Articles Posted in Asset Protection

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Partners pay tax on income earned even if it is not paid out to them

The taxation of Family Limited Partnerships should be carefully considered in advance of setting up and rolling out your new FLP.

FAMILY LIMITED PARTNERSHIP DEFINED

State laws have provisions allowing people to establish limited partnerships.  Limited partnerships provide limited liability protection for the limited partners similar to the liability protection afforded corporation shareholders.  The limited partnership is established by filing a form in the state in which it is being established and by the preparation of a limited partnership agreement which governs the ownership income and management of the partnership. The limited partnership agreement is custom prepared by the attorney forming the limited partnership and can have many variable aspects that need to be considered as part of the formation process.

A family limited partnership is legally no different from any other limited partnership except that it’s only members are family members. The term “family limited partnership” is something commonly used in the estate planning and asset protection field. A family limited partnership will have one or more general partners and one or more limited partners. Their respective roles are defined in the chart below:

THE ROLES OF THE PARTNER TYPES

Partner type What they do
♦ General Partners Manage and control all of the money, business and affairs of the partnership.   They sign all checks and all contracts that the partnership enters into.
♦ Limited Partners Limited partners have no voice in the management and no control.  They only have voting rights to vote on specific things such as sale of property or removal of the General Partner

THE IRS DOES RECOGNIZE FAMILIY LIMITED PARTNERSHIPS FOR TAX PURPOSES

The Internal Revenue Code, which is the place where all of the federal tax laws are located in the federal legal system, has provisions for partnerships.  There is no distinction in the tax laws between prayer partnerships, limited partnerships, and family limited partnerships. Any partnership is a separate legal entity and would need to obtain a federal tax ID# upon formation.   Tax returns to be filed are the form 1065 income tax return and California  partnership tax return form 565. These tax returns are due on April 15.

WHO PAYS THE TAXES ON PARTNERSHIP INCOME?

The partnership does not actually pay any income taxes. The partnership tax returns merely report the income for the total partnership enterprise. The partners are identified in the partnership income tax returns and the percentages of ownership of assets and income are stated.  The partnership income is then allocated to each partner according to his or her percentage.  The partnership income tax returns have a form K-1 for each partner stating that partner’s share of the partnership income, deductions and credits.  Each partner then takes the form K-1 to his or her tax return preparer and the amounts on the form K-1 are reported on the the partners’ personal income tax returns.  A partnership is often referred to in tax literature as a “pass through entity” meaning that all partnership income is not taxed at the partnership level but simply passes through and is tax to the partners on their individual income tax returns.

CALL  (949) 229-7034  to speak with Lawyer  David L. Crockett

DISTINCTION BETWEEN INCOME EARNED AND DISTRIBUTED

Without exception the partnership income earned by the partnership is allocated to the partners whether or not they actually receiving income.  In the context of a family limited partnership this can create problems if some of the income is held back and not distributed. This may occur for example in a situation where the general partners have discretion to not pay out all the income which is a typical asset protection clause. However, even if the income is not actually paid out to the partners, they still have to pay the taxes on the income. Therefore, general partners will typically try to get enough cash out to the limited partners so that they can pay their taxes by April 15.

Purposes of Family Limited Partnerships

Image of umbrella over house, care and stack of coinsPeople form family limited partnerships (FLP’s) to (i) transfer ownership of properties or assets to family members while still maintaining control; (ii) to save on estate and gift taxes; (iv) to shift income from parents’ higher tax brackets to children’s lower tax brackets; (iii) to provide some asset protection against liabilities of the property or assets put into the limited partnership or (iv) to provide asset protection against creditors of the limited partners.

Typical example-an apartment building

A mom and dad own a 10 unit apartment building which is paid for and provides substantial cash flow income.  They have 3 children and 1 of the children is heavily in debt and cannot handle money.  They transfer the apartments into a FLP and the FLP agreement provides that the parents own 40% of the assets and income and the children own 60%.  It is set up so that payment of income is discretionary with the parents who are the general partners.  The FLP prevents any creditors of the building from going after the parents’ or the childrens’ individual assets outside of the FLP.

The FLP prevents any of the childrens’ creditors from forcing a payment of income to pay the children’s debts.  The parents essentially still control the money flow and manage the property. There are many variations possible to this so the entire financial and legal picture needs to be gone into before jumping into any FLP.

Legal status

A Limited Partnership is a legally recognized type of partnership entity that has one or more general partners and one or more limited partners.  The designation as a “family” limited partnership simply means that family members are the owners.  It maintains its own bank accounts and accounting records, its own tax id# and files its own tax returns, including partnership forms: IRS form 1065 and California FTB form 565.

Formation

A legal contract known as a limited partnership agreement is prepared and signed by all the partners and there are also registration forms which must be filed with the state.  After that, various transfer documents are done to place property and assets into the FLP.

