Asset protection caveats when using family limited partnerships as an estate planning vehicle.

Recently, the estate planning community has been deluged by articles, seminars and other forms of presentations professing the benefits of family limited partnerships as the estate planning tool of the 1990s. In making this statement, practitioners are comparing them to what was considered to be the estate planning recommendation of the 1980s--the use of a living trust. Some commentators have indicated that the family limited partnership is a vehicle that should generally be used by wealthy clients, while others have concluded that the family limited partnership is not solely applicable to the wealthy, but can also be very valuable when the value of a client's estate is slightly beyond that of the unified credit equivalent amount.

Certain commentators have indicated that the family limited partnership should be considered the integral component of an estate plan after credit shelter planning and an irrevocable life insurance trust. Others advance this position further, indication that the family limited partnership could be used to provide a client with credit shelter planning (through the use of lifetime gifts of limited partnership interests) and could further be used as the vehicle to hold life insurance policies (thereby eliminating the need for irrevocable life insurance trusts).

A family limited partnership has the ability to be a very powerful estate planning tool, with a broad range of applications. It can provide a client with estate, gift and income tax benefits; ease the burden placed on a family in administering an estate plan; provide personal benefits to family members; and be used as a means of providing additonal protection in preserving a family's assets. The family limited partnership is of substantial benefit when the following client concerns exist:

* Assets have the potential of being exposed to creditors.

* Probate proceedings would make assets public record and would be costly (especially in states where probate fees are still being assessed statutorily, based on a percentage of assets).

* High rates of transfer taxes.

* Loss of control of an asset in order to meet other estate planning objectives.

These client concerns are not new ones. However, recent adverse legislative changes and judicial decisions have made it increasingly difficult to alleviate these concerns without the use of highly sophisticated estate planning techniques, which are often extremely costly and confusing to clients. While many other estate planning techniques still remain available to reduce or eliminate these client concerns, it appears that the family limited partnership may be the optimal estate planning vehicle to be used in these situations.

The family limited partnership is not without disadvantages. Most practitioners already know the benefits that could be provided by a family limited partnership, as well as the tax detriments (both transfer and income) that could result from not complying with proper valuation concepts, Subchapter K and Chapter 14 of the Internal Revenue Code. However, one of the professed major benefits of a family limited partnership--increased creditor protection--has been frequently touted, with minimal discussion of the potential problems that could result. These potential nontax problems could diminish or eliminate the family limited partnership's asset protection feature.

Assets that could otherwise be attractive to a creditor become unattractive by transferring them to a family limited partnership in exchange for general and limited interests. After the transfer, the transferor owns a partnership interest, rather than the specific assets. Most state partnership laws provide that, generally, the only remedy available to a creditor against a partnership interest is the issuance of a "charging order" by a court. A charging order is a rather limited remedy; the creditor is only entitled to reach the partner's beneficial interest in the partnership without becoming a substitute partner. Therefore, the creditor does not obtain any right to disrupt partnership operations or require that the partnership be dissolved, but merely acquires the right to receive partnership income or assets when the general partner decides to make distributions. Moreover, a creditor who obtains a charging order against a partnership interest may face the risk of receiving "phantom" taxable income from the partnership, without receiving adequate (or any) distribution of cash or property to pay the associated tax (see Rev. Rul. 77-137). However, absent other potential creditor remedies, if a charging order has been obtained by a creditor against a partner, other partners may prevent the creditor from obtaining any assets under the order by restricting their own access to partnership assets.

While a family limited partnership does provide additional creditor protection, this creditor protection is not absolute. In addition to charging orders, there are other ways in which family limited partnership assets could be attached by creditors, thereby removing any asset protection benefit.

1. The assets placed within the family limited partnership inherently have liability risks associated with them. One of these assets could generate liability inside the family limited partnership, causing partnership assets to be subject to creditors' claims.

2. The transfer into the family limited partnership is considered a fraudulent conveyance under fraudulent conveyance statutes, in effect in many states. These statutes contain provisions that allow the courts to broadly define what constitutes a "fraudulent conveyance."

3. The courts may require a principal purpose for the creation and funding of a partnership, other than for the protection of assets, and, in the absence thereof, may not limit a creditor's remedy to a charging order.

4. In addition to the "principal purpose" requirement discussed in #3, certain courts have already expanded the remedies available to a judgment creditor against limited partnership interests (Crocker National Bank v. Perroton, 208 C.A. App.3d 1 (1989); Hellman v. Anderson, 233 C.A.3d 840, 284-1 CR 830 (1991)). In these cases, the court allowed the sale of the partnership interest. Initially, Crocker required the consent of all other partners, but Hellman did not.

5. The general partner is personally liable for creditor claims against the partnership (which is why it is often advisable to provide the general partner with only the minimal interest, and/or use a corporate general partner). Also, if the general partner is a corporation, a judgment creditor or bankruptcy trustee (discussed in #9) of a controlling shareholder of the corporation may be able to obtain control of the corporate general partner, thereby indirectly obtaining control of the family limited partnership.

6. Under most state partnership laws (especially in states that have adopted the Revised Uniform Limited Partnership Act), an event causing withdrawal of the sole general partner could cause a dissolution of the family limited partnership, allowing judgment creditors to obtain partnership assets.

7. A constructive trust argument could be made, indicating that title to the assets placed into the family limited partnership never properly vested, with limited partner transferees acting as "trustees" and holding the assets for the benefit of the transferor.

8. A partner grants a creditor a security interest, which was perfected under the Uniform Commercial Code. A perfected security interest in a partnership interest allows a creditor to obtain the partner's ownership interest in the partnership.

9. A partner files for bankruptcy. In bankruptcy, a bankruptcy trustee's options with regard to family limited partnership interests are substantially greater than those of a judgment creditor. This is especially true in the bankruptcy of a general partner. (Note that the specific options available to a bankruptcy trustee are beyond the scope of this article.)

The remedies available to creditors illustrate that a family limited partnership is by no means a foolproof vehicle to achieve creditor protection. With proper drafting and implementation of a family limited partnership, exposure to certain creditor remedies may be reduced or eliminated. However, as long as the family limited partnership and its assets remain subject to the U.S. legal system, the possibility of exposure remains.

Because of what practitioners perceive as an erosion of the asset protection benefit of the family limited partnership, some practitioners are now recommending that family limited partnerships be used in conjunction with offshore trusts designed exclusively for creditor protection. While these trusts have the potential for adding significant creditor protection, they are extremely costly and not without their own drawbacks. The most important is the stability of the foreign situs and trustee, and the client's ability to maintain constant contact with the trustee in order to ensure that both the family limited partnership and trust objectives are met if creditor claims arise. Any further discussion of foreign situs trusts and the use of these trusts with family limited partnerships is beyond the scope of this article.

It should be emphasized that, although the creditor protection benefit of a family limited partnership is not absolute, this entity has the ability to provide creditor protection in certain instances and to act as a deterrent or impediment to creditors in others.

From Richard J. Mikuta, CPA, J.D., Ostrow Reisin Berk & Abrams, Ltd., Chicago, Ill.