USING LIMITED PARTNERSHIPS FOR LAWSUIT PROTECTION
The Family Limited Partnership is an outstanding device for providing the highest degree of lawsuit protection for family wealth. When used as part of a properly designed overall strategy, an unsurpassed level of asset protection can be accomplished.
Under the typical arrangement, the FLP is set up so that Husband and Wife are each general partners. As such, they may own only a one or two percent interest in the partnership. The remaining interests are in the form of limited partnership interests. These interests will be held. directly or indirectly, by Husband, Wife or other family members, depending upon a variety of factors which will be discussed.
After setting up the FLP, all family assets are transferred into it, including investments and business interests. When the transfers are complete, Husband and Wife no longer own a direct interest in these assets. Instead, they own a controlling interest in the FLP and it is the FLP which owns the assets. As general partners, they have complete management and control over the affairs of the partnership and can buy or sell any assets they wish. They have the right to retain in the partnership proceeds from the sale of any partnership assets or they can distribute these proceeds out to the partners.
Creditor Cannot Reach Assets
Now, let us see what happens if there is a lawsuit against either Husband or Wife. Assume that Husband is a physician and that there is a malpractice judgment against him for $1,000,000. The plaintiff in the action is now a judgment creditor and he will try to collect the $1,000,000 from Husband.
The judgment creditor would like to seize Husband's bank accounts and investments in order to collect the amount which he is owed. However, he discovers that Husband no longer holds title to any of these assets. In fact, since all of these assets have been transferred to the FLP, the only asset held by Husband is his interest in the FLP. Can the creditor reach into the partnership and seize the investments and bank accounts?
The answer is no. Under the provisions of the Uniform Limited Partnership Act, a creditor of a partner cannot reach into the partnership and take specific partnership assets. The creditor has no rights to any property which is held by the partnership. Since title to the assets is in the name of the partnership and it is the Husband partner rather than the partnership which is liable for the debt, partnership assets may not be taken to satisfy the judgment.
Charging Order Remedy
If a judgment creditor cannot reach partnership assets, what can he do? Since Husband's only asset is an interest in the FLP, the creditor would apply to the court for a charging order against Husband's partnership interest. A charging order means that the general partner is directed to pay over to the judgment creditor any distributions from the partnership which would otherwise go the debtor partner, until the judgment is paid in full. In other words, money which comes out of the partnership to the debtor partner can be seized by the creditor until the amount of the judgment is satisfied. Cash distributions paid to Husband could, therefore, be taken by the creditor. A charging order does not give the creditor the right to become a partner in the partnership and does not give him any right to interfere in the management or control of partnership affairs. All he gets is the right to any actual distributions paid to Husband.
Under the circumstances in which a creditor has obtained a charging order, the partnership would not make any distributions to the debtor partner. This arrangement would be provided for in the partnership agreement and is permissible under partnership law. If the partnership does not make any distributions the judgment creditor will not receive any payments. The partnership simply retains all of its funds and continues to invest and reinvest its cash without making any distributions.
The result of this technique is that family assets have been successfully protected from the judgment against Husband. Had the FLP arrangement not been used and had Husband and Wife kept all of their assets in their own names, the judgment creditor would have seized everything. Instead, through the use of this technique, all of these assets were protected.
Reason For This Law
The law prohibiting a creditor from reaching the assets of the partnership has been well established for many years. In fact, these particular provisions of partnership law were first adopted as part of the English Partnership Act of 1890 and were subsequently adopted as part of the Uniform Partnership Act which has been the basis of the law in the United States since the 1940s.
The reason for these provisions is that they are necessary to accomplish a particular public policy objective. This policy is that the business activities of a partnership should not be disrupted because of non-partnership related debts of one of the partners. Prior to the adoption of these provisions it was possible for a creditor of a partner to obtain a Writ of Execution ordering the local sheriff to levy directly on the property of the partnership to satisfy the creditor's debt. The local sheriff went to the partnership's place of business, shut down the business, seized all of the assets and sold them to satisfy the debt. These methods not only destroyed the partnership's business but also caused a significant economic injustice to the non-debtor partner through the forced liquidation of partnership assets. The non-debtor partner didn't do anything wrong. Why should he be forced to suffer?
In order to avoid precisely these unfair results, the law was formulated so that a creditor with a judgment against a partner--but not against the partnership--cannot execute directly on partnership assets. Instead, the law allows the creditor to obtain a charging order which affects only the actual distributions made to the debtor partner. The business of the partnership is allowed to continue unhampered and the economic interest of the non-debtor partner is not impaired.
The protection of partnership assets from the claims of one partner's creditors is deeply entrenched in the foundation of American and English partnership law. Without such protection the formation of partnerships would be discouraged and legitimate business activities would be impeded. When understood in this light, it is clear that the asset protection features of a Family Limited Partnership are neither a fluke nor a loop hole in the law. Rather, these provisions are an integral part of partnership design and it is unlikely that changes in the law will ever be made which would impair these features.
