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Family Limited Partnerships

Author johnbsims3
Admin 

#1 - Posted: 24 Oct 2006 11:58 
Family Limited Partnerships
Copyright 1997 Francis O'Brien & Sons Publishing Company

The Family Limited Partnership (FLP) is an excellent device for providing a high degree of lawsuit protection for family wealth. When used as part of a properly designed strategy, the Family Limited Partnership can also provide significant income and estate tax savings advantages.
A Family Limited Partnership is a specially designed type of 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 and a limited partner, as long as there are at least two legal persons 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 and stand to lose only the amount contributed to the partnership.
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 does not 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.
Using Family Limited Partnerships for Lawsuit Protection
Under the typical arrangement, the FLP is set up so that Husband and Wife are each general partners, (A single person can act as the sole general partner.) As such, they might own, for example, a one or two percent interest in the partnership. The remaining interests are in the form of limited partnership interests. These interests can be held by Husband and Wife or other family members. This basic plan is illustrated on the following page.
After setting up the FLP, most types of family assets are transferred into it, including real estate and business interests. When the transfers are complete, Husband and Wife no longer own these assets directly. 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 funds 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 some time after setting up the FLP there is a lawsuit and 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, investments and other property 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 property in the FLP?
The answer is no. Under the provisions of the Uniform Limited Partnership Act, the 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 to the debtor partner, until the judgment is paid in full. In other words, money which comes out of the partnership to the Husband 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. Wad 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 1949s.
These provisions 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 the 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 did not 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.
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 allocated on $100,000 of the $200,000 of 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 and grandchildren. The tax savings were held as a college fund for the grandchildren.
Estate Tax Benefits
The Family Limited Partnership is also a powerful technique for dramatically reducing or eliminating estate taxes.
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's primary asset is a rental property with equity of $2,000,000. Under current law, a properly designed estate plan, taking maximum advantage of the $600,000 exemption, would result in an estate tax of approximately $400,000. 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 a FLP which is established to hold family assets. Mr. and Mrs. Smith would be the general partners of the FLP. As such they would have complete 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 may 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 to accomplish. A simple notation may be made in the partnership document reflecting a decrease in the parent's ownership and an increase in the children's ownership. This procedure is easier 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.
The Family Limited Partnership is an excellent strategy for accomplishing asset protection, income tax savings and reducing or eliminating estate taxes. For those individuals who have acquired a substantial net worth, the ELF by itself, or combined with other vehicles, can be a valuable component of a comprehensive financial plan.

Author johnbsims3
Admin 

#2 - Posted: 24 Oct 2006 12:02 
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.
Dangerous 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
Safe Assets, with a low probability of creating lawsuit liability can be maintained in a single partnership.
Family Home
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.

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