What is a Family Limited Partnership?
Limited partnerships can be a great asset protection tool, however, it is not right for many people.
The term "Family Limited Partnership", simply refers to a Limited Partnership that is tailored for the use as an asset protection tool for a family. There is no legally-recognized entity called a "Family Limited Partnership".
The Limited Partnership exists in one form or another in every state. They differ from General Partnerships, wherein all the partners are liable for partnership debts and the acts of the other partners. The difference is that with the limited partnerships there is a separate class of partners -- really, mere investors -- called "limited partners", and who are not liable for partnership debts. This class of partners was created around the turn of the century so that partnerships could raise money without making the new investors liable for the debts of the partnership. The investors were the limited partners, and could invest their money safely without risking liability over their investment. The general partners, who control the limited partnership, still have liability.
This concept of limited partners as mere passive investors who are not liable for partnership debts but who also have no control is very, very important from an asset protection standpoint.
How do FLPs protect assets?
The "charging order" protection is the first benefit of limited partnerships.
The revelation that creditors could be stopped cold by way of charging order had dramatic implications. In effect, this meant that if one of the limited partnerships went bust, and a creditor sought to collect on the limited partnership share, that the only thing a creditor could do was get a court order (the "charging order") which essentially said "You Mr. Creditor can't have any of the assets in the limited partnership, but if the general partner of the limited partnership decides to make any distribution of proceeds to that particular limited partner's share, then you Mr. Creditor will get the proceeds." But what the charging order didn't tell the creditor was that if the limited partnership agreement was drafted correctly and did not violate state law, that the general partner never had to distribute anything to the creditor, i.e., despite the charging order the creditor never got anything: zippo, nada.
Limited partnership agreements contained ironclad clauses which absolutely limited a creditor’s remedies to a charging order, and made it so that if a creditor was successful in obtaining a charging order, that the general partner was relieved from making any distributions to the creditors.
"Discounting" is the second benefit of limited partnerships.
A limited partnership interest isn't necessarily as valuable as its face value. In other words, it can be argued that if you own a 50% limited partnership interest in a limited partnership with $1 million, that your limited partnership isn’t worth $500,000 -- instead it is worth more like $300,000. Why? Because of the concept which became known as "discounting" of the limited partnership interest.
So why would a 50% interest in a $1 million limited partnership only be worth $300,000? The argument is that while limited partnerships are like a stock investment, they aren't as valuable as stock. First, limited partnerships aren't regularly traded, and interests in small and obscure limited partnerships aren't traded at all. So they don't have any immediate value. Second, because the limited partnership is tied up by these ironclad limited partnership agreements, it may be difficult for a limited partner to get his money back out of the partnership. There are other creative reasons people have come up with over the years as to why the limited partnership interests should be discounted, but these are the two most oft-articulated reasons.
The effect of "discounting" is that it can make a great deal of difference where federal gift and estate taxes are concerned. Let's assume that your estate is worth several million dollars, so you are in the highest estate and gift tax bracket, which is 55%. You decide to give your limited partnership interest to your daughter. If your limited partnership interest is valued at $500,000, then your estate tax on that interest is $275,000. But if your limited partnership interest is valued at $300,000, then your tax is only $165,000 – which is a $110,000 difference.
Why value it at $300,000? Why not value it at $200,000 or $100,000? Then your estate tax savings would be that much greater. Well, in theory the value is tied to some mathematical valuation based on comparable sales, etc., which you get some independent appraiser to figure out for you. But in truth, estate planners just pull these numbers out of thin air, based upon what they think they can get away with against the IRS, and then they tell their "independent" appraiser (who would be out of work if he were in fact independent) to sign an affidavit assigning the estate planner's arbitrary discounted value to the limited partnership interest. At first, some planners attempted to discount the limited partnerships by as much as 80%. The IRS didn't like that, and the Service started ignoring these calculations and assigning their own valuations, which were much more conservative. So, then it got to where it is today, where people take a discount somewhere between 20% and 35% and are comfortable with it.
