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Creating a FLP to Place a Barrier between Business and Personal Assets
Editor:
Editor’s note: This case study has been adapted from PPC Tax Planning GuidePartnerships, 16th edition, by Grover A. Cleveland, James A. Keller, William D. Klein, Terry W. Lovelace, Sara S. McMurrian and Linda A. Markwood, published by Practitioners Publishing Company, Fort Worth, TX, 2002 ((800) 323-8724; www.ppcnet.com).
Facts: John Clark, age 55, recently resigned as an executive for a computer company. His net worth is approximately $10 million, $8 million of which is not exempt from creditors claims. He wants to establish a chain of gasoline superstations (i.e., gasoline stations with attached grocery stores). He plans to invest approximately $1 million of his own funds and borrow $1 million to open the first superstation.
Analysis The tax adviser first sits down with John to discuss his motives for seeking asset-protection planning. The advisers objective is to preliminarily determine that Johns desire to protect assets is not a blatant attempt to defraud creditors or further illegal activity. A detailed fraudulent-transfer analysis should be completed before implementing the chosen strategy. Transfers made with the intent to hinder creditors may be voided if challenged in court. Assuming the adviser is satisfied that asset-protection planning can be accomplished without making fraudulent transfers, he or she should begin examining the various strategies available to protect Johns assets, including purchasing insurance, retitling property to transfer the ownership of nonexempt property to other family members, and taking full advantage of the available state and Federal property exemptions (e.g., state homestead rules and Employee Retirement Income Security Act of 1974 protection of qualified retirement plan assets). More complex strategies (e.g., establishing a FLP or domestic or offshore trust) should be considered when simpler strategies are inadequate and the client has the desire and financial resources to implement such tools. Further, when evaluating appropriate strategies, the tax adviser should consider Johns risk exposure. In this case, John has substantial risk exposure, due to his new business venture, which involves the sale of a hazardous product (gasoline) to the general public. The tax adviser then addresses Johns concern that his creditors (or his childrens creditors) could somehow obtain ownership of the new entity. He notes that a FLP can be a useful vehicle for shielding assets from creditors, because transferring assets to the partnership makes them less attractive to a partners creditors. In this case, each superstation would be held in a separate corporation; the stock would be owned by the FLP. Creditors can generally only reach the partners interest in the partnership, not the partnership assets. Further, a FLP allows a high-risk client (such as a professional or small business owner) to transfer asset ownership (in the form of limited partner (LP) units) to low-risk family members, while still retaining control (as the FLPs general partner (GP)).
Protection against an LPs Creditors A FLPs asset-protection benefits may address Johns concerns. The LPs enjoy the same kind of inside-out protection available to corporate shareholders. LPs are not personally liable for the partnerships debts, except to the extent of their investment in the partnership. The partnerships assets (inside assets) are not subject to the claims of the partners creditors (so-called outside-in protection). Thus, an LPs creditor generally cannot reach the partnerships assets to satisfy a claim. In many instances, the only remedy available to an LPs creditors may be a charging order entitling the creditor to receive distributions (if distributions are made by the GP) that would otherwise go to the debtor-partner.
Protection of Partnership Assets from a GPs Creditors The GP makes the FLPs management and investment decisions, including when and whether cash distributions will be made. Note: The downside is that the GP is exposed to unlimited personal liability for partnership activities to the same extent that partners in a general partnership are liable for partnership debts. A GP who is also an LP is not sheltered from unlimited personal liability by his or her LP status. This personal liability can be managed by using a corporation or limited liability company (LLC) to hold the GP units. In most instances, a GPs creditors cannot reach the partnerships property. Instead, the creditors must settle for a charging order entitling them to distributions, if any. However, a GPs creditors can force a sale of the general partnership interest, leading to dissolution and a liquidating distribution of the FLPs property to the creditor, when:
The following strategies can prevent the exposure of partnership assets to a GPs creditors: 1. A partnership agreement provision preventing partners from pledging partnership interests as security for loans. 2. A provision stating that the assignment of a GPs interest does not terminate a GPs status as a partner. 3. A provision stating that the partnership will continue to exist on the GPs withdrawal when there is another GP to assume management responsibilities. 4. The use of a corporation or LLC with multiple shareholders or members to own the GP interest. The GPs unlimited liability can be handled by using a corporate (or LLC) GP, as opposed to an individual. For example, John and June can form a corporation that they control. The corporation can then organize the FLP and serve as the GP. If the corporation is adequately capitalized and operated as a separate entity, the Clarks can avoid personal liability for partnership debts, while retaining control over partnership assets. When the parents are in control of a corporate GP, there is a risk that a creditor with a claim against the parents will succeed in obtaining ownership of the stock, thereby gaining control over the partnership. In states that recognize tenancies by the entirety for personal property, both parents can hold title to the stock of the corporate GP as tenants by the entirety. While a creditor of both spouses would be able to gain control of the corporate GPs stock, a creditor of one parent would not be able to obtain stock ownership. The use of multiple GPs may also solve this problem. Should John or an LP face a creditor attack, it is very likely that the creditor will seek to reach his or her interest in the partnerships assets (i.e., ownership of the superstations). If a creditor threatens to go after the FLPs assets: 1. The creditor may settle on favorable terms. When confronted with the existence of the corporate GP and the FLP, and proof that the entities were established without fraudulent intent, the creditor may wish to settle its claim on terms favorable to John, particularly if the creditor thinks that its only remedy is a charging order. 2 .The creditor may pursue its case in court and receive a charging order. If the creditor doubts the GPs ability to refrain from making distributions to partners, the creditor may obtain a charging order entitling it to receive a portion of the partnership distributions (if made). Nevertheless, the creditor will be powerless to force distributions, asset sales or other measures designed to expose partnership assets to the individual partners creditors. Some cases (particularly in California) suggest that in certain situations, courts may order a sale of partnership assets or other remedies when charging orders are insufficient. Currently, this type of extraordinary relief is the exception. However, the use of a trust to own the LP interests can provide additional protection in those cases.
Conclusion The Clarks tax adviser suggests that a FLP would allow John and June to place a legal barrier between their business and personal creditors. With the help of their tax adviser and an attorney, John and June decide to incorporate the new business. Stock in the new venture will be held in a FLP. They will also form a wholly owned corporation to act as the FLPs GP. The corporate GP will be a 2% GP; initially, John and June will each be 49% LPs. Each year, they will be able to give up to the annual gift tax exclusion amount ($11,000 per parent, per donee in 2003) in LP interests to each child, without gift tax implications. By re-taining the GP interests for themselves via the corporate GP, John and June retain control over the business while transferring a portion of its value to their children (in the form of LP interests) each year. They retain total control over the operating entities, because they are transferring LP interests to their children, rather than stock (the stock remains in the FLP). The inside-out protection available to the LPs is well known and easily understood. However, the outside-in protection previously discussed is not as well known. Many clients are unaware of the special protection provided to limited partnerships (there is no equivalent protection for corporate shareholders). This outside-in protection feature of limited partnerships makes this form of doing business particularly beneficial for asset-protection purposes. |
