By Alan R. Eber

Excerpted from Asset Protection Strategies & Forms

A Family Limited Partnership (FLP) is a descriptive term used in asset protection planning for a limited partnership that is owned by family members and is drafted to contain clauses that are more beneficial to protecting assets than a more standard limited partnership.

Limited partnerships (and thus FLPs) are created by state law (a state limited partnership act, or a state version of the Uniform Limited Partnership Act).

The difference between a family limited partnership and a limited partnership is that certain asset protection provisions are specifically drafted into the FLP Agreement. These provisions enhance the FLP’s ability to withstand creditor attack.

Family limited partnerships are non-taxable (tax pass through) entities.

Characteristics of an FLP

A.    Advantages of FLPs

§9:10       General Partner Keeps Control

Even if all they own is a one percent general partner interest, an FLP allows senior family members to keep total control and management of the FLP’s assets. Thus, a person can transfer his or her estate and yet still keep control over the assets.

For this diagram, see “Figure 9-10 General Partner Keeps Control.pdf” in the “Diagrams” folder on your CD.

§9:11       Business and Tax Advantages

In addition to asset protection, FLPs:

  • Enable families to pool investments.
  • Permit partners to obtain valuation discounts.
  • Allow intra-family income shifting, so that income can be shifted away from high tax bracket family members to lower tax bracket members.
  • Allow the transfer of FLP interests more easily than transferring undivided interests in the underlying assets.
  • Reduce the size and tax value of assets, thereby permitting “leveraged gifting” and “valuation adjustments” to reduce estate and/or gift taxes.
  • Make it clear that the partners are family and outsiders are truly not wanted.

§9:12      Gift Tax Result

The retention of managerial powers as a sole general partner does not cause the transferred interests to be included in the donor’s estate or render a gift incomplete. [Priv. Ltr. Ruls. 9546007, 9546006 (extending to FLPs the rationale of United States v. Byrum, 408 U.S. 125 (1972), where the court interpreted IRS §2036 to mean that a donor’s retained right to vote a majority of shares of the stock given away did not cause them to be included in his estate, since that right was subject to a fiduciary duty to the minority stockholders).]

[For more on gift taxes, see §9:114.]

§9:13       Estate Tax Savings

An FLP can provide estate tax savings because the value of FLP interests are reduced as a result of the limitations placed on a limited partner’s ability to control the operations of the partnership.

However, special structuring is required to accomplish this. [See §§9:40 et seq., 9:101. See Strangi, 115 T.C. No. 35 November 30, 2000 (Strangi I), Estate of Strangi v. Commissioner, T.C. Memo. 2003-145 (2003) (Strangi II),Estate of Strangi v. Commissioner, No. 03-60992, (5th Cir. 2005) (Strangi III).]

[§§9:14-9:19 Reserved]

B.    The FLP as an Asset Protection Tool

§9:20       FLPs Compliment Liability Insurance

Insurance is the first line of defense against liability, and asset protection does not replace liability insurance coverage.

However, a properly asset protection designed FLP can compliment insurance coverage by providing additional protection in the event that a judgment either:

  • Exceeds the limits of insurance coverage.
  • Is not covered by the policy.

§9:21       History of the Charging Order

The means by which a judgment creditor may reach a partnership (“FLP”) interest of a judgment debtor is a charging order.

Prior to charging orders, courts used collection procedures that discouraged the use of the limited partnership format. Despite the fact that individual partners did not have title in family limited partnership property, FLP property could be seized under writs of execution and sold, resulting in compulsory dissolution and winding up of the FLP.

Things have changed! FLPs (and LLCs) now work for asset protection because of Lord Justice Lindley of the English Court of Appeal. Lord Lindley described the previous collection procedure as follows:

When a creditor obtained a judgment against a partner, the sheriff went to the partnership, seized everything, stopped the business, drove the solvent partners wild.

. . .

A more clumsy method of proceeding could hardly have grown up.

[Brown Janson & Co. v. Hutchinson & Co., 1 Q.B. 737 (1895).]