But the IRS didn't like this 30% discounting either, especially since most of the limited partnerships are held between family members (now we are to the so-called "Family" Limited Partnership), and so to say that the partnership interest should be discounted because it theoretically can't be sold is a sham. The familial reality is usually that there isn't any difficulty selling them between family members, and if the family members wanted the assets back they could simply wind it up.
[Note: For whatever reason, the IRS never argued that if the limited partnership were to be discounted for lack of control and liquidity, this meant that the value of the general partnership interest should be priced at a premium, i.e., at a higher value than its face value since it had all the control and thus would be liquid. Since the parents typically retain the general partnership interest, this meant that most of the "lost value" the FLP marketers crowed about really remained in the estate after all, so long as the parents kept the general partnership interest. As shown, the IRS simply decided to eliminate discounting -- but it is conceivable that in the future the IRS could challenge valuations of the general partnership interests, with very bad consequences for taxpayers who have to-date taken advantage of discounting. And perhaps the IRS is aware of it, but simply waiting for people to lock themselves in by claiming the discounting advantage so that they can later be slammed on the enhanced valuation of the general partnership interest?]
At any rate, the IRS is now trying to get legislation passed which will completely eliminate the discounting of limited partnership interests about everywhere you would want to use it, and especially between family members. No professional we know thinks the IRS will not be successful in quashing discounting.
People who are forming FLPs only for the gift and estate tax savings are probably wasting their money. But "charging order" protection still exists, although it too has been dissipated to some degree. So excuse us if we don't spend much time talking about "discounting" and estate and gift taxes -- but as you probably know there are lots of information about that on the estate planners' websites, so you will not be left entirely in the dark.
Now, many states' Limited Liability Company (LLC) laws restrict a creditor's rights to the "charging order". For a variety of tax reasons (outside the scope of this page), LLCs are preferable to limited partnerships – but for asset protection purposes in those states where the creditors remedies against an LLC interest are also limited to a charging order, they act about alike. So, a good deal of our discussion herein probably applies to LLCs as well -- although LLCs are relatively new and sometimes you really have gaze into your crystal ball and old bar journals to guess how a judge might rule based on corporation and partnership law. In some areas, the rulings will be the same for both limited partnerships and LLCs, and in other areas the rulings will be completely opposite -- especially where the LLCs have only one or two members. This disparity alone is good reason for you to consult someone knowledgeable in the areas of partnership and corporation law to help you with your planning.
Similarly, the offshore jurisdictions -- always smelling dollars -- are trying to get into the limited partnership business, and many have enacted new limited partnership acts similar to the Revised Uniform Limited Partnership Act. The offshore jurisdictions have also enacted Limited Liability Company acts which ostensibly limit creditors' remedies.
How Does a Limited Partnership Work?
A limited partnership by itself provides little asset protection, and is just one cog in a bigger asset protection machine. If you utilize a limited partnership for asset protection planning, you have to protect both the limited partnership interest as well as the controlling general partnership interest. Because the general partner is generally liable and does not have charging order protection, you should only give the general partner the smallest possible interest to keep control, usually 1%. This means that 99% of the assets are in the limited partnership interest, which is what you are protecting from creditors, which means that you must protect the limited partnership interests to the greatest degree possible. But you must also protect the general partnership interest, because if the creditor gets control of the general partnership interest, the creditor can do a variety of things -- from ordering the distribution of all assets to the creditor to dissolving the partnership -- so it is critical that the general partnership interest be protected as well.
To protect both the general partnership interests and the limited partnership interests, the typical structure is to form a corporation to act as the general partner, and to have an offshore trust hold the limited partnership interests. Worst-come-to-worst, the theory holds, you can simply liquidate the limited partnership and the assets "pour" to the offshore trusts, where (in more theory) they will be protected from creditors. We'll look at this structure, and some common and uncommon variations, below.
