Family Limited Partnerships

Winning Asset Protection Strategies: Family Limited Partnerships

The Family Limited Partnership (FLP) is termed 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.

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 dentist and some time after setting up the FLP there is a lawsuit and a malpractice judgment against him for $500,000. The plaintiff in the action is now a judgment creditor and he will try to collect the $500,000 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?

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. 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 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:

Suppose you had taxable income from various investments of approximately $200,000, consisting of interest and dividends from bonds, stocks, and trust deeds which he owned. You are 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 that would be 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 Anderson 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. Anderson 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. Anderson 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 Andersons 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 Andersons 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 Andersons 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 FLP by itself, or combined with other vehicles, can be a valuable component of a comprehensive financial plan.