Creating a FLP to place a barrier between business and personal assets.

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.

John wants to protect his (1) personal assets from liabilities resulting from the superstations' operation and (2) newly formed business venture from potential claims of personal creditors. While neither John's wife, June, nor their two children (ages 25 and 28) will be officers or employees of the business, the couple Wants the children to own the business someday. They want to start transferring ownership of the business to the children, yet retain control of the business's operations. Issue: Can John use a family limited partnership (FLP) to place a barrier between his personal assets and his newly formed (and somewhat risky) business venture?

Analysis

The tax adviser first sits down with John to discuss his motives for seeking asset-protection planning. The adviser's objective is to preliminarily determine that John's 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 John's 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 John's 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 John's concern that his creditors (or his children's 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 partner's 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 partner's 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 FLP's general partner (GP)).

Protection against an LP's Creditors

A FLP's asset-protection benefits may address John's concerns. The LPs enjoy the same kind of inside-out protection available to corporate shareholders. LPs are not personally liable for the partnership's debts, except to the extent of their investment in the partnership.

The partnership's assets (inside assets) are not subject to the claims of the partners' creditors (so-called "outside-in" protection).Thus, an LP's creditor generally cannot reach the partnership's assets to satisfy a claim. In many instances, the only remedy available to an LP's 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 GP's Creditors

The GP makes the FLP's 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 GP's creditors cannot reach the partnership's property. Instead, the creditors must settle for a charging order entitling them to distributions, if any. However, a GP's creditors can force a sale of the general partnership interest, leading to dissolution and a liquidating distribution of the FLP's property to the creditor, when:

* The GP has pledged the partnership interest to the creditor.

* The creditor obtains a charging order, demonstrates to a court it is an insufficient remedy and the court orders a foreclosure sale.

* The partnership is determined to be a sham (i.e., it lacks a business purpose) or the transfer of assets to the partnership is successfully challenged by a creditor on fraudulent--transfer grounds.

The following strategies can prevent the exposure of partnership assets to a GP's 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 GP's interest does not terminate a GP's status as a partner.

3. A provision stating that the partnership will continue to exist on the GP's 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 GP's 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 GE 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 GP's 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 partnership's assets (i.e., ownership of the superstations). If a creditor threatens to go after the FLP's 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 GP's 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 FLP's 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 retaining 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.

Editor's note: This case study has been adapted from "PPC Tax Planning Guide--Partnerships," 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 ([phone]; www.ppcnet.com).

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Potomac, MD