The General Partners
The General Partners manage the limited partnership. They make all partnership decisions without any real input from the limited partners, and this power significantly includes the right to make or not make distributions to any particular limited partner. This power also typically includes the right to dissolve the partnership. So, it is important that no creditor of one of the limited partners "take over" the limited partnership by gaining control of the general partner. If the creditor is successful, the creditor can either order that distributions be made to the creditor, or the creditor can simply dissolve the partnership -- which largely has the same effect.
The worst structures make the client the general partner, which assures that a creditor will get the limited partnership assets in the shortest possible period of time. This is insane, and in a given situation can amount to malpractice for an attorney to form such a structure (it is the unauthorized practice of law -- a felony offense in many states -- for non-attorneys to draft the documents which facilitate limited partnerships). These structures usually assume that at the first hint of trouble the partnership will be wound up and the assets transferred to a an offshore trust which holds the limited partnership interests. This leaves you wondering why you just didn't transfers all the assets to the offshore trust to begin with.
Truth is, once you start figuring out how all of this is supposed to interact, it gets pretty complicated and actually requires a great deal of thought and careful planning. This is anathema for most planners, who have trained their paralegals to crank out these documents off the word processor in the shortest possible time and with little thought. Moreover, the vast majority of planners in truth don't have the litigation skills and experience to predict how these structures will be interpreted in court, so they simply punt and assume the best. Thus, when most planners sell you a "Family Limited Partnership" they are really just selling you a plain-vanilla limited partnership, which in most states should be less than $1,000 including their word-processing fees (the rest is their profit).
Another consideration is that if you have a significant portion of your assets in the limited partnership you probably don't want to lose control. But as shown above, you probably dont want to personally be the general partner, either. So what do you do?
A good method of protecting the general partnership interest is to form a new corporation, LLC, an offshore trust,or even another limited partnership and have it act as the general partner (we’ll refer to it here as a corporation). The advantages are:
- Not subject to lawsuit -- The general partner corporation will not be subject to be subject to the claims of creditors, and its stock will not be subject to the client's creditors if the client doesn't own the stock. This means that the creditor will have to bring a separate lawsuit against the corporation to make it distribute to the limited partnership interests, which is a lawsuit the creditor has a very poor chance of winning if the limited partnership agreement is carefully drafted.
- Ownership not discoverable -- Since a creditor doesn't have a lawsuit against the corporation which is acting as the general partner, the creditor probably doesn't have any right to find out who owns the corporation. While this is not an absolute rule, it can make it very difficult for a creditor to find out who controls the general partner corporation, which correspondingly makes it more difficult to prove that the entire arrangement is a sham.
- Transferability -- Ownership in general partnership corporation is readily transferable, since the shares in the corporation can be sold. Fraudulent transfer problems? Probably not, since the general partnership corporation probably doesn't own anything except a 1% interest, and this can be transferred for value (it is extremely difficult for a creditor to prove fraudulent transfer against a for-value transaction).
- Migration -- The general partnership corporation can be migrated outside the U.S. to some debtor-friendly jurisdiction. Just let the creditor try to get a Bahamas court to order a Bahamas-domiciled corporation to make a distribution of anything. [Note to planners: File an election with the IRS to have it taxed as a domestic entity if you are worried about negative foreign corporation tax consequences.]
- Management Business -- The general partnership corporation can earn management fees, and use those fees to pay salaries, purchase health and disability insurance, contribute to retirement plans, buy split-dollar insurance, and create additional benefits for the family member employees.
The weakness here is that you have to protect the stock in the corporation, or else the creditor may get control of the corporation and thus take over the limited partnership. There are many ways to prevent this from happening. First, the shares of the corporation should be restricted so that the shareholders MUST elect the client (or, better, someone selected by the client) as the sole Director of the corporation and the manager of the limited partnership. Second, steps should be taken to make it extremely difficult to discover who owns the corporation (this is a place you might use a Nevada corporation and bearer shares). Third, you can domicile the corporation offshore and have its stock held offshore. Creditor wants control of the corporation which is acting as the general partner? Fine, let the creditor go to the Bahamas and sue a Bahamas corporation in a Bahamas court (good luck).