Who Should Hold Interests in the Partnership?
A decision must be made concerning who should own the limited partnership interests in the Family Limited Partnership. Under the arrangement which we have proposed, Husband and Wife are general partners, each owning a 1% interest. The question is who should own the remaining 98%? There are several possibilities to consider.
Husband and Wife Own Limited Partnership Interests
The first alternative is that Husband and Wife could own all or most of the limited partnership interests. It is perfectly acceptable for the same person to be both a general partner and a limited partner. The Uniform Limited Partnership Act specifically sanctions this set-up.
The advantage of this arrangement is that it is attractive and convenient. The parents fully control all partnership assets by virtue of their powers as general partners. In addition, the parents have retained most of the equity through their ownership of the limited partnership interests. This arrangement is generally consistent with the parents' desire not to part with assets in any meaningful way.
The disadvantages of this format are that the equitable interests retained by the parents may open the door to particular remedies which can be employed by a potential creditor. These remedies are the charging order and a possible foreclosure of the partnership interests.
Foreclosure Remedy
We have previously discussed the fact that a judgment creditor of a partner can obtain a charging order against the debtor's partnership interest. A charging order does not give a creditor any right to participate in partnership affairs, nor does it give him any right to demand payments from the partnership. A charging order does give the creditor a right to receive the debtor partner's share of any distributions made by the partnership. The charging order stays in effect until the creditor has been paid in full or until the time limit for collecting the judgment has expired (usually 20 years).
Traditionally, the charging order has been the sole remedy of the creditor. Recently, however, there has been a movement to allow a creditor with an unsatisfied charging order to obtain a foreclosure of the debtor partners interest. A foreclosure means that the court allows a seizure and a sale of the debtors partnership interest. Just like with a charging order, the purchaser of the partnership interest would not become a partner and would not have any right to interfere in partnership affairs. A creditor still would not have any right to seize any of the assets of the partnership. The difference between a charging order and a foreclosure is that a creditor with a charging order would be entitled to distributions only to the extent of the judgment. A creditor who has foreclosed on a partnership interest would be entitled to the debtors share of distributions without regard to the amount of the judgment.
For example, a creditor with a $100,000 judgment must release his charging order when he has been paid the full amount of the judgment. If the creditor instead forecloses on the partnership interest, he will be entitled to all distributions, regardless of the amount, for the life of the partnership.
As a practical matter, the partnership may never make any actual distributions and the creditor would not receive anything under either a charging order or a foreclosure. Alternatively, the general partner may dissipate the assets of the partnership such that an interest held by a creditor becomes worthless. It is not clear what relief a court would offer a creditor under those circumstances.
Crocker and Hellman Cases
Two California courts have interpreted California partnership law in a way which sanctions a court ordered foreclosure of a debtor partner's interest under certain circumstances. In the 1989 case of Crocker National Bank the court held that a foreclosure of a debtor partner's interest was permissible if three requirements were met:
1) The creditor must have a judgment against the partner;
2) The creditor must have an unsatisfied charging order; and
3) The non-debtor partners must consent.
At least in the context of a Family Limited Partnership, the rule in Crocker would not cause any concern. The requirement that all partners must consent to a foreclosure would present an obvious impediment, since other family member partners would not be expected to consent to this action.
However, in a 1991 case, before a different appellate circuit, the court disagreed with the consent rule established in Crocker. In Hellman v. Anderson, the court held that the consent of the other partners was not a prerequisite to foreclosure of a partnership interest. Instead, the court adopted the rule that a foreclosure was permissible, unless it would impair the ability of the partnership to carry on its business. An example presented by the court of this type of impairment involves the foreclosure of a general partner's interest. If the services provided by that partner were essential to the conduct of partnership business, a foreclosure would not be warranted if the effect of the foreclosure would be to deprive the partnership of the services of that partner.
If is difficult to predict exactly how the law on this matter will be resolved. Because of the disagreement between the two appellate circuits in Crocker and Hellman, the issue may have to be resolved by the California Supreme Court. It will also be interesting to see how other state courts approach this question and whether the Hellman decision begins a trend that will ultimately prevail throughout the country.
In light of the Hellman case, and anticipating that ultimately it may become the established rule throughout the country, Husband and Wife should not hold most of the limited partnership interests in their names . Since partnership interests held by Husband or Wife are subject to charging order and possibly foreclosure, various alternatives should be explored which would remove the partnership interests from the danger of a possible foreclosure.
Transfer to Less Vulnerable Spouse
If one spouse is more vulnerable then the other to potential lawsuits allowing the less vulnerable spouse to hold the partnership interests may be one useful technique. For example, let's use the situation again where Husband is a physician with high potential liability and Wife is a school teacher with low potential liability. Both Husband and Wife would be general partners, each with a 1% interest. But instead of dividing the limited partnership shares equally, all of the limited partnership interests would be held by Wife. If Wife's partnership interests were considered to be her separate property (not community property) , a judgment creditor of the Husband could only get a charging order or a foreclosure against the 1% interest held by Husband. Although Husband still enjoys co-equal management and control of the family assets as co-general partner, he has effectively parted with beneficial ownership so that potential creditors are left without a means for recovery. In the event of a charging order or foreclosure, the creditor will only be able to reach the 1% general partnership interest retained by Husband. The other 99% will be protected. This technique will not produce any gift tax consequences, because of the unlimited marital deductions for gifts between spouses.