The following legislation has developed to prevent such hold up of the FLP business and the consequent injustice done the innocent partners from execution against FLP property:

  • English Partnership Act of 1890.
  • Uniform Partnership Act.
  • Uniform Limited Partnership Act (ULPA).

These statutes developed the charging order, which makes FLPs effective asset protection tools in the proper circumstances.

§9:22       Charging Orders Protect FLP Assets

Because of the charging order, the FLP can turn assets that are attractive to creditors (e.g., cash) into assets that are unattractive to creditors.

The cash becomes an unattractive asset because the judgment creditor’s remedy changes. The judgment creditor cannot execute upon cash in an FLP. Instead, the creditor gets only what the general partner decides to distribute, which is often nothing. As a result, FLP interests are much less attractive to judgment creditors.

In addition:

  • The judgment creditor’s attorney, if on a contingency fee arrangement, may need to wait years before he collects anything for his efforts.
  • The attaching creditor will have significant tax issues. [IRS Rev. Rul. 77-137; see §9:92.]

This charging order concept prevents creditors of a partner from disrupting the FLP business. It also can prevent the distribution of funds to the judgment creditor.

[For the charging order procedure, see §9:90.]

[§§9:23-9:29 Reserved]

C.    Comparison of Partner or Partnership Creditors

§9:30       General Points

A partner is not liable to creditors of the FLP. A creditor of the FLP is referred to as an “inside” liability.

An FLP is liable to its own creditors, but it is not liable to creditors of one of its partners. A creditor of a partner is referred to as an “outside” liability.

§9:31       Inside Liability (Claims Against the FLP)

An FLP provides protection to the partners from:

  • Liability from the conduct of the partnership.
  • Creditors of the partnership.

FLP creditors are entitled to all assets held by the FLP. For this reason, care must be taken to avoid mixing safe assets (stocks, bonds, and cash) with dangerous assets (apartment complexes, and businesses).

In many instances it may be advisable to create one FLP that owns several limited liability companies (LLCs). Each LLC can own one dangerous asset to avoid the domino effect that an FLP generated judgment could cause to all the assets held within that one vehicle to be forfeited.

Example:

Mark and Judy are married, have two children, and own a business and two apartment buildings. Mark’s business is high risk; Judy is a teacher. They place their business and each of their buildings into separate LLCs, and have the LLCs owned by an FLP in exchange for general and limited interests.

The general partner interests are held by each as sole and separate property. The majority of the limited partnership interests are placed into an irrevocable discretionary trust for their children.

Inside Liability: LLC Sued

The LLC that owned one of the apartment buildings is sued and a judgment exceeds the property’s liability coverage by $2 million. The LLC loses the building, but the only asset that Mark and Judy lose is that one LLC. All the other entities are unaffected.

§9:32       Outside Liabilities (Claim Against a Partner)

A creditor of a partner has no greater rights against FLP assets than the other partners.

Example:

Assume the same basic facts as in the example regarding inside liabilities (Mark and Judy place their business and each of their buildings into separate LLCs).

Outside Liability: Individual Sued

Mark is sued and suffers a $1 million judgment. Mark’s only major assets are his general and limited FLP interests.

In a jurisdiction (e.g., Nevada) that prohibits foreclosure and limits judgment creditors to charging orders, the creditor can obtain only a charging order and hope that Mark’s wife will make distributions.

However, the holder of the interests will be taxed on its share of FLP income even though the income is not distributed. [See §9:92.]

In a jurisdiction that permits foreclosure (e.g., California), the result is considerably worse than what Mark achieved using a Nevada FLP. Although foreclosure of Mark’s FLP interests will not permit the creditor to access the FLP’s assets, the judgment creditor can now sell the FLP interest on which he has the charging order. The sale will be at a discounted price because the purchaser will also not be able to do anything but wait for distributions to be made. However, if the purchaser pays $100,000 (at a bona fide sale) for an interest that is worth $1 million, then the purchaser can afford to wait, and the $1 million judgment against Mark is only reduced by $100,000 rather than $1 million.

