CAN CREDITORS BREAK DOWN THE FLP DOOR?

Today, many business owners look at wealth preservation and asset protection as key estate planning issues. As a result, the use of the family limited partnership (FLP) as a powerful estate planning and asset management tool has gained in popularity. However, one of its chief benefits— increased creditor protection—is often touted with little mention of the complications that could arise.

Taking a Closer Look

Generally, an FLP is a family asset management organization whereby a general partner manages partnership assets and limited partners, who own partnership interests, have limited liability. Once transferred to an FLP, assets that may otherwise be attractive to a creditor may now become unattractive because limited partners own partnership interests rather than the assets directly.

Under many state partnership laws (which incorporate Section 703 of the Revised Uniform Limited Partnership Act), the only remedy generally available to a creditor against a partnership interest is in the form of a “charging order” by a court. A charging order is considered a limited remedy, in that the creditor’s interest against a partner is limited to distributions of income or principal made from the partnership and not to the partnership interest itself.

Since the general partner, who is a family member, determines the timing and amount of distributions, the creditor’s ability to gain satisfaction under a judgment can effectively be blocked. The ultimate deterrent for a “judgment creditor” is that, by obtaining a charging order, the creditor risks receiving “phantom” taxable income. Ironically, the creditor may be treated as being the owner of a portion of a partnership interest for income tax purposes and must therefore pay income tax on his share of the partnership income, even though he does not receive an income distribution.

Cracks in the Wall?

While a limited partnership provides significant asset protection, the creditor protection feature of an FLP is certainly not absolute. Here are some circumstances under which the asset protection benefit might well be compromised:

Tainted Assets. If assets placed within the FLP have inherent liabilities associated with them, they could generate a liability within the family limited partnership, thereby subjecting partnership assets to the claims of a creditor.

Creditor Evasion. If a court deems the creation of the FLP was for the sole purpose of protecting assets, it may not limit the creditor’s remedy to a charging order.

Corporate General Partner. If the general partner is a corporation, a judgment creditor of that corporation may indirectly gain control of the FLP by gaining control of the corporate general partner.

State Laws. Most state partnership laws allow that an event causing the withdrawal of a sole general partner could result in the FLP being dissolved, allowing access to distributed partnership assets by a judgment creditor.

Limited Partner’s Action. Should a limited partner grant a security interest obtained under the Uniform Commercial Code to a creditor, the creditor might be able to obtain the partner’s ownership interest in the partnership.

Overly aggressive use of FLPs should not be suggested. There could be unwanted surprises for the unwary. Because the family limited partnership has become particularly popular as a tool for managing family enterprises, the use of an FLP should continue to remain attractive in possibly reducing the size of estates for tax purposes, while retaining control of the business operation.