Family Limited Partnerships: Asset Protection Strategies

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Paul Sundin, CPA

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Family Limited Partnerships are a great estate planning tool. But how good are they at asset protection? We will examine the issue in this post.

Asset protection concerns an individual being able to shelter their personal assets from personal liability. Although asset protection can be an issue for just about anyone, specific clients will have outstanding liabilities that require asset protection. 

Professionals, for instance, are generally concerned about potentially unlimited liability for professional malpractice. This is true for physicians and especially true for high-exposure specialties. Other business owners also may fear liability for various torts. 

For instance, a person in an environmentally sensitive business may fear environmental liabilities. There are many other liabilities a business owner might face. Generally, while non-professionals can use a corporation to shield them from personal liability for their negligence, there still may be individuals who fear personal exposure—such as a writer who fears defamation claims. 

Family Limited Partnerships Asset Protection

Some clients may fear personal liability for contracts signed. Even though a corporation will shield someone from personal liability for corporate obligations, the individual will frequently personally guarantee an obligation, particularly a loan, in which case the corporate shield provides no personal protection. Other clients will have marital concerns and want to protect assets from the claims of a spouse. 

The client’s goal is to transfer assets to the partnership, maintain control over that partnership, and protect partnership assets from their creditors. The partnership contains a substantial amount of creditor protection in a concept known as the “charging order. ” 

Family partnership planning is closely tied to family trust planning. Sometimes partnerships and trusts will be used to accomplish similar goals, and there is a choice of entity issue involved. Other times partnerships and trusts will be used together, such as when a trust is the owner of a partnership interest. 

For that reason, a course on family partnerships necessarily includes an extensive discussion of specific trust issues. In this and the following chapter, we’ll look at asset protection, that is, protecting assets against the claims of creditors. 

We’ll start by talking about the asset protection elements inherent in partnerships and then move to a discussion of asset protection trusts that can be used in conjunction with partnerships or simply by themselves.

What About Charging Orders? 

When a creditor obtains a judgment against a partner, the judgment creditor cannot foreclose on all the partner’s rights in the partnership. Instead, the most that the judgment creditor can get is all the rights of an assignee. 

These rights are referred to as the charging order. Getting the rights of an assignee means that the creditor may receive only the partner’s share of actual distributions from the partnership. 

The partner has no rights over the partnership, either in terms of control, rights to the principal, or even rights to determine when and how much income is distributed. The basic charging order principle will apply to most, although not all, general partnerships, limited partnerships, and limited liability companies. 

Since these entities are all governed by state law, it’s the state law that determines whether the charging order concept applies and, if so, whether there are any special rules or limitations. Generally, however, it will be found in its basic form in a state that has adopted a Uniform Partnership Act, Uniform Limited Partnership Act, or Revised Uniform Limited Partnership Act. 

There is no uniform LLC act (although the development of one is in progress). Still, many states’ LLC laws have charging order provisions, including Arizona, Delaware, Georgia, Idaho, Iowa, Louisiana, Maryland, Michigan, Minnesota, Nevada, and Virginia. 

In the states that have adopted the charging order provisions of the uniform laws, or states with analogous provisions in their LLC laws, one might say, then, that the creditor has nothing since the partnership (now controlled by the debtor’s family members) can simply refuse to make distributions. 

One could go further and say the creditor has less than nothing, that the creditor has a liability rather than an asset. That’s because the creditor will be responsible for paying income taxes on its share of undistributed partnership income. The creditor receives a Form K-l from the partnership as an assignee, allocating the debtor’s share of partnership items to the creditor. 

A creditor with a charging order cannot require the payment of distributions. It is also true that the creditor will still have to pay taxes on undistributed income. Thus, many commentators have concluded that the family partnership is a complete asset protection device and that other asset protection moves are unnecessary. There are several reasons why this is wrong.

First, the conclusion is based on the assumption that withholding income from creditors and sticking them with taxes is a perfectly satisfactory result to the debtor. But it isn’t. 

The debtor may still want access to partnership income and even principal, and the only way to defeat the creditor is for the debtor to tie up the benefit of the partnership. Ultimately there will be two kinds of creditors, those with or without staying power. Those who can’t wait until the partnership is liquidated and don’t want to pay current taxes are the creditors who the charging order determines. 

More solvent creditors will be able to wait. The benefit may not be paid to them right away with those creditors, but any benefit to the debtor will still be lost.

Second, the conclusion doesn’t consider inherent imperfections in the law related to claims against partners and LLC members. This is especially true where there are claims against LLC members. There is very little case law that establishes the absoluteness of the charging order protection. What’s more, the patchwork of statutes makes it possible that one state will have a hard time enforcing the LLC laws of another state, and this could result in a debtor losing the charging order protection. 

Some advisors have recommended against using the LLC for asset protection until there is a uniform law. The theory is that this will make it more likely that a debtor would not have to worry about an out-of-state judgment from a state that doesn’t recognize charging order protection in an LLC. 

It may be overly cautious not to use an LLC for this reason. Still, it does underscore the need not to rely on charging order provisions alone if asset protection is part of the client’s motivation in using a family partnership or LLC.

Final Thoughts

In this post, we address many asset protection issues with family limited partnerships. But none of this is a replacement for good insurance.

Make sure you discuss your asset protection goals with an experienced attorney.

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