[§§9:33-9:39 Reserved]

III.  Structuring and Funding the FLP

A.    Forming an FLP

§9:40       The FLP Must Have a Business Purpose

The FLP must have a business purpose. [See In re Turner, 335 B.R. 140, 147-48 (Bankr. N.D. Cal. 2005) (stating that an entity may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors). But see ULPA §104(b) (stating that “this Act does not require a limited partnership to have a business purpose).]

If the only purpose of the FLP is to protect assets, a court may determine that a creditor’s remedy is not limited to obtaining a charging order. [For more on charging orders, see §§9:90 et seq.]

There are multiple reasons for selecting the FLP as a planning tool, including:

  • Protecting and consolidating assets.
  • Shifting income.
  • Transferring wealth efficiently.
  • Financially educating and involving younger family members.
  • Maintaining parents’ control and lifestyle.
  • Limiting Payroll Taxes.
  • State Taxes/Income Tax Flexibility.
  • Valuation Discounts.
  • Consolidation of Assets.
  • Asset Protection-Inside & Outside of the FLP.
  • Separate Property Maintenance/Pre-Martial Planning.
  • Continuity of Management.

However, FLPs that are created solely for asset protection or to avoid known creditor claims will probably not provide asset protection.

On the other hand, FLPs that are created for valid business purposes, and that carry out those purposes in actual operation, should enjoy the ancillary benefit of asset protection.

§9:41       Filing the Certificate of Limited Partnership

An FLP is formed when a Certificate of Limited Partnership is filed in the Office of the Secretary of State of the appropriate state. [ULPA §201 (2001).]

§9:42       Maintain the FLP’s Separate Status

Just as a corporation must be operated as an entity separate and apart from its owners to prevent a creditor from “piercing the corporate veil,” an FLP also must be operated separate and apart from its partners to prevent a court or the IRS from discarding it.

Partners should use FLP assets only under a rental or lease arrangement.

All filings and registrations must be undertaken properly, a written partnership agreement entered into, tax returns filed, and the assets of the FLP must not be commingled or treated as if they are assets of the general partner.

[§§9:43-9:49 Reserved]

B.    Identifying the Partners

§9:50       Possible Partners

Any of the following may be a partner of an FLP: individuals, corporations, LLCs, custodianships for children, trusts, or other partnerships. [See ULPA 102(14) (definition of person).]

Flexibility of who may be a partner of an FLP is quite unrestricted when you compare it with who may be a shareholder of an S Corporation. All S corporation stockholders must be individuals, estates, specifically described organizations or trusts. [See instructions for IRS Form 2553 regarding who may elect to be an S corporation.]

§9:51       General Partners

The general partner manages the business of the FLP, its investments, and its day-to-day activities.

Although limited partners are not responsible for partnership liabilities, general partners of an FLP are liable for partnership debts. [ULPA §303 (2001) (limited partners); ULPA §§404-405 (2001) (general partners).]

Individuals as General Partners

An individual general partner is personally responsible for partnership liabilities. [ULPA §§404-405 (2001).]

Therefore, if the FLP is funded with liability producing assets, it is advisable to use a trust or LLC as a general partner rather than an individual family member.

Corporations as General Partners

A creditor of a shareholder who gains control of 51% of the corporate stock would control the corporation, and through the corporation, the FLP.

Therefore, great caution must be exercised when choosing a corporate general partner.

Children’s Trusts as General Partners

A children’s trust should rarely be used as a general partner for the following reasons:

  • The trust, and not Mom and Dad, is entitled to the general partner fee.
  • The trust, not Mom and Dad, can borrow from the FLP.
  • The trustee would owe a fiduciary duty to the children, and not to mom and dad.

§9:52       Provide for a Successor General Partner

A general partner is dissociated from the FLP in the event of either:

  • Bankruptcy [ULPA §603(6) (2001)], or
  • Death. [ULPA §603(7)(2001). See also ULPA §604(b)(2) (2001).]

Therefore, the FLP should provide for a successor general partner in case the general partner dies, becomes bankrupt or has his or her partnership interest charged or foreclosed upon by creditors.

Limited partners are dissociated on death [ULPA §601(6)] but not on bankruptcy. [See comments to ULPA §601 (2001).]

