Credit-Proofing Your Assets With a Family Limited Partnership

The limited partnership has become a foundation for protecting domestic assets because it enables an individual to maintain complete control over their assets as the general partner and indirectly owning the assets through a LP interest. When properly transferred, assets moved to the limited partnership become fully protected and are safely beyond the reach of any future creditor.

Popular consensus amongst most Asset Protection attorneys is that the limited partnership and the LLC are generally the most effective domestic entities for protecting assets, which is why they are the cornerstone for safeguarding assets within the United States.

Considerations you should be aware of when contemplating a limited partnership include:

1. Exactly how does the limited partnership protect assets?

2. How much protection does a LP provide?

Answering these questions requires an understanding of the specific rights and limitations of a partner's personal creditor when that partner's assets are protected through an interest in a LP. Generally, a creditor of a limited partner can attempt to seize only three types of assets:

1. Limited partnership interest.
2. Profits or distributions payable to the limited partner.
3. Assets previously transferred to the limited partnership by that debtor-partner.

Let's examine each of these scenarios:

1. Limited Partnership Interest Seizure: A creditor of a limited or general partner cannot seize the limited partnership interest. A judgment creditor of a limited partner can only obtain a charging order against the LP interest and the charging order gives the creditor only the right to claim profit or liquidation distributions payable to the limited partner, but no other remedy for collection or enforcement.

The court ordered charging order does not make the creditor a substitute partner in any way. Nor does it give the creditor any partnership rights (except the right to claim profits or distributions payable to the debtor-partner in the future—if any distributions are ever made). The creditor cannot sell or auction the partnership interest, vote as a limited partner, or inspect the partnership books. The creditor becomes only an assignee of the LP interest for the purposes of collecting profit distributions voted by the general partners and paid to the limited partner without any other rights.

The primary purpose of the charging order is to protect the partners that are not involved in the debts of the debtor-partner from any undue interference in the affairs of the partnership by the creditor. This benefit of the LP is distinguished from a typical corporation where a shareholder's creditors can, under certain circumstances, force the sale of the debtor-shareholder's shares. The buyer of the shares becomes a successor stockholder and inherits all of the rights of a stockholder. This key feature of the LP makes the limited partnership highly useful for safeguarding wealth.

2. Profit or Liquidation Distribution Seizure: A creditor's right to distributed profits or liquidating proceeds resulting from the debt of one partner is not a very effective remedy for the creditor because of its limitations. Partnership profits can be illusive--particularly when the LP is family-owned or the interests of the partners are closely aligned. Furthermore, the decision to distribute profits belongs exclusively to the general partner. A creditor cannot force a distribution and the limited partnership can simply defer profit distributions until a creditor holding a charging order loses patience and settles.

Conveniently, deferring distributions to avoid a creditor with a court-ordered charging order will not deprive the debtor-partner access to partnership funds because the debtor-partner is still entitled to accept loans, salaries, consulting fees or payments for other assets he may sell to the limited partnership. The debtor-partner can also divert profits to other interconnected entities that may transact business with the limited partnership, becoming a protected conduit for partnership earnings that are not subject to the charging order because they are not a distribution of profits.

It is possible to structure a limited partnership to allocate a higher percentage of profits to non-debtor partners—even if they own a smaller percentage of the partnership. A limited partner may own, for instance, 80% of the limited partnership but be entitled to only 20% of its profits, which would be the only vulnerable amount to the limited partner. Using a wide range of strategies and tactics, there are extensive ways to prevent a creditor from receiving partnership profits and making the wait extremely long and frustrating for a creditor.

The ability to frustrate a creditor is more complicated if the debtor only holds a minority interest in a LP with hundreds of investors and have an unaffiliated general partner whose interests and agenda may not parallel that of yours as a debtor-partner. Under these circumstances, if a LP generates a constant and substantial profit stream, it is possible that a creditor's charging order will very likely produce payment, in which case the debtor-partner's only option is to sell or encumber their partnership interest (or assign future partnership profits to another protected entity).

A creditor is in a superior position when the debtor-partner cannot control or influence the distribution of profits, such as when the LP includes large numbers of unrelated partners. A 2% debtor-partner who receives consistently large cash dividends will likely lose those dividends to a charging order creditor, in which case the limited partnership becomes far less advantageous as an asset shield. Despite this limitation of the LP, we frequently use a strategy that places a minority interest in another limited partnership of which the debtor is a majority partner, creating a flow of distributions from one protected entity to another, from which distributions can then be withheld. It is essential for the partnership-to-partnership arrangement to be configured and employed prior to any award by a creditor, underscoring the need for proper advance planning using a highly qualified legal advisor.

