General Practice, Solo, and Small Firm Division The Compleat Lawyer
Winter 1997, Volume 14, No. 1 copyright American Bar Association. All rights reserved.
BY MARALEE BUTTERY VEZIE
Maralee Buttery Vezie is a lawyer at the New York office of Sonnenschein Nath & Rosenthal.
Lawyers are increasingly called upon to structure their clients' personal and business affairs so that assets will be protected from creditors. These days, the popular structures to use are limited liability partnerships, including family limited partnerships, and limited liability companies.
Clients may need creditor protection from a variety of sources, ranging from tort liability claims that could arise out of the operation of a business, to environmental liability claims, to malpractice exposure for the professional, to protection of assets from a retaliatory spouse should a divorce occur.
Limited Liability Partnerships
A limited partnership affords the limited partners two types of asset protection. First, limited partners who do not actually participate in the management of the partnership are liable for the partnership's debts only to the extent of their partnership interest. (The general partners, as well as limited partners who actively participate in the management of the partnership, remain jointly and severally liable for the partnership's debts to the extent that partnership assets are insufficient.) Second, the assets owned by the limited partnership are protected from the limited partners' own individual creditors.
The liability protection from a limited partner's own individual creditors arises from the restricted rights of a judgment creditor. A judgment creditor's sole remedy against a limited partner who does not actively manage the partnership business is to seek a charging order against that limited partner's interest. If partnership distributions are made, under a charging order the distributions attributable to a debtor/partner instead will be made to the judgment creditor. In most cases, however, a judgment creditor has no right to compel distributions or to demand that the limited partnership interest be liquidated and the liquidation proceeds distributed to the creditor.
In fact, transferring assets to a limited partnership not only makes the asset less attractive to a judgment creditor, but also may convert the asset into a liability insofar as a judgment creditor is concerned. Under a charging order, the creditor becomes an assignee of the partnership and therefore is subject to income tax on its pro rata share of the partnership income--whether or not partnership income is actually distributed. The general partner, who often is a family member, controls the timing of partnership distributions. As long as the general partner has a valid business reason for retaining partnership income, which is an easy test to satisfy, a judgment creditor may end up with no actual recovery of dollars to satisfy the debt and also with a significant income tax liability on income that has not actually been received.
These asset protection characteristics make the limited partnership an attractive vehicle to hold an investment in an operating business (other than an S corporation). In general, to protect assets from claims arising from the ownership of other assets, separate limited partnerships should be used for different categories of investments; for example, a client's portfolio of liquid securities might be transferred to one partnership, while real estate properties would be transferred to a second limited partnership (or to several separate limited partnerships if the client wants to insulate each property from possible liability claims arising on the other parcels).
Care should be taken when more than 80 percent of the value of the limited partnership's assets consists of readily marketable securities. In that situation, if the transfer diversifies the transferor's investment holdings, then the transferor must recognize gain or loss (and the limited partnership's basis in the assets is equal to their fair market value on the date of transfer). Otherwise, the general rule is that the transferor is not required to recognize gain or loss on the transfer of assets to the limited partnership (in which case, the limited partnership's basis in the assets is equal to that of the transferor).
Family Limited Partnerships
Increasingly, families are forming limited partnerships, referred to as family limited partnerships, to hold a family's assets. Such limited partnerships are structured according to the provisions of Chapter 14 of the Internal Revenue Code, specifically 2701-2704, to avoid any of the valuation penalties prescribed under that legislation. Family limited partnerships serve a number of other useful functions, such as enabling families to pool investments, obtain valuation discounts, or institute a gift-giving program.
From an asset protection standpoint, family limited partnerships are very useful because any judgment creditor is at best limited to obtaining a charging order as a remedy against the limited partners. As a result, the limited partnership interests of family members are much less attractive to any judgment creditor. The partnership structure also provides asset protection to family members in the event of a divorce or in the event of their own financial irresponsibility.
Because the general partners of a limited liability partnership remain jointly and severally liable for partnership debts, instead of having the senior family member serve as general partner in his or her individual capacity, a lawyer may recommend that a trust or a corporation serve as general partner. Doing so, however, requires the client to maintain two sets of books--one for the trust or corporate general partner and one for the partnership itself--and to prepare and file two sets of income tax returns. An alternative to the limited partnership that is becoming increasingly popular is the incorporation of a limited liability company, or LLC.
Limited Liability Companies
A limited liability company, when properly structured, is classified as a partnership for federal income tax purposes. Instead of partners, however, the limited liability company has two or more members. Any member of an LLC may participate in the management of the assets or business held in the LLC without risking loss of personal liability protection from the LLC's debts. This feature may constitute a significant advantage over the limited partnership structure. However, even properly structured LLCs, although treated as partnerships for federal income tax purposes, may be classified as corporations for state law purposes and subject to state corporate income or franchise taxes.
An LLC is a useful entity to hold a liquid portfolio, but it may be less useful if an operating business is involved. Because LLCs are not universally acceptable, and because of the variations between state LLC statutes, a business that operates in more than one state's territorial boundaries would be a poor candidate to be structured as an LLC. In addition, professionals may not be able to practice under an LLC, depending on each state's licensing requirements. If the LLC is being formed to hold a portfolio of securities, attention must be paid to whether the transfer of the assets may require the recognition of gain or loss.
Beware of Fraudulent Conveyance Rules
When using any asset protection technique, practitioners must consider the relevant fraudulent conveyance rules. A fraudulent conveyance is often found when the liability occurred prior to the transfer of assets to the separate entity. If a transfer of assets to an entity such as a limited partnership or an LLC is categorized as a fraudulent conveyance, the transfer will be void, and the assets transferred will not be protected.
Weigh the Costs
Lawyers must consider all of the start-up and continuing costs (whether tax, legal, or otherwise) involved in operating a different entity, so that these costs do not outweigh the advantages of the separate entity. An additional consideration is the client's ability to manage a detailed or more complex arrangement. A general rule of thumb is that the assets that would be transferred to the new entity should exceed $1 million, and perhaps $2 million, in value.
None of these asset protection techniques are foolproof, and all of them require meticulous care in structuring to operate effectively. Basic familiarity with the available options and issues will help lawyers address all of a client's business, financial, and estate planning needs.