§9:53       Trusts as Partners

A donor may give a limited partnership interest to an irrevocable protective trust established for the benefit of family members.

Since the interests given away are limited partnership interests, the donor maintains control. That is, the donor might exercise some control over the interest given away by appointing a friendly trustee or using a trustee and a protector.

§9:54       Minor’s Interest

If a client desires to make a minor a partner, then use either a guardian or a trust. [See Uniform Gifts to Minors Act; Uniform Transfers to Minors Act; IRC §2503(b) & (c).]

[§§9:55-9:59 Reserved]

C.    Drafting for Asset Protection

§9:60       General Points

The FLP should provide for the following:

  • Super majority required for certain actions.
  • 100% required to permit withdrawal. [See §9:61.]
  • Limit right to demand distribution. [See §9:61.]
  • Limit transferability of interests.
  • Do not allow assignee as automatic substitute partner. [See §9:63.]
  • Use an entity (perhaps an LLC) as the general partner to prevent any partner having personal liability. [See §9:51.]
  • Authorize mandatory capital contributions. [See §9:64.]
  • Permit the redemption of interests seized by creditors (foreclosure) or subject to a charging order. [See §9:65.]

§9:61       Restriction on Withdrawal or Distribution of Capital

If the FLP agreement does not specify the time when partnership capital is to be withdrawn, partners may not withdraw their capital. [ULPA §505 (2001).]

The following clause may be used to restrict the return of capital:

Notwithstanding any other provision of this agreement, no Partner shall have the right to demand or to receive the return of all or any portion of such Partner’s Capital Account, Partnership Interest, or of such Partner’s Capital Contribution.

§9:62       Distributions Only at Discretion of General Partners

One of the advantages of the charging order procedure is the income tax consequence to the creditor who obtains a charging order. The creditor may find that he does not receive an income distribution, but is required to pay income taxes on undistributed profits. [See §9:92.]

To obtain this result, provide in the FLP agreement as follows:

Earnings shall be distributed at least annually, except those funds which, at the sole discretion of the general partners, are reasonably reserved for the conduct of the FLP business.

Since income may be held in the FLP at the sole discretion of the general partners, distributions can be stopped when there is a creditor with a charging order.

Caveat:

Care must be exercised not to be in a situation where a client cannot pay his living expenses or taxes. If no distributions are made to one partner, unless the FLP Agreement has otherwise provided, no distributions can be made to any partner. It has been suggested that as a contract, the partners could agree that to the extent a charging order is affected, the allocation to those interests would be held in a special account fully vested in the charged partner. This would allow the non-charged partners to get their fair share and the charged partner to have his share in a vested account. In addition, the FLP agreement may provide for a “guaranteed salary” to the less vulnerable general partner and by approval of the majority of the partners, this “guaranteed salary” may be increased or decreased.

§9:63       Prohibit Assignee From Becoming a Substituted Partner

Limited partners may freely assign their interests. However, it should be stated that absent unanimous consent of all other partners, the assignee is merely an assignee and not a substituted limited partner. [ULPA §702 (2001).]

Draft the FLP so that an assignee cannot become a substituted partner without the unanimous consent of all of the partners, as follows:

No person, corporation, trust, limited liability company, or other legal entity shall be admitted as an additional Limited Partner without the unanimous consent of all of the Partners.

This prevents a creditor from becoming anything more than an assignee. [See §9:04.]

§9:64       Have Authority for a Mandatory Capital Contribution

Give the general partner the authority to require a mandatory capital contribution, with the provision that if a partner fails to proportionately contribute, then the percentage ownership of that non-contributing partner is reduced.

To obtain this result, provide in the FLP agreement as follows:

The general partner shall have the power to require the partners or assignees of partnership interests to contribute additional capital when additional capital is needed to pay.

This provision will apply to a judgment creditor who obtains a charging order, so that the creditor’s ownership percentage may be reduced.

§9:65       Permit the Redemption of Seized Interests

A partnership is a contract between people. If they do not want an outsider among them, they can all decide that if an outsider is able to charge the interests or become an assignee, the partnership has the right to buy that person out on the terms stated in the partnership agreement.

