Family Limited Partnership

Efficacy of Family Limited Partnerships in California: A Case Study

The Family Limited Partnership (FLP) is probably the most beneficial structure available for wealth preservation via asset protection, estate planning and tax minimization. Although you “can’t take it with you,” by placing your assets into FLPs you can legally and successfully protect everything you own from attack by creditors and from erosion by exorbitant taxes.

In order to illustrate the efficacy of Family Limited Partnerships from an asset protection, estate planning and tax minimization point of view, consider the case of “Dr. Franklin,” a fictitious character derived from actual client situations. [Although, for illustration purposes, we have created a hypothetical physician, the principles discussed herein apply equally to all professionals and, indeed, to all individuals who have accumulated significant wealth.]

Dr. Franklin is a successful physician in San Diego, California. He is approximately 50 years old, is married with three teen-aged children, and is chief of surgery at a major hospital. Dr. Franklin’ estate is worth approximately five million dollars.

In addition to his surgery practice, Dr. Franklin owns his home, as well as several investment properties including an apartment building and a shopping center. Dr. Franklin also sits on the board of directors of his hospital and his country club.

Dr. Franklin wanted to establish a wealth preservation strategy for three specific reasons:

  1. Dr. Franklin was very concerned by the proliferation of medical malpractice lawsuits and wanted to protect his significant assets in the event that he was sued by a patient. In addition, Dr. Franklin knew that as a landlord, he was prone to litigation from tenants and other persons who might be injured on one of his properties. He was sensitive to the fact that as a physician and a property owner, he was perceived as a “deep pocket target” by aggressive negligence lawyers.
  2. Dr. Franklin wanted to reduce his estate tax liability so that upon his and his wife’s deaths, their children would inherit as much as legally possible, with as little as possible (or nothing) paid to the I.R.S. in the form of inheritance taxes.
  3. Dr. Franklin hoped to minimize his current income tax liability on the income received from his rental properties.

FIRST GOAL: ASSET PROTECTION

Asset protection is defined as the safeguarding of personal wealth from attack by future creditors. “Assets” are broadly defined and include homes, cars, boats, jewelry, business interests, cash, bank accounts, brokerage accounts, stocks, bonds, art and other collections, real estate, etc.

“Creditors” are also broadly defined and include actual creditors as well as identifiable probable creditors, such as litigants, soon-to-be ex-spouses, disgruntled business partners, or anyone who you know that has a claim against you, even if they do not yet know it. Creditors may even include government agencies, such as the I.R.S.

The effectiveness of an FLP in providing asset protection is statutory, meaning that it has been codified as law. The Revised Uniform Limited Partnership Act (RULPA), which has been adopted in all fifty states, provides that the assets owned by a limited partnership are not owned by the individual partners.

Therefore, those assets cannot be attached by the personal creditors of a partner. If a person contributes assets to an FLP, those assets are no longer owned by that person (although, as explained below, the person may still control those assets), and creditors of that person may not attach those assets merely because they have a judgment against a partner of the FLP.

THE ESSENCE OF ASSET PROTECTION PLANNING: CONTROL EVERYTHING BUT OWN NOTHING

A family limited partnership is, by definition, a joint venture between family members. The partnership is comprised of both general and limited partners. Dr. and Mrs. Franklin are each the general partners. [Because Mrs. Franklin is not a licensed physician, Dr. Franklin is the sole general partner of the FLP that owns the stock in his medical practice.]

Dr. and Mrs. Franklin also own limited partnership interests, as do their children. The general partners manage and control the partnership. The general partners decide and implement all decisions of the partnership, such as whether to buy or sell an asset in the partnership, what investments the partnership should make, and whether to make a distribution of profits from the partnership. The general partners may even determine to dissolve the FLP. It should be apparent that the general partners control the operation of the partnership, in their absolute discretion. Dr. and Mrs. Franklin thus control the assets and make the decisions regarding those assets just as they did before the FLP. Although they transferred legal ownership or “title” to those assets to the FLP, they retained control.

Unlike corporations, FLP’s are not democracies — there is no 51% majority control. Even if they own 99% of the FLP, the limited partners do not outvote the general partners. The limited partners in the FLP are similar to “silent” partners or passive investors.

They have equity interests in the partnership, but have no decision making authority over the partnership or the assets therein. Limited partners, for example, are not entitled to demand distributions or other payments from the FLP. In addition, limited partners may not sell or assign their partnership interests without the consent of the general partners, nor force the liquidation of the FLP. The general partners are thus in complete control of the FLP, although they do not own the assets in the FLP.

THE STRUCTURE OF THE ASSET PROTECTION PLAN: SEGREGATION OF HIGH RISK ASSETS

Dr. Franklin and his advisors set up a complete FLP plan in order to achieve his first goal, asset protection. Early in the process, they took inventory of Dr. Franklin’ assets. They examined each asset individually and evaluated its likelihood of being attacked, based on the chances it would generate a liability. They placed each of Dr. Franklin’ properties into a separate FLP.

Thus, the shopping center that he owned was placed in one FLP, and his apartment building was placed in another FLP. The reason for treating each real estate asset individually and placing each one in its own FLP is to minimize the litigation exposure of each asset.

If an FLP would be sued as owner of a property by someone hurt on that property, assets in a different FLP would not be in danger. In general, high risk assets or those prone to litigation, such as rental property, should be kept separate from low risk assets, like Dr. Franklin’ personal bank and brokerage accounts, which were all placed into one FLP. Dr. Franklin’ home was also placed into a separate FLP. Dr. Franklin’ private medical practice was registered as a professional corporation.