The charging order is not the best vehicle for a creditor pursuing limited partnership interests because the creditor becomes liable for the payment of taxes on partnership profits that are allocated to the debtor-partner—even if no distributions are made. In the example of a creditor holding a charging order against a limited partner with a 30% partnership interest and annual profit of $90,000 in a tax year, $30,000 is allocated to the debtor-partner who is responsible for the taxes on that amount in the year allocated. Any creditor holding a charging order would be liable for that tax even if no distributions were made and the debtor-partner would end up with tax-free retained earnings within the limited partnership.

IRS Revenue Rule 77-137 states that the tax obligation of a partnership distribution falls entirely on a charging order creditor when the creditor—not the debtor-partner—receives a K-1 distribution statement reported to the IRS. In some states a charging order creditor is prohibited from releasing the charging order without the consent of the debtor, making the charging order a highly ineffective creditor tool that frequently leads to a tax liability instead of a cash distribution.

Within legal circles there is some debate as to whether the mere holder of a charging order may be liable for the debtor's share of partnership liability because IRS Revenue Ruling 77-137 proclaims that "only an assignee of partnership interest that holds complete dominion and control over the interest would be liable for the debtor's payments on partnership liability". A well-crafted partnership agreement will authorize the general partner to transfer voting and other rights to a creditor without jeopardizing the partnership or an individual debtor's partnership interests. This careful legal strategy makes sure that the debtor's share of tax liability will properly flow to the creditor. In general, there is no statute that would prohibit a general partner from sending a K-1 to the creditor and even the presentation of a tax liability for undistributed profit acts as a threat to a creditor and mitigates the value of a charging order as an asset recovery tool.

3. Recovering Assets Transferred to the Limited Partnership. A third strategy is to induce a creditor to waive a charging order remedy and set aside prior transfers of assets from the debtor to the limited partnership. If successful, these assets would no longer be part of the partnership and would be unprotected and subject to creditor seizure, reflecting a far more threatening possibility than the presence of a charging order.

Creditors are frequently successful in recovering assets that are proven to be fraudulently transferred to a limited partnership. A creditor cannot directly claim limited partnership assets because the assets no longer belong to the debtor-partner, they are owned by the limited partnership under a tenancy-by-partnership statute. The only successful strategy that a creditor can undertake is to attempt to demonstrate prior transfer to the partnership as unlawful.

Creditors have numerous remedies at their disposal if assets are proven to be fraudulently transferred to a limited partnership (or any other party). A clear example would be the case of $100,000 owed by an individual and $70,000 in cash being transferred to a limited partnership to avoid seizure by the creditor. This could easily be established as a fraudulent transfer and the cash could be recoverable from the partnership (or any other transferee) if the limited partnership was structured in a certain way. If a husband and wife, for example, each contributed $70,000 in exchange for 50% partnership interest then a court might agree that the transfer was a fair consideration exchange because each spouse now owns 50% of a limited partnership with assets worth $140,000. Each spouse's interest is equal to the original $70,000, however if one spouse owned a disproportionately smaller partnership interest (or no interest) it could be established that part of the contribution was given away and that portion could be deemed recoverable by a current creditor.

Unfortunately, many debtors overlook this detail and quickly transfer their assets to a limited partnership for a disproportionately small partnership interest because they are attempting to foul a creditor's charging order but overlook the important factor of the creditor being obligated to pay a larger share of taxes owed on partnership profits. This case of poor Asset Protection strategy enables the creditor to successfully argue that the transfer was without fair consideration and thus fraudulent, opening the door to loss and legal complications. Even if consideration is deemed to be fair it does not guarantee that a court will not set aside a transfer if it was made in the face of present creditor. In fact, many courts rule that impairing a present creditor from collection is sufficient to constitute a fraudulent transfer — even when the consideration (the limited partnership interest) has a value that is reasonably equivalent to the value of the transferred asset.

Laws and legal opinions can vary widely between individual cases and different states and it is unwise to assume that a transfer to a limited partnership in the presence of a legitimate creditor is safe or protected. While a limited partnership provides greater protection than unprotected assets maintained in the name of a creditor, it offers much less protection than an international trust, international LLC, or another foreign structure that keeps assets beyond the reach of U.S. courts.

It is possible to physically transfer liquid assets to an international entity that is beyond the reach of U.S. jurisdiction but that is not always possible with real estate that cannot be moved, in which case the unmovable assets must be either sold/liquidated or encumbered (using liens as a debt-shield) with their liquid value safely moved to an international trust or comparably protective entity.

Still, from the debtor's position, the limited partnership shields partnership assets from all but the most determined creditor. A creditor must overcome numerous barriers before they can successfully recover assets. As a practical matter, very few creditors pursue a partnership interest or assets held by a partnership unless the claim and the corresponding assets are exceptionally large and merit the expense and effort required to attempt a recovery.

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