To obtain this result, provide in the FLP agreement as follows:

In order to reduce a burden upon resources, the partnership has the option to pay anyone who has either charged a partnership interest or become an assignee its promissory note, payable in 360 monthly installments at market interest.

§9:66       Employment Agreement for a General Partner

If the FLP has an individual general partner, draft an employment agreement for the general partner to manage the FLP’s assets.

Then, even if the individual is removed as a general partner, he or she will still maintain an income stream.

Form:

9-1 Employment Agreement for an FLP

§9:67       General Partner Interest Held as Separate Property

Be careful when one of the spouse/general partners is high-risk. Make sure that their FLP general partner interests are held as sole and separate property and not community property.

This way, if one spouse/partner suffers bankruptcy, then the other is not dragged in and the bankruptcy trustee cannot force the dissolution of the FLP.

§9:68       Provide for Several Limited Partners

Provide that several “innocent” partners (aside from the initial husband and wife) be made limited partners of the FLP.

The risk if the only members of the LLC are debtors is that the charging order limitation no longer serves any purpose, and a debtor may become a “substituted” member. [See In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo.2003) (bankruptcy trustee became a substituted member).]

[For an explanation of a “substituted” member, see §9:04.]

However, the “innocent” partners should be real partners, and not merely nominal ones. [See In re Ashley Albright, 291 B.R. 538 (Bankr. D. Colo. 2003) (noting in dicta that the law does not create an asset shelter for clever debtors because to the extent a debtor intends to hinder creditors through a multi-member LLC with “peppercorn” co-members, bankruptcy avoidance provisions and fraudulent transfer law would provide creditors with recourse).]

§9:69       Prohibit Holding General Partner Liable

The FLP agreement should clearly state that partners will only look to FLP assets for distributions of cash, and repayment of contributions and loans.

Thus, no partner shall have the right to hold general partners liable upon dissolution of the FLP for these items.

This prevents a court from holding general partners liable to limited partners for a financial return on their investment.

To obtain this result, provide in the FLP agreement as follows:

The partners shall look solely to partnership assets for the return of their capital contributions. If this is not sufficient, the partners shall have no recourse therefore against the partnership or any other partners.

§9:70       Minimize the Ability to Dissolve or Liquidate

An FLP can be dissolved. [See ULPA §801(2001).]

For tax purposes, an FLP will be terminated if no part of any business, financial operation, or venture of the FLP continues to be carried on by any of its partners. [IRC §708(b)(1)(A).]

However, to the strictest degree permitted by state law, the FLP agreement should not permit a partner to dissolve or liquidate the FLP. The partnership should provide for a long life that can be extended.

If partners can dissolve the FLP, then a creditor of a partner or a trustee in bankruptcy will be able to dissolve the FLP.

To minimize the ability to dissolve, provide in the FLP agreement as follows:

No partner shall have the right to institute any proceedings to, or to demand or require the liquidation or dissolution of, the partnership.

[§§9:71-9:79 Reserved]

D.    Funding the FLP

§9:80       General Points

Upon forming an FLP, the partners (generally the husband and wife or entities controlled by them) contribute investment assets to the FLP.

If asset protection of risky assets (e.g., rental property) is desired, the family should form a limited liability company to own the property. The FLP can then be the major (or even sole) member of the LLC. [For more on LLCs, see Chapter 10, Limited Liability Companies.]

Only “safe assets” are typically held inside an FLP.

FLPs can be funded by either:

  • Making gifts of cash or other assets. The gift recipient can then contribute the cash to the FLP for FLP interests.
  • Gifting cash directly.

§9:81       Appropriate and Inappropriate Assets

Business assets

FLPs should be funded with business and investment, not personal assets.

Real Property

Real Property is usually transferred to an FLP by either:

  • A general Warranty Deed (in mortgage states).
  • A Grant Deed (in deed of trust states).

A quitclaim is not advised because it may make it more difficult for the FLP to transfer the property.