Additionally, it is possible for have several general partners, which manage the limited partnership by committee. Let's say the limited partnership has three general partners, consisting of a Bahamas corporation, a Cayman corporation, and a Nevis corporation. This means that a creditor would have to penetrate two of these corporations to get control of the limited partnership – a daunting task for any creditor. And, the credito would have to penetrate two of the corporations at the same time or else the other two would simply terminate the third as a general partner. A good limited partnership agreement will allow for additional general partners, meaning that if things get sticky then you can add a couple of general partners. Expensive, yes, and probably unnecessary in 99.999% of cases involving FLPs. This just shows you some of the alternatives if you have a corporate general partner. You don't have any of these alternatives if some mere individual is the general partner (a stupid, stupid, stupid way to form these things).
The Limited Partners
The limited partners are passive investors. They transfer money or other assets to the limited partnership, and receive limited partnership interests in return. The limited partners have no management responsibilities; indeed, if they are found to have any power or control over the limited partnership they probably will be deemed to be de facto general partners.
One thing about a limited partnership is that the limited partners have no right to control the limited partnership -- just like you can't tell Bill Gate what to do if you buy 100 shares of Microsoft stock -- but also no right to demand distributions. This means that you can give limited partnership interests to your kids, but they don’t get any right to control the assets until you choose to give them control. This makes the FLP at least equivalent to the oversold and mostly-worthless living trust, since you can transfer assets to the FLP and then give control of the FLP to your kids at your death or disability by having them step into control of the general partnership corporation. The FLP also helps prevent family squabbles over control, and keeps the kids' creditors from getting family assets.
The limited partnership shares must be protected from creditors. The established method of doing is this to have the limited partnership shares owned by an offshore trust. In the event of trouble -- the theory goes -- the limited partnership will simply be wound up and all the assets transferred to the offshore trust. Probably more than half of the FLPs are set up in this fashion. The problem here is that offshore trusts are in serious disfavor with U.S. courts, have not really provided that much protection in the offshore jurisdictions, and may in fact provide less protection in some circumstances than if the client simply decided to stand behind the FLP and fight.
How much better off are you in putting the limited partnership shares into an offshore trust than I am taking other steps, such as forming an offshore limited partnership, from the outset? Your answer to this will probably depend on the recommendation of your planner, and how comfortable you feel with him or her.
Charging Order Protection
What makes the limited partnership a good tool for asset protection is this: If a creditor sues a limited partner and wins, the creditor can't simply cash in the limited partner's interest to satisfy the judgment -- any more than a creditor who gets a debtor's Exxon stock could compel Exxon to turn over some oil rigs for the stock. Instead, the creditor essentially gets the limited partner's right to payments of proceeds from the interests and nothing more. The creditor doesn't technically take over the limited partnership interest, but even if the creditor did take it, the interest wouldn't be of much value because the general partner probably will never make any distributions to that particular interest.
So, the charging order protection is what makes limited partnerships effective for asset protection. You must understand what this is, how it operates, and what the limitations on it are.
Charging order protection arises from statute. The protection is that under some states' laws, a creditor has only one remedy and that remedy is the charging order. Other states give creditors other rights against the partnership -- usually something like "and all other remedies which exists in law or equity" -- which give the courts in those states carte blanche to do whatever the judge feels like to make things right for the creditor. To say the least, this pretty much defeats the charging order protection. So, whether you are forming a limited partnership or an LLC, you need to make sure that creditors are limited to the charging order in the particular state where the limited partnership is formed AND where the assets are located. For instance, even if State A where the limited partnership is formed limits creditor's remedies to a charging order, that probably will not help you if the assets are in State B and State B does not limited the creditor's remedies -- and possibly vice versa depending on how the conflict-of-laws issues shake out in a given case.
The partnership agreement must limit a limited partner's remedy to the charging order. Amazingly, many of the agreements for limited partnerships formed for asset protection reasons don't have this most-important provision. Sort of like building a bullet-proof car with windows which don't roll up.
One of the best things about limited partnerships is that there are some reasons why a smart creditor probably doesn't even want either the charging order or even the limited partnership interest itself.