The role of the partner types

Partner type What they do
♦ General Partners Manage and control all of the money, business and affairs of the partnership.   They sign all checks and all contracts that the partnership enters into.
♦ Limited Partners Limited partners have no voice in the management and no control.  They only have voting rights to vote on specific things such as sale of property or removal of the General Partner

Limited liability and asset protection for limited partners

The law governing  limited partnerships (including  family limited partnerships) provides that the limited partners do not have individual liability for debts and claims against the partnership.  The most that a limited partner can lose is his or her investment in the limited partnership.  In addition, a limited partner has asset protection, depending upon how the FLP agreement is prepared, where the general partner retains discretion to decide if income is to be paid out the limited partners.

Unlimited liability for general partners

The general partners are personally liable for the debts and obligations of the limited partnership.  A solution to this in some situations is to form a corporation and have the corporation serve as the general partner.  The corporation could be a California corporation or it could be a corporation formed in another state or country for more confidentiality and more asset protection.

Permanency

A limited partnership is a permanent legal contract between the general partners and the limited partners.  It therefore cannot be changed or revoked unless all of the limited partners and general partners agree in writing to do so.  Property and money cannot be removed or paid out unless everyone agrees.  Contrast this with living trust arrangements where properties can be freely taken in and out of a living trust and percentages of what various beneficiaries will receive can be changed solely by the parents.

Planning and formation issues

In preparing the limited partnership agreement, there are many custom variables and options which the estate attorney forming it should consider including: (i) how long will the FLP last; (ii) what happens on the death, divorce or disability of a partner; (iii) what will the limited partners be permitted to vote on; (iv) should the general partner be an individual or a corporation; (v) how frequently will money and profits be paid out to the partners and can some money be held back for reserves; (vi) will there be any requirement for partners to put more money into the partnership; (vii) what will the percentages of ownership of capital and profits/losses be among the partners; (viii) what property and assets will go into the FLP and (ix) will there be some asset provision protections built in.

CALL  (949) 229-7034  to speak with Lawyer  David L. Crockett

Taxation considerations

FLP’s once formed are permanent and eliminate some tax flexibility such as individual partners being able to sell their shares or being able to do a tax deferred exchange of their share.  For example, if the family mentioned in the example above decided to not do a FLP and instead decided to hold ownership to the apartment building as tenants in common, there is nothing in the tax law preventing any owner from selling their share or doing a tax-deferred exchange with their share.  On the other hand, owning as tenants in common eliminates asset protection and leaves all owners open to liabilities of the apartment building and of their own personal liabilities.  Also, there are estate and gift tax considerations which must be understood and discussed before putting any assets into a family limited partnership. There may be a loss of basis step up which would otherwise occur on the death of a partner as one example.
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Don’t wait until you get sued to do asset protection

Danger of moving assets illegally – Law Against Fraudulent Conveyances

DANGERS OF OWNING ASSETS IN YOUR OWN NAME

Image of asset protectionIf you lose a lawsuit that has been filed against you personally then the winning party obtains a court judgment.  That judgment is then enforceable against any accounts or property owned in your name.  Also, the judgment is enforceable against whomever you transferred the accounts of property to if the transfer was a gift or a sale for less than fair market value.

DON’T WAIT UNTIL YOU ARE SUED TO PLAN

You can be sued under the law against fraudulent conveyance for improper transfers.  Also, whomever you have transferred money or property to can be sued to make that asset transferred available to the creditor. Any transfer of money or property out of your own name and into an entity needs to have a legitimate business purpose.  Protection from personal liability is such a purpose. 

However, any transfers with intent to hinder, delay or defraud a creditor may be set aside under the law against fraudulent conveyances. Also, transfers without receiving equivalent value and which render you insolvent or put you in the position of being unable to pay your debts would also violate the law.  Thus, if you have been sued or are facing a definite liability or claim, it may be too late to make asset protection transfers.  The time to do transfers is BEFORE you have any significant claims or lawsuits.

Get your assets out of your personal name AND get your name off of public records associated with the asset.

DANGERS OF OWNING ASSETS IN YOUR OWN NAME

If you lose a lawsuit that has been filed against you personally then the winning party obtains a court judgment.  That judgment is then enforceable against any accounts or property owned in your name.

ASSET PROTECTION STAGE 1

Asset Protection – Stage 2The most common asset protection plan is to form a corporation to conduct a business enterprise. If the corporation is properly maintained, the debts and liabilities of the Corporation are not passed through to the shareholders.  In other words, the corporation’s owners (shareholders) are not personally responsible for the corporation’s liabilities.  Only the actual money invested by the shareholders in the corporation is at risk and liable to pay the corporation’s debts.

DOWNSIDE OF STAGE 1

If you own a corporation or an LLC you do get some asset protection but your corporation or LLC will be filing a statement of information with the names of the officers and directors which typically are the owners.  A creditor with a judgment may then try to