Since only business or investment property should be placed into the FLP, FLPs should not be used to protect a personal residence. If a contributor continues to use the home, then he or she must pay rent to the FLP. Rent is not tax-deductible to the client, but the income to the FLP is taxable. This FLP income then is taxable to the FLP partners through the K-1 according to their percentage ownership.

In addition, putting a personal residence into an FLP will cause the loss of the homestead exemption and loss of the $250,000 capital gains exclusion.

Caution:

Use caution in transferring real property to an FLP. Areas of special concern are:

•    Due on sale clauses.

•    Contaminated property.

•    In California, Proposition 13 concerns.

Personal Business Property

The sale of tangible personal property should be documented by a bill of sale and the FLP should pay for insurance on these items.

Often the FLP will then lease the equipment to the operating business. Since the equipment is only leased by the operating business, if the operating business loses a major lawsuit, the equipment is not lost.

Life Insurance

[For a discussion of having an FLP own insurance, see Chapter 11, Insurance.]

Personal Use Property

Personal use property should not be held by an FLP unless the donor pays rent.

“Controlled Company” Stock

A transfer of closely held stock to an FLP, where the transferor retains the right to vote the stock, will cause the stock to be included in the transferor’s estate at death. [See IRC §2036(b) (providing that the retention of the right to vote shares of stock of a controlled corporation is a retention of the enjoyment of transferred property, and that a “controlled corporation” is a corporation that the decedent had the right to vote stock possessing at least 20% of the total voting power).]

This can be a problem because senior family members like the ability that FLPs give them to control the FLP while making gifts of FLP interests to family members.

The rule applies if voting shares of a closely held business are transferred to an FLP of which the transferor is a general partner. [See TAM 199938005 (IRS concluded that §2036(b) applied to bring the stock back into the decedent’s estate).]

However, this issue can be overcome by inserting a clause into the FLP agreement requiring the general partner to permit the limited partners to vote the stock of the controlled corporation in proportion to the percentage they own in the FLP, as follows:

If the partnership holds stock in any IRC §2036(b)(2) controlled corporation, the general partner shall notify all partners of their right to vote the stock of such corporation in proportion to the percentage owned.

§9:82       FLP Investment Company Rules

Generally, no capital gain is recognized when an individual transfers appreciated assets to an FLP in return for an FLP interest. [IRC §721(a).] However, this general rule does not apply when the FLP is deemed an investment company. [IRC §721(b).]

The investment company rules were designed to prevent individuals from diversifying their holdings without paying capital gains tax.

If you plan to fund an FLP with marketable securities, be careful not to inadvertently trigger portfolio gains by violating the investment company rules. If you transfer a portfolio into the FLP and your holdings become diversified as a result, you may be required to include the gain on the investments in your income even though the partnership has not sold any of them.

Example:

A owns 100 shares of ABC, Inc., and B owns 100 shares of XYZ, Inc. Each has a small tax basis in his shares and would like to diversify his holdings to reduce risk, but doesn’t want to sell because capital gains tax would be owed. Instead, they form an FLP and contribute their respective shares to it. As a result, each has diversified as each now owns a 50% interest in the FLP (assuming the value of the contributed shares was equal). This technique could have been used to get around the capital gains tax rules were it not for the investment company rules.

A transfer of property to an FLP is considered a transfer to an investment company if both:

•      The transfer results in diversification of the transferors’ interests.

•      More than 80% of the value of the FLP’s assets (excluding cash and nonconvertible debt obligations) are held for investment and are “readily marketable stocks or securities.”

[IRC §721; Treas. Reg. §1.351-1(c)(1)(i).]

§9:83       Liabilities in Excess of Basis

Gain may be triggered if the liabilities assumed by the FLP upon transfer exceed the basis of the property transferred. [IRC §752(b).]

A partner recognizes gain on the distribution of property from an FLP to the extent that money distributed (including marketable securities and any reduction in his share of FLP debt), exceeds his basis in his FLP interest. [IRC §731(a)(1).]

[§§9:84-9:89 Reserved]

IV.  Effect of a Charging Order

§9:90       The Charging Order Procedure

Assets that would otherwise be attractive to creditors are rendered unattractive by transferring them to an FLP in exchange for interests therein. Following the transfers, the transferor owns interests in the FLP rather than the transferred assets.

