In this article, we will go off on a rabbit trail. The highly litigious nature of our times is not news to you. You are aware of how ridiculous some of the huge courtroom judgments have gotten in the past decade or so.
Not only should you be concerned about saving your farm or business from the adverse effects of estate taxation, you should be likewise interested in protecting your other assets from a frivolous lawsuit in which a jury has decided to heap piles of retribution against you because of your hard work and success.
Let me clearly state that I am not criticizing just and proper awards for negligence and harm done. That's why we all have insurance. Rather, I am being critical of some of the absurd and outrageous judgments rendered in what I personally perceive to be a sue-happy society.
Consequently, we will turn our attention for a few articles to the Family Limited Partnership. Not only does it have some great opportunities for asset protection, it is also a proven vehicle to assist in estate planning through some greater life-time giving. In this column, we will talk about the asset protection nature of the limited partnership.
The term “Family Limited Partnership” (FLP) is a slang term used by planners. There is no statute anywhere that uses the term, nor does the Internal Revenue Code use it. What “Family Limited Partnership” refers to is a limited partnership formed to hold the family business or investments, with the idea being that the parents will make gifts of their limited partnership interests to their children.
It is a partnership in which there is at least one general partner and at least one limited partner. Typically, the general partner runs the operations of the business and the limited partners provide the capital (land/money/business) and are liable only to the extent of their investment — like a corporation.
The general partner has unlimited liability to third parties for the partnership's debts, not the limited partner. Their exposure is limited. If the limited partner becomes active in the management of the partnership, his/her status will be elevated to that of a general partner.
When the partnership gets sued in a lawsuit for a debt or a negligence action, the partnership itself is totally and wholly liable for any negligence or misfeasance it might have committed.
However, the limited partner can only lose his capital investment in the partnership. The general partner therefore should be a thinly capitalized corporation or limited liability company and not a person with assets.
If a plaintiff prevails in a court action, he/she can get a judgment obtaining his/her award directly from the partnership. However, if you or I are involved in a personal lawsuit and we get a judgment against us in excess of our insurance coverage, then the plaintiff can attempt to seize our personal assets.
Can they get our investment in the partnership? No — not if the lawyer has properly done his or her job in drafting the partnership document. The judgment creditor can only go to the judge and apply for a “charging order” against the limited partners interest in the partnership interest. What this means is that the general partner must use any benefits we get from the partnership to satisfy the judgment creditor's rights. The creditor does not get our ownership interest in the partnership.
Now direct your attention to one important issue you might not be thinking of. The general partner should have the right to individually allocate who gets real dollars out of the business operation, who gets appreciation, and who might get depreciation.
The general partner might also be able to determine whether or not to “retain income” and other economic benefits of the partnership for the benefit of the partnership itself instead of distributing them to the partners.
Retained earnings is a commonly used accounting and financial principle in corporations, partnerships and limited liability companies. However, in a partnership, the Internal Revenue Service does not tax the partnership itself. It taxes the partners personally.
A partnership is therefore known as a “flow-through entity.” The income flows through it to the partner so that he/she is personally liable for the tax. What about when the entity retains the income and other economic benefits earned? Yes, the partners are still liable for this even though they do not get that. This is known as Phantom Income. And taxes still have to be paid on it.
Your question now should be, “But what if I don't get the income and the judgment creditor gets it instead?” Well, now the judgment creditor gets a K-1 form from the general partner and has the pleasure of paying tax on income he/she did not actually receive. You should be asking yourself right now if this is true. The answer is yes. Now the creditor will probably back off and run for the barn. They will most often settle for the limits of the insurance policy and leave your personal assets alone if they are in a FLP.
This is a commonly used practice for asset protection. It is not right for all people and situations, however. Some lawyers don't like these partnerships because the improper construction of the document and incorrect management of the partnership can cause troubles. To this extent, they are right. But when handled properly from the beginning, the FLP can be a terrific opportunity for protecting your personal wealth from an over-zealous civil jury.
In the next article, we will continue with some valuable tax aspects of the limited partnership. Until then, God bless you and America.
Mark Tippins is an Auburn, Ala., attorney licensed in Alabama and Florida. For questions or comments, he can be contacted at [email protected] or (334) 821-3670.