There are several tax reasons why a creditor may want to stay miles away from taking a limited partnership interest.
First, even if the creditor takes over the limited partnership interest or gets a charging order, the creditor is probably not going to get any assets. However, the general partner may still distribute so-called "phantom income" to that particular limited partnership interest, meaning that the creditor pays the limited partnership's income taxes!
Here's how it works. Let's say the limited partnership owns 10,000 shares of IBM stock that was purchased at $10 per share. The stock is now worth $90. The general partner decides to sell the stock, which generates a profit of $800,000 and capital gains taxes of $160,000. However, instead of distributing the $800,000 to the partners, the general partner decides to re-invest the stock. So, the limited partners don't get any money. However, somebody has to pay the capital gains taxes on the transaction, so the general partner "distributes" the taxes to the limited partner. The upshot is that the creditor gets no money, but does have to pay $160,000 in taxes.
It is also possible by a variety of methods to "enhance the yield" of the tax penalty for creditors. Essentially, you look for ways to trigger the worst possible tax consequences to the creditor -- such as changing the accounting method of the partnership. For example, in some cases it may be possible to create a foreign grantor trust (an offshore trust with a U.S. trustee) for the benefit of the limited partnership, and to transfer the limited partnership's assets to the foreign grantor trust. If a creditor comes along and takes a charging order or accept the limited partnership interest in partial settlement, the U.S. trustee is fired. This converts the foreign grantor trust to a pure foreign trust, and triggers a substantial excise tax – which is distributed to the creditor. This can effectively mean that the creditor pays the gift and estate taxes to transfer assets to the kids!
The idea is to create the worst possible tax consequences for the creditor. The IRS doesn't mind, and almost consistently rules against creditors who have stepped into these traps (creditors, especially institutional creditors, usually have the money available to pay the tax burden and so the IRS doesn't have to try to collect from a debtor who is already strapped for cash).
These methods of enhancing the tax yield to creditors are sometimes called "booby traps" or "poison pills" and this is probably an apt description. The ability strike back and actually hurt creditors makes the limited partnership a better tool for asset protection devices than such purely defensive mechanisms such as offshore trusts, which have no ability to fight back. These scenarios create leverage to force creditors into settlement: If they don't take the limited partnership interest or get a charging order they may have effectively given up, but if they do take it they may take a nasty tax hit.
Notwithstanding any of the foregoing, it should be noted that in many states there has been a gradual erosion of this charging order protection. Like anything else, the more charging order protection is asserted (and are asserted by idiots in cases where there are bad facts) the more courts are finding exceptions to it. Thus, you shouldn't assume that the charging order protection will absolutely stand up. And you should be very careful about standing behind limited partnerships in states such as California, where they have already been penetrated in some circumstances.
Estate Planning and "Discounting"
The IRS doesn't like discounting and has been trying to eliminate it for some time, both by proposing legislation to Congress and by attacking discounting in court. So far, the IRS has been generally unsuccessful (the Service has had a few wins, but also some spectacular losses), so enjoy it while it lasts!
The Limited Partnership Itself
Partnerships are created by an act of government, such as by the issuance of a Certificate of Limited Partnership by the Secretary of State. The partnership is a legal entity which is recognized separately from its partners. This means that the partnership can do an act which gives rise to liability, thus creating what is known as "inside liability".
"Inside liability" means that the partnership has itself incurred a liability. This would occur if, say, the partnership itself incurred a debt, or if a vehicle driven by a partnership employee hurt someone. "Inside liability" is to be distinguished from "outside liability", which is liability of a partner that the partnership is not responsible for, but which the creditor may seek to get at the partnership assets to satisfy the offending partner's liability.
The concept of inside-outside liability has some practical ramifications. The most important of these is this: You don't put your assets into a partnership which is likely to generate liability. Instead, it is better if you put your "passive" assets -- such as stock -- into one or more partnerships (called "cold" partnerships if they are not likely to generate liability), and then you put assets which are likely to generate liability -- such as your construction business or the piece of property with the environmental hazard -- into another partnership or series of partnerships (called "hot" partnerships when they are likely to face lawsuits). For example, you don't put your car into the "cold" partnership, since that is likely to generate liability which could wipe out your stock account.