A judgment creditor’s remedy against a partner of an FLP is to obtain a charging order. The charging order directs the FLP that all distributions that would have gone to the debtor-partner must instead go to the creditor. After the charging order is issued, the debtor-partner remains a partner but is not entitled to receive distributions or liquidating proceeds until the order is satisfied. Instead, the FPL must deliver to the creditor any money or property that would otherwise be distributed to the debtor-partner.

However, if the FLP agreement gives the general partner discretion as to when and how much to distribute to the partners, the general partner may decide not to make distributions when a partner has creditor problems. Or he may not distribute to that one partner. [See §9:62.]

If there are no distributions, then the creditor with the charging order gets nothing from the FLP.

The general partner does not owe a duty to the holder of a charging order because there is no fiduciary relationship between them. The holder of the order is a mere assignee and has not been substituted into the partnership. [See Kellis v. Ring,92Cal. App. 3d 854, 859-860, 155 Cal. Rptr. 297 (1979) (assignee cannot bring an action for breach of fiduciary duty).]

Most FLP agreements provide that a creditor of a partner does not have the right to:

  • Become a substituted partner in place of the judgment debtor.
  • Seize assets of the FLP.
  • Compel the FLP to liquidate and distribute assets.
  • Exercise power over or possession of any specific partnership property.
  • Demand that money or property be distributed from the partnership to the creditor or any other partners.

However, for income tax purposes, the holder of a charging order is treated as a partner. [See §9:92.]

§9:91       ULPA Provisions Regarding Creditors’ Remedies

The operative provisions for FLPs emanate from the Uniform Limited Partnership Act (ULPA).

The key ULPA provisions regarding the procedure for creditor remedies are as follows:

  • A partnership interest is personal property. [ULPA §701.]
  • A judgment creditor of a partner may obtain a charging order, charging the partner’s FLP interest. However, the judgment creditor has only the rights of an assignee. [ULPA §703(a).]
  • An assignee is entitled to receive distributions to which the assignor would be entitled, but is not entitled to participate in the conduct of the partnership. [ULPA §702(a)&(b).]
  • Only a partner can seek judicial dissolution. [ULPA §§801, 802.] Since an assignee is not a partner, an assignee cannot cause a liquidation of the FLP.

The FLP also provides that a court may order a foreclosure upon the interest subject to the charging order at any time. The purchaser at the foreclosure sale has the rights of a transferee. [ULPA §703(b).] However, some states have not enacted the foreclosure procedure. [See §9:95.]

§9:92       Taxation of “Charging” Creditor

Although a creditor with a charging order may get no money, he may get something that he does not want: an income tax liability.

Although for state law purposes a creditor is not recognized as a substituted partner, for federal income tax purposes a judgment creditor with a charging order is treated as a substituted partner in place of the debtor. [Rev. Rul. 77-137.]

As a result, a judgment creditor of an FLP has the tax consequences resulting from ownership without the capacity to force either the dissolution of the partnership, or distributions from it.

FLP profits are passed through to the partners for income tax recognition on the partners’ individual income tax returns. However, FLP agreements can be drafted to give the general partner complete discretion as to whether the cash that generated the profit is passed through. If that cash is not distributed, the partners still recognize taxable income but do not have a cash distribution to pay the tax.

This concept of “phantom income” enhances the asset protection feature of the FLP because the creditor is taxed but receives no income. This has been called the “K-0 by K-1” (the K-1 is the IRS form that tells the “charging” creditor the proportionate amount of taxable income on which he needs to pay tax).

Example:

Assume that an FLP has $100,000 of taxable income in a tax year. If a judgment creditor has charged a 50% partner and the FLP does not distribute cash, the judgment creditor will have $50,000 of phantom income on which he must pay income tax. This potential phantom income problem can deter many creditors from obtaining a charging order.