Dr. Franklin owned one hundred percent of the stock of that corporation and he placed that stock into a separate FLP. If Dr. Franklin were to get sued, the professional corporation would cease paying him a salary. Instead, it would distribute profits (and management fees) directly to its shareholder, the FLP, where the money would be protected.

Thus, Dr. Franklin’ assets were protected from each other and, as explained below, they were all protected from any future personal attack against him.

KEEPING THE WOLVES OUT: A FEW EXAMPLES

During one snowy winter day, a tenant in Dr. Franklin’ apartment building stepped outside, took a few steps and promptly slipped on the icy sidewalk. An aggressive personal injury attorney convinced the tenant to sue her landlord for injuries sustained in the fall, including pain and suffering, loss of income and post-traumatic stress. The tenant’s spouse also sued for “loss of consortium”.

The attorney, expecting to reap a windfall from a “deep pocket” doctor, took the case on a 33% contingency. When the attorney investigated who the landlord was, to his chagrin he learned that it was the “Dr. Franklin Apartments Family Limited Partnership,” not Dr. Franklin himself.

A little more research revealed that the partnership owned no assets other than the apartment building, and a local bank held a large mortgage on the building. All of Dr. Franklin’ other assets were owned by other FLPs which had nothing to do with this accident and could therefore not be included in this lawsuit.

To their great disappointment, the tenants and their attorney quickly understood that there was no “deep pocket” and there would be no windfall. The attorney realized that, even if he won the case, the judgment would be uncollectible. Since 33% of zero equals zero, he quickly settled for whatever Dr. Franklin’ insurance company offered and went away.

The very next month, an auto accident occurred in the parking lot of Dr. Franklin’ shopping center. A smarter, more aggressive negligence lawyer, realizing that a lawsuit against the “Dr. Franklin Shopping Center Family Limited Partnership” would not yield very much, also sued Dr. and Mrs. Franklin personally as general partners of the FLP.

He claimed that, as general partners, they were personally liable for the FLP’s negligence in maintaining the shopping center. Dr. and Mrs. Franklin’ attorney promptly informed the plaintiff’s negligence lawyer that Dr. and Mrs. Franklin had no attachable assets.

They owned nothing — not even Dr. Franklin’ medical practice (although they controlled a great deal). A judgment against Dr. and Mrs. Franklin would therefore be uncollectable. Once again, there was no “deep pocket” and no windfall. Rather than wasting his time on a case with little or no potential reward, this lawyer also quickly settled for Dr. Franklin’ insurance company’s offer.

The following summer, when a guest was hurt in the swimming pool at Dr. Franklin’ country club, the injured guest sued not only the country club, but also each of the members of the club’s board of directors, including of course, Dr. Franklin. The plaintiff claimed negligent supervision of the club by its directors. Unfortunately, the country club did not carry errors and omissions insurance for its directors.

Again, Dr. Franklin’ attorney promptly explained to the plaintiff’s attorney that Dr. Franklin had no attachable assets. In order to avoid a lengthy litigation and its attendant legal expenses, Dr. Franklin offered to settle the lawsuit against him for a nominal amount — less than the expected cost of legal fees to defend it.

Dr. Franklin made his settlement offer to the plaintiff on a “take it or leave it” basis. Since the settlement offer was better than an uncollectible judgment, the plaintiff reluctantly took it. The plaintiff pursued his litigation against the country club and the other unprotected directors, while Dr. Franklin watched from the golf course.

Finally, one of Dr. Franklin’ patients developed a post-surgical infection with complications. The patient sued Dr. Franklin, the hospital and every doctor and nurse who had any contact with the patient during and after the surgery. The lawsuit demanded $5,000,000 in damages from each defendant, jointly and severally. Unfortunately, last year Dr. Franklin’ malpractice insurance company had reduced the liability limits of all policies across the board to $1,000,000 maximum per occurrence.

If the plaintiff were to win his lawsuit, Dr. Franklin would be personally liable for $4,000,000. Once again, Dr. Franklin’ attorney uttered the magic words, no attachable assets. The plaintiff accepted the insurance company’s payment of $1,000,000 in full settlement of his claim against Dr. Franklin and dropped the doctor from the lawsuit.

In each of the above cases, the fact that Dr. Franklin had no attachable assets served to effectively discourage the lawsuit. Once the plaintiff realized that, even if it wins the lawsuit, it would be almost impossible to collect a judgment, the plaintiff was forced to accept a settlement on Dr. Franklin’ terms. This, indeed, is the real value of asset protection via FLPs.

RECOURSE OF A JUDGMENT CREDITOR: K.O. WITH A K-1

But what if a plaintiff refuses to settle, prosecutes its lawsuit and wins a humongous judgment against Dr. Franklin? The successful plaintiff in this scenario (who is now known as a judgment creditor) is limited to a “charging order.”

A charging order entitles the judgment creditor to receive Dr. Franklin’ share of any distribution of profits or assets made by the FLP. The judgment creditor is still not entitled to reach the assets owned by the FLP. Distributions are, however, made in the sole and absolute discretion of the general partners, Dr. and Mrs. Franklin.

As general partners, they may determine never to make a distribution. The FLP may still pay salary to Mrs. Franklin, who is not a judgment debtor, and it may make loans to Dr. Franklin’ children, who also are not judgment debtors. Neither of these payments are “distributions” to Dr. Franklin. They are therefore not subject to the charging order and beyond the reach of the judgment creditor.

The judgment creditor’s charging order is, however, a