Volume IV, Number 1 – January 1995
© Donlevy-Rosen & Rosen, P.A.
LIMITED PARTNERSHIPS: A CLOSER LOOK
How and Why They Work To Protect Your Assets
PREFACE. The use of limited partnerships in asset protection planning was generally discussed in Volume I, Numbers 3 & 4. In this issue we will take a more detailed look at how and why limited partnerships are used in asset protection planning, and the limitations of the limited partnership technique.
BACKGROUND. Limited partnerships have existed in the United States since the first limited partnership statute was adopted by New York in 1822. At this writing, 48 states and the District of Columbia had adopted the Revised Uniform Limited Partnership Act of 1976 (“RULPA”), some of the provisions of which (discussed below) provide the basic protective aspects of limited partnerships.
ASSET PROTECTION ASPECTS. There are two facets to the asset protection afforded by the use of a limited partnership. The first, widely known facet, is the “inside out” protection available to the limited partners. This asset protection aspect is similar (if not identical) to the protection generally available to corporate shareholders: a limited partner’s personal exposure for the debts of the partnership is generally limited to his investment in the partnership. Thus, a creditor of the partnership cannot execute upon the personal assets of a limited partner in order to satisfy the partnership’s debt. The second asset protection facet of the limited partnership is two-pronged: One prong is arguably provided by the Internal Revenue Service (discussed below) and the other prong is provided by the “outside in” protection afforded by the charging order concept. Under the charging order concept of the RULPA, discussed below, partnership assets (“inside”) are protected from the judgment creditors (“outside”) of both the limited and the general partners. This result becomes very important in a limited partnership whose members include only an individual, his immediate family, and entities created by such persons, when a significant portion of the family wealth can be provided substantial protection from untoward future events by merely changing its form of ownership.
THE CHARGING ORDER. Under general common law principles, a judgment creditor can execute on the personal property of a debtor. In essence, this means that the creditor can sell the property to satisfy his claim. Thus, if Mr. A had a judgment against you and you owned all of the shares of stock in a corporation (and that corporation owned significant assets), Mr. A could execute on your shares, become the owner of your corporation, and liquidate it in order to get at its assets so his claim would be satisfied. Limited partnerships are different: The sole remedy of the judgment creditor of a partner is a charging order. This effectively limits a creditor’s ability to reach partnership assets. A charging order under the RULPA places the judgment creditor in the position of an assignee of the debtor partner’s ownership interest in the partnership. Under the RULPA, an assignee has none of the rights of a partner in the limited partnership: he cannot vote on partnership matters, he cannot see the partnership’s books and records, he cannot reach any assets owned by the partnership, and he cannot sell or foreclose on the partnership interest. What does the creditor get under the charging order? He gets the right to any partnership distributions which would have otherwise been paid to the debtor partner – if, as, and when they are made. Guess who decides when those distributions are made? You do! In addition, the IRS says the creditor must pay the federal income tax on the share of the partnership income subject to his charging order – even if it’s not distributed to him!! This is what we refer to as the “outside in” protection afforded by the limited partnership.
SEGREGATING REAL ESTATE. The two types of protection we have just discussed have their limitations. For example: suppose you were utilizing a limited partnership to hold all of your investment assets: liquid assets (stocks, bonds, securities, cash) and investment real estate. Then suppose a significant environmental problem was discovered on the real estate. Assume that the EPA ordered you to remediate (clean up) the contamination, and that the costs of cleaning up the property far exceeded all of the assets held by your limited partnership. The result would be financially catastrophic: all of the assets held by the limited partnership would be used to pay for the cleanup of the property. Why? Because the partnership which owns your liquid assets also owns the contaminated real estate, and the owner of contaminated real estate (the partnership in this case) is one of the persons the EPA can order to pay for the cleanup of the property, and the EPA can order that all of the owner’s assets be used to pay for the cleanup. The lesson: ALWAYS segregate your investment real estate (raw land, rental properties, and general partnership interests in real estate partnerships) from your liquid assets in a way which will result in the separate protection of the liquid assets and the real estate assets. Real estate is the type of asset that can generate its own liability, as we have just shown in the above example, and that fact must be taken into consideration when planning the protection of the real estate and your other assets. A basic solution would involve placing your liquid assets in one properly structured limited partnership and your investment real estate in another. The ideal plan would be to place each real estate interest in a separate limited partnership, so that if a problem developed on one parcel, the values of the other parcels would not be available to satisfy the creditor’s claim. You should also note that environmental claims are just one example of the type of liability to which you can be exposed as a real estate owner (See AP NEWS, Vol. II, #’s 3 & 4). Another example would be a claim in excess of your insurance coverage by a person who was injured on your property. Remember: your insurance is only as good as its policy limits, and never forget that insurance companies are not in the business of paying claims – they will try to avoid coverage whenever possible. You should take steps on your own to protect yourself.
REMEMBER: Although the protection afforded through the use of limited partnerships is primarily a result of statutory law, a properly drafted partnership agreement combined with other sophisticated planning techniques can significantly strengthen that protection.