This arrangement will also be useful if the income from partnership assets is essential for the support of the family. For instance, the assets of the partnership may consist of retirement savings, the income from which is used to pay family living expenses. If a creditor obtains a judgment and the right to any distributions, money cannot be distributed to a debtor partner without being seized by the creditor. Instead, if the debtor partner owns only a 1% interest as general partner, the creditor could claim only 1% of any distributions. Distributions made to Wife, who is not a debtor partner, would not be available for the creditor. In our example, Wife owns 99%, allowing 99% of the partnership income to be distributed to her free of the creditors claim.
The primary disadvantage of this technique is that a low vulnerability to lawsuits does not mean no vulnerability. It is often very difficult to determine where and when an accident may occur or liability may arise. In this example, a lawsuit against Wife would be disastrous because of her ownership of all of the limited partnership interests. Also, again, transfers of all interests to Wife will certainly cause problems in the event of a divorce.
Transfers to Children
Sometimes, Husband and Wife are equally vulnerable to lawsuits or Husband doesn't feel comfortable transferring to his spouse all of the beneficial interests in the partnership. In circumstances where partnership assets do not generate income or distributions are not necessary for family support, a transfer of the partnership interests to the children is a technique to consider. An irrevocable domestic trust would be a method to accomplish this. Husband and Wife could be the trustees of the trust, but under the law of most states they could not have any beneficial interest in the trust if they wished to protect the partnership interests from a possible creditor.
Gift Tax Consequences
In establishing such a trust, the parents must keep in mind potential gift tax consequences. If the transfer of the partnership interests to the trust is considered to be a completed gift, it may give rise to current gift tax liability, depending upon how the interests are valued. The parents may use up their combined credits against tax which total $1,200,000 without incurring any immediate tax liability. And, as discussed, annual transfers of partnership interests with a value of $20,000 per donee can be made.
If Husband and Wife own property with a value greater than $1,200,00, it may be difficult to make an immediate transfer of all of the partnership interests to a trust without triggering a gift tax liability. For example, if Husband and Wife have three children and no grandchildren, the most that can be transferred in the first year is $1,260,000.
Incomplete Gifts
In order to transfer amounts over $1,200,000 without gift tax, a trust arrangement can be created which is not considered to be a completed gift for gift tax purposes. Although the trust is irrevocable and the transfer is complete under state law with respect to potential creditors, a gift can still be incomplete for tax purposes. An incomplete gift occurs when the donor retains some significant powers over the gifted property. Even if the donor cannot re-acquire the property and cannot enjoy the property himself, if he is able to exercise significant control over the property, the gift will be considered incomplete. For example, if a donor retains a right to add beneficiaries to the trust or to alter the interests of the beneficiaries, the transfer would not be a completed gift and no gift tax liability would be created. Similarly, for income tax purposes the trust can be structured so that all of the income tax attributes of the property are retained by the donor. In essence, the trust would be treated as a grantor trust, in the same manner as the revocable trust. If Husband and Wife have an estate larger than $1,200,000 and wish to protect the interests in the partnership without incurring any gift tax liability, the incomplete gift technique is an excellent method for doing so.
Advantages and Disadvantages of Irrevocable Trust
Partnership interests which have been transferred to an irrevocable trust are immune from charging order or foreclosure. The parents, as general partners of the partnership and trustees of the trust have retained complete control over the assets of the partnership and the timing and amount of any distributions to the children. If the transfer takes the form of a completed gift, the value of the partnership interests will not be includable in the estate of the parents. This can be a very effective estate planning maneuver.
The major disadvantage is that the parents have, in fact, irrevocably parted with legal ownership of the interests in the partnership. As general partners and trustees, they are bound by the laws of the state to carry out their responsibilities in a fiduciary capacity. That is, the parents now have a legal obligation to administer the partnership and the trust, not in their own self interest but in the best interest of the children. If partnership assets are wasted or if the general partners receive excessive compensation, the children will have a legal cause of action for damages. These facts may or may not cause concern. Many of our clients are completely comfortable with this type of arrangement and do not view a potential lawsuit from their children as a serious possibility.
Asset Protection Trusts
For those people who are reluctant to create an irrevocable trust and relinquish all beneficial ownership to their children, a trust established under the more favorable laws of a foreign jurisdiction will provide a satisfactory solution to these concerns. In the next Chapter, we will examine how Asset Protection Trusts can be used in conjunction with the Family Limited Partnership to provide the ultimate asset protection strategy.
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