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Types of Partnerships

Author johnbsims3
Admin Male

#1 | Posted: 24 Oct 2006 12:00 
Different Types of Partnerships

General Partnerships
A partnership is formed when two or more persons agree to carry on a business together. This agreement can be written or oral. A general partnership is formed when two or more people intend to work together to carry on a business activity. No local or state filings are required to create this type of partnership. This is different than a corporation which does not come into existence until Articles of Incorporation have been filed with the Secretary of State.

The distinguishing feature of a partnership is the unlimited liability of the partners. Each partner is personally liable for all of the debts of the partnership. That includes any debts incurred by any of the other partners on behalf of the partnership. Any one partner is able to bind the partnership by entering into a contract on behalf of the partnership. If Jackson and Wilson are partners, and Wilson signs a contract on behalf of the partnership, Jackson will be personally liable for the full amount. This is true regardless of whether Jackson authorized the contract or whether he even knew of its existence. This feature of unlimited liability contrasts with the limited liability of the owners of a corporation. As discussed previously, when a contract is entered into on behalf of a corporation, the owners are not personally liable for its performance.

Because each of the partners has unlimited personal liability, a general partnership is the single most dangerous form for conducting one's business. Not only is a partner liable for contracts entered into by other partners, each partners is also liable for the other partner's negligence. When two or more physicians or other professionals practice together as a partnership, each partner is liable for the negligence or malpractice of any other partner.

In addition, each partner is personally liable for the entire amount of any partnership obligation. For example, Doctor Smith may be one of ten partners in a medical partnership, but he is not responsible for only 10% of partnership obligations. He is responsible for 100%--even though he owns only a 10% interest. If Doctor Smith's other partners are unable to pay their respective shares, he must pay the entire amount.

Limited Partnerships

Obviously, the unlimited liability feature of general partnerships is a serious impediment to conducting business using a partnership format. In order to mitigate the harsh impact of these rules, every state has enacted legislation allowing the formation of a type of partnership known as a limited partnership.

A limited partnership consists of one or more general partners and one or more limited partners. The same person can be both a general partner and a limited partner, as long as there are at least two legal persons who are partners in the partnership. The general partner is responsible for the management of the affairs of the partnership and he has unlimited personal liability for all debts and obligations. Limited partners have no personal liability. The limited partner stands to lose only the amount which he has contributed and any amounts which he has obligated himself to contribute under the terms of the partnership agreement. Limited partnerships are often used as investment vehicles for large projects requiring a considerable amount of cash. Individual limited partners contributing money to a venture, but not having management powers, will not have any personal liability for the debts of the business.

For example, Able and Baker form a limited partnership with Able as the general partner and Baker as the limited partner. Baker contributes $100,000 Able will run the day-to-day affairs of the business and Baker will provide all of the initial capital. If Able enters into a contract which causes the partnership to incur a liability of $500,000, Baker will lose his $100,000 contribution, but he has no obligation to contribute any additional funds. Able, as the general partner, has personal liability for the entire amount. He has no right to demand that Baker make any further contributions.

In exchange for this protection against personal liability, a limited partner may not actively participate in management However, it is permissible for a limited partner to have a vote on certain matters, just as a shareholder has a right to vote on some corporate matters. A typical limited partnership agreement may provide that a majority vote of the limited partners is necessary for the sale of assets or approval may be required in order to remove a general partner. The partnership agreement determines whether the limited partners can vote on these matters.
If a limited partner assumes an active role in management, that partner may lose his limited liability protection and may be treated as a general partner. For instance, if a limited partner negotiates a contract with a third party on behalf of the partnership, the limited partner may have liability as a general partner. For this reason, a limited partner's activities must be carefully circumscribed.

Tax Treatment of Partnerships

Unlike corporations and irrevocable trusts, a partnership is not a taxpaying entity. A partnership files an annual information tax return setting forth its income and expenses, but it doesn't pay tax on its net income. Instead, each partner's proportionate share of income or loss is passed through from the partnership to the individual. Each partner claims his share of deductions or reports his share of income on his own tax return.
Since the partnership is a "pass through" entity, there is no potential for double taxation as there is with a C Corporation. Typically, when a business is expected to show a net loss rather than a gain, the partnership format is used so that the losses can be used by the partners. Limited partnerships have always been used for real estate and tax shelter investments in order to pass the tax deductions through to the individual investors. These losses are then used by the partner to offset other income he might have. Although the Tax Reform Act of 1986 now limits the ability to immediately deduct losses from "passive activities" to offset wages or investment income, the partnership format may still be desirable, if the circumstances of the individual partner are such that he is able to take advantage of these losses.

The rules regarding the taxation of partnership activities are lengthy and cumbersome. As a general rule, however, transfers of property into and out of a partnership ordinarily will not produce any tax consequences.

Author johnbsims3
Admin Male

#2 | Posted: 24 Oct 2006 12:01 
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.