On the other hand, if there is a distribution so that the creditor receives income from the FLP, then the income the creditor receives reduces the amount of the debtor’s debt and the debtor has paid his debt without paying tax because the tax was levied on the creditor. [Rev. Rul. 70-195, 1970-1 CB 265 (payments made to creditors of taxpayer included in taxable income).]

§9:93       Charging Orders Make It Difficult for Creditors

For a creditor to collect from a debtor who has assets in an FLP, the creditor must:

  • First, litigate and obtain a judgment against the debtor partner.
  • Then, obtain a charging order from the court.
  • Then, have a receiver appointed to receive distributions from the FLP.
  • Finally, if no distributions are forthcoming, apply to the court to foreclose on the debtor partner’s interest.

Even when the process is completed, the creditor still is not able to attach partnership assets and may find that he is being taxed on income he may never receive.

§9:94       Disadvantages of Charging Orders

A charging order may be onerous to the judgment debtor and the other partners.

In addition to directing that the FLP must pay the debtor’s share of any and all distributions to the creditor, the charging order may require that the FLP:

  • Is prohibited from making loans to any partner or anyone else.
  • Is prohibited from making capital acquisitions without Court approval.
  • Is prohibited from entering into or consummating any sale or encumbrance of any interest without Court approval.

§9:95       States That Limit Creditors to Charging Orders

The following states limit creditors to a charging order as their sole remedy against assets held in an FLP. That is, foreclosure is not allowed in:

  • Alaska
  • Arizona
  • Delaware
  • Florida
  • Minnesota
  • Nevada
  • New Jersey
  • Oklahoma
  • Virginia
  • Wyoming

§9:96       Erosion of Charging Order Protection

There is a trend by courts to allow for judicial foreclosure of a charging order. Judicial foreclosure permits a judgment creditor with a charging order to sell his “assignee” interest. This creates a means by which the judgment creditor can at least partially satisfy his debt.

Although judicial foreclosure does not create rights in the purchaser of the assignee interest to participate in the FLP’s management, it does create significant asset protection issues:

  • The judgment creditor is less likely to enter into negotiations with the debtor if he has the potential to receive a larger payoff via judicial foreclosure sale.
  • The interest will likely be sold at a considerable discount, the debtor will realize less than the asset was worth, meaning a substantial portion of the judgment indebtedness could remain post-sale.
  • The client may be in the uncomfortable position of having to negotiate to re-purchase the FLP interest that was lost.
  • The purchaser will have the right to receive distributions until the FLP is dissolved, whereas the original charging order granted the creditor solely the right to receive distributions until it was satisfied.

In California, a judgment debtor’s interest in an FLP may be foreclosed upon and sold if the foreclosure does not unduly interfere with the partnership business. [Hellman v. Anderson, 233 Cal. App. 3d 840 (1991).] In Hellman, the court concluded that foreclosure would not be allowed if it would cause a partner with essential managerial skills to abandon the partnership. However, it would be allowed if it would have no appreciable effect on the conduct of partnership business. The effect of foreclosure on the partnership needs be evaluated on a case-by-case basis.

And a bankruptcy court has held that the charging order limitation serves no purpose with a single member LLC because there are no non-debtor members to protect. The court thus allowed the bankruptcy trustee to cause the LLC to sell its assets. [In re Ashley Albright, 291 B.R. 538 (2003). However, the Court stated that the result would have been different if there were other non-debtor members in the LLC.

Caveat:

The law regarding charging orders is evolving, and there is a definite trend toward allowing judicial foreclosures of charging orders.

Furthermore, In re Ashley Albright may have opened the door to penetration of multi-member FLPs where “there are no non-debtor members to protect.” The next case may very well be an FLP where the only partners/members are a husband and wife.


Alan R. Eber is a pioneer in the asset protection field and a highly sought after speaker on estate and wealth planning and protection.  Since 1974, Mr. Eber has assisted clients in establishing a wide variety of wealth preservation structures. Currently, Mr. Eber is presenting seminars on Advanced Asset Protection and Techniques and Domestic and International Trusts for the National Business Institute (NBI), the Lorman Group, and numerous other groups.  He is the author of Asset Protection Strategies & Forms, from which this article is excerpted.