proper way to conduct this type of business activity is through a separate corporate or partnership arrangement.
By using the proper planning techniques potential liability can be significantly reduced and valuable personal assets may be protected from a dangerous lawsuit. Had this arrangement been used, our client would not have lost $600,000. Instead, the buyer and seller would probably have re-negotiated the terms of the purchase in a way that was mutually satisfactory to each side.
This example illustrates the necessity for conducting business activities through an entity outside of the Family Limited Partnership so that family assets are not exposed to the risk of liability. The proper role of the Family Limited Partnership in this context is to hold the interests in the business entities that are themselves subject to risk.
The reason for this should now be apparent. If you own the shares of a corporation and you are sued, a successful creditor will seize the shares. He can then dissolve the corporation and reach its assets. Therefore, you would want to protect the corporate shares by placing them in the Family Limited Partnership.
The only potential drawback to the partnership owning the stock is that a partnership cannot be a shareholder of an S Corporation. Only individuals and certain types of trusts ( e.g. grantor trusts) are permitted shareholders of this kind of stock. As a result, if the corporation has assets and you wish to hold the stock in the Family Limited Partnership, you cannot use an S Corporation. Alternatively, if you do not wish to use a C Corporation, an Asset Protection Trust, which qualifies as a grantor trust would provide the necessary protection of the corporate shares.