Author johnbsims3
Admin Male

#3 | Posted: 24 Oct 2006 12:01 
How to save Income and Estate Taxes
Income Tax Benefits
If family assets are held in the form of a limited partnership, it will be possible to obtain certain income tax savings in addition to the asset protection benefits previously discussed. These income tax benefits can be realized by spreading income from high tax bracket parents to lower tax bracket children and grandchildren who are 14 years or older. Let's look at an example of how this might work:
One of our clients had taxable income from various investments of approximately $200,000, consisting of interest and dividends from bonds, stocks, and trust deeds which he owned. He was in a 32% maximum tax bracket and paid taxes of approximately $64,000 per year on this income. As part of an overall business plan which we established, all of his assets were transferred into a Family Limited Partnership and a total of seven children and grandchildren were brought in as limited partners of the partnership. Under the partnership agreement, the children and grandchildren were taxable on $100,000 of the $200,000 in income generated by the partnership. Each of these children was in a maximum tax bracket of 15% and thus the total taxes owed on this $100,000 of investment income was reduced from $32,000 to $15,000. This produced a savings of $17,000 in overall family income taxes. Under the partnership agreement it was not required that the $100,000 actually be distributed to the children. In fact, the parents as general partners retained all of this amount except for what was needed to pay the taxes on the children's share of partnership income. The parents thereby reduced their annual income taxes by shifting a substantial amount of income to their children. The tax savings were held as a college fund for the grandchildren.
Estate Tax Benefits
We have devoted a considerable amount of attention to the usefulness of the Family Limited Partnership for various asset protection strategies. However, the importance of the FLP as a vehicle for dramatically reducing or eliminating estate taxes must not be overlooked.
This estate tax reduction can be accomplished because of certain unique attributes of the FLP which are not present in any other business entity. Of primary importance is the ability to shift the value of assets out of your estate without any concomitant loss of control, through a program of gifting limited partnership interests to your children or other family members.
For example, the Smith family has equity in a home of $500,000, a rental property with equity of $500,000 and retirement savings in stocks and bonds equal to $1,000,000. Under current law, a properly designed estate plan, taking maximum advantage of the $600,000 exemptions, would result in an estate tax of approximately $400,000. Congress is also considering new proposals which would reduce the amount of the lifetime exemption from $600,000 per person to only $200,000. Under the new proposals the amount of estate tax would equal approximately $800,000. Mr. and Mrs. Smith would like to take steps to preserve the family estate for the benefit of their three children but they do not wish to give up control over their assets during their lifetime.
The solution to the problem involves a properly structured estate plan including an FLP which is established to hold all family assets. Mr. and Mrs. Smith would be the general partners of the FLP. As such they would have complete management and control over their property in the FLP. Initially, they could make a gift of the limited partnership interests to their children in an amount equal in value to the combined maximum estate tax credit (currently $1,200,000). In subsequent years they could gift limited partnership interests equal to the amount of the annual gift tax exclusion of $20,000 per child ($60,000 per year).
Under this approach, in roughly 13 years, the Smiths would be able to eliminate potential estate taxes and could preserve $400,000 to $800,000 of family wealth. At the same time that the Smiths are accomplishing this result they would not relinquish any degree of control or authority over their real-estate or their retirement savings.
A further advantage to using the FLP in this manner is that according to IRS regulations, the value of each gift of a limited partnership interest must be discounted in order to account for the lack of marketability and the lack of control associated with those interests. For example, if the parents transfer assets with a value of $1,000,000 to an FLP, a gift of a one percent limited partnership interest should not be valued at $10,000. Instead, because the interest cannot be readily sold and because the donee has no right to participate in management of the FLP, a reasonable approach to determine value, suggested by many financial advisors, would be to discount the transferred interest by approximately thirty percent.
Once this discount is taken into consideration, the value of the gifted interests is reduced from $10,000 to $7,000. By valuing these interests at this reduced amount, a greater amount can be gifted each year. In the example that we used above, the Smiths could reduce their taxable estate to zero in only 9 years by discounting the value of the gifted interests in this manner.
From a practical standpoint a transfer of a limited partnership interest is easy and convenient to accomplish. A simple notation may be made in the partnership document reflecting a decrease in the parents' ownership and an increase in the children's ownership. This procedure is simpler than transferring a fractional interest in an asset, such as real estate, which would require the preparation of a new deed each year to reflect the correct ownership percentage held by the children. If a trust has been used to hold the limited partnership interests, annual transfers can be accomplished by an assignment, of the desired percentage from the trust to the beneficiary each year.
The Family Limited Partnership is the best legal device available for minimizing or eliminating estate taxes through the transfer of ownership to other family members. The ability of the parents to maintain control over the assets and the administrative ease with which these transfers are accomplished makes this device superior to any other available technique for accomplishing these objectives.

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Types of Partnerships
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