Creditor Protection and FLPs

The family limited partnership (FLP) has been touted as a powerful tool for estate planning and for managing and protecting family wealth. One of its major benefits— increased creditor protection—has been emphasized with, perhaps, too little attention given to the potential complications that could arise.

In theory, assets that may otherwise be attractive to a creditor may become unattractive once transferred to an FLP. After the transfer, the limited partners own partnership interests rather than the specific assets themselves.

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.

Consequently, the creditor does not obtain any right to influence the operation of the partnership. Furthermore, 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. 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 or she does not receive an income distribution.

Not So Fast. . .

While this mechanism does provide significant asset protection, it would be unrealistic to think the creditor protection feature of an FLP is absolute. Here are some circumstances under which the asset protection benefit could be compromised:

o 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 creditors.

o 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.

o 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.

o 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.

o Should a limited partner grant a security interest obtained under the Uniform Commercial Code to a creditor, the creditor could obtain the partner’s ownership interest in the partnership.

The family limited partnership has become particularly popular as a tool for managing family enterprises. An estate owner can give away limited partnership shares, possibly reducing the size of his or her estate for estate tax purposes, while retaining control of the operation of the business. However, the overly aggressive use of FLPs could lead to undesirable results that may potentially undermine an individual’s overall planning objectives.

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