For this reason, planners who put everything hot and cold into one partnership not only just idiots, but they are probably committing malpractice. To do this right, you have to be prepared to create multiple partnerships as needed. If you are not prepared to do this, don't use partnerships at all! Because the first thing which will probably happened is that you will put all your assets into a partnership, and it will do something to generate liability, and then all your assets will be lost.
Some Additional Advantages of FLPs
- Centralized Family Control -- The FLP consolidates and centralizes control of family assets. Instead of simply passing down assets to the kids, the FLP allows the assets to be kept together, and changes in family control facilitated by simply changing the directors of the general partner corporation.
- Privacy -- Control of the limited partnership is kept private, insofar as the person who acts on behalf of the general partner corporation in managing the limited partnership need not be disclosed in most circumstances. When a change of control is desired, the old managing family member simply resigns and a new managing family member takes over the job.
- Pre-Nuptial Agreements and Divorce Planning -- The FLP can be a fantastic pre-nuptial agreement insofar as the parties rights can be determined by the limited partnership agreement, and the assets can be dropped down into separate single-member LLC (the member being the partnership) managed by each spouse, so that assets are owned by both of them, but certain assets are individually managed by each of them.
- Ease of Liquidation -- Partnerships are usually much easier to wind down and dissolve than any other entity, such as trusts or partnerships.
- Minimizing Income Tax -- By placing assets into a limited partnership, and making family members paid managers of the general partner corporation, it is sometimes possible to "spread" income among some non-close family members, thus placing some income with family members in a lower tax bracket.
Some Additional Disadvantages of FLPs
- Management Costs -- Partnerships require management and increased tax filings. Partnerships should not be formed by persons who are not willing to completely separate their business and personal affairs, i.e., if you use the partnership to buy the kids' clothing, it will be seen as a sham and will not be effective. Many people form partnerships with great expectations, only to find that they can't stand the additional expense or the restrictions on what they can use the partnership for.
- Cost-Benefit -- Which brings us to an important point: Limited partnerships are not cost-beneficial for many people. Typically, and unless some pre-nuptial or other planning is done by the partnership, people who have less than $250,000 in net assets are probably better off purchasing umbrella general liability insurance policies than they are setting up a limited partnership. Probably the only limited partnership folks in this asset bracket can afford are the cheapie limited partnerships sold by the word-processor mills, but as discussed above these cheapie limit partnerships can often put you in a worse position relative to creditors than if you had no protection at all.
- Loss of Protections and Deductions -- There are some assets that you might not transfer to a limited partnership. An example is your house. If you transfer your house into the limited partnership you may have given up your homestead protection (which is very powerful in some debtor-friendly states such as Texas), and you may have also given up certain tax benefits, such as local exclusion from ad valorem taxes, or tax-free rollovers of property on sale, or even your residential mortgage interest deduction. So you have to be very careful about what you decide to transfer into the partnership, and know in advance the ramifications of what you are doing.
- Nasty Tax Traps -- There are several hidden tax traps which you can fall into if you are not careful. For instance, if nothing but securities are transferred to the partnership, then there is a serious risk that the partnership will be classified as an "investment company" and the partners may be required to pay capital gains taxes on the transfer to the partnership (Ouch!). However, if securities are but one of many types of assets being transferred to the partnership, then there probably will be no problem. Also, the transfer of certain small business stock or stock options to the partnership might cause acceleration of the recognition of capital gain, or the loss of a favorable exemption. The point is: The transfer of assets to a partnership can get complicated and there are lots of traps for the unwary and the inexperienced.
- Limited partnerships are not a fungible -- Limited partnerships can be a great tool for asset protection planning, but they are only a tool. Don't call us saying that you want to buy a limited partnership, because it may not be what you need, or you may need it but in some combination with other planning.