LEGAL GUIDE
Written by attorney Sebastian Gibson | May 22, 2010

The Advantages of Family Limited Partnerships for Asset Protection in the U.S.

What are family limited partnerships and how do they protect a person's assets? A family limited partnership is an incredibly useful asset protection tool used by asset protection lawyers. To create a family limited partnership, an operating agreement must be drafted by an experienced attorney. U.S. taxpayers without claims against them, pending litigation or judgments in U.S. courts can seek to protect their assets by a number of domestic actions, such as the creation of a family limited partnership in states such as Nevada or Delaware where the protection they offer is strong or if they don't mind moving their homes, by purchasing and homesteading expensive homes in states such as Florida and Texas. For most people, however, moving to Texas or Florida is not a viable option. Faced to choose from other options, while offshore asset protection typically requires having to give up control of a person's assets to a foreign trustee a person has never met before in their life, domestic asset protection offers both the advantages and disadvantages of keeping one's wealth in the U.S. where a person has greater control. The downside is, assets are also a more attractive a target to one's future creditors or claimants when they are on American shores. Still, the advantage of the primary domestic asset protection vehicle, family limited partnerships, are many. One of the primary advantages is, if the family limited partnership is set up correctly in certain states, is that a creditor can only obtain a charging order, that is, the right to get a distribution if one is made in the future, instead of an order to sell the debtor's ownership right. It can also be possible to still be paid money from the partnership in salary that avoids a charging order. Compared to an irrevocable trust which cannot be amended, a family limited partnership is much more flexible. If all of the partners in the family limited partnership (the family members) agree, the partnership agreement can be amended and even terminated. One of the primary advantages of a family limited partnership is that the senior family members can retain total control of and thus manage the partnership assets even as they transfer interests in their assets to their junior family members. Sometimes a child's distribution from a family limited partnership is made to a spendthrift trust. Such trusts do not allow a creditor of a beneficiary to attach the beneficiary's interests. If you're already being sued or you think you are about to be served with a lawsuit, it's already too late to utilize a family limited partnership to protect your assets. A transfer of assets to a family limited partnership created for the purpose of protecting assets from existing creditors can be viewed by a court as a fraudulent conveyance or transfer. Because of the possibility of a creditors bringing a suit against a family limited partnership on the basis of allegations there was a fraudulent conveyance or fraudulent transfer of assets, a family limited partnership should only be considered where there is no pending litigation. There should ideally be no claims the asset holder is aware of and the family limited partnership should be created only as part of a comprehensive estate plan which includes a trust and a will. Family limited partnerships are not bulletproof, contrary to what some would have you believe on the internet. In fact they are being attacked with greater frequency. If an individual has a number of investment properties or businesses, a separate family limited partnership needs to be set up for each of them. The higher the risk involved with an asset (risk, being the likelihood of lawsuits) the more important it is to be segregated into its own family limited partnership. A family limited partnership can even be attacked if the individual does not have charging order protection in the jurisdiction of their domicile and creates a Family limited partnership in a jurisdiction in which that person has no nexus or ties. If the formalities of the family limited partnership have not been adhered to such as holding meetings in accordance with what the operating agreement provides, keeping good accounting records and treating the Family limited partnership as a separate entity and not commingling Family limited partnership funds with personal funds, the family limited partnership can fall apart under such scrutiny by a court of law. An individual should not transfer all of their assets into a family limited partnership to prevent it from appearing that the family limited partnership has been utilized for purposes of creditor avoidance or to accomplish a fraudulent transfer. The mechanics of a family limited partnership are these. Essentially, it is a partnership between family members with general and limited partners but with some differences. The parents are the general partners, the children are the limited partners. The general partners make all the partnership decisions, even though they own a small minority of the interest in the partnership. The children, or limited partners have no decision making authority whatsoever. The general partners are in complete control, as they should be. The selling point of family limited partnerships for the past few years has been that a creditor who sues a general partner and obtains a judgement is only entitled to a charging order entitling that creditor to any distributions made to that general partner. Even if no distributions are made, the judgement creditor has a tax obligation on any income that should be distributed to the general partner as indicated on the yearly Schedule K-1 form. In jurisdictions where a Family limited partnership limits a creditor's rights to a charging order that entitles the creditor to claim distributed profits, the benefit to a creditor can be elusive. A creditor with a large judgment may have a long wait for his or her judgment to be satisfied. If the distributions of the debtor-partner go into another limited partnership where distributions are withheld, the creditor obtains nothing. A creditor's better choice of remedies is often to allege a fraudulent transfer took place, i.e. that the family limited partnership general partner transferred his assets to the Family limited partnership to defeat the claims of a known creditor. The creditor's claim has even more credence when a general partner receives a disproportionately small partnership interest for his or her contribution. For this reason, assets should not be transferred to a domestic family limited partnership when creditor claims are known or suspected. If a Family limited partnership provides the general partner with discretion as to whether or not to make a distribution to the partners or just to one partner, a creditor with a charging order will get nothing from the Family limited partnership. There is no fiduciary relationship between the general partner and a creditor and thus no obligation to make a distribution. While the primary focus of asset protection is to help an individual keep their assets you have by making them less vulnerable to attachment by future litigants and creditors, sometimes a good asset protection device also produces tax savings. So it is with family limited partnerships. When the assets are gifted to the parents' children, the IRS will generally allow a reduction in the value of the assets due to the fact that a limited interest in a family partnership for which there is no ready market does not have the same value as a proportionate interest in an actual asset. A further tax savings results when distributions are made to children who are in a much lower tax bracket usually than the parents. Family limited partnerships are flow through devices where tax is payable only by the ultimate recipient of the income, in this case, the children who may own as much of the interest in the family limited partnership as the general partners wish, and the general partners owning as little as they wish, though with some small interest so they remain general partners. This is called income spreading. A Family limited partnership can also pay a salary to the general partners for their management of the Family limited partnership with pre-tax dollars and pay that salary to a retirement plan of the general partners and receive a tax deduction for the contribution. If the estate of the general partners would otherwise have required the payment of estate taxes upon the death of the parents, the use of the family limited partnership may eliminate some of the estate taxes that otherwise would have been required to be paid. Income tax will also have been reduced by the general partners on the income they would have received had they not set up the Family limited partnership. A drawback of the family limited partnership is that when the assets are eventually received by the children in the family, they will be at their original basis rather than at a stepped-up basis. If the children ever sell the assets, there will be capital gains tax on the increased value of those assets. But those children having inherited all their parents assets without the payment of any estate tax to the IRS should not complain. Family Limited Partnerships will still require some pre-planning by the parent owners of a family business such as who, among the family members should be the eventual owner of the business, or, if the family will continue to jointly share the business, who will be the manager, how will disputes will be resolved, and who will be employed by the business. Additionally, family limited partnerships are expensive. There is the initial start up fee, annual taxes and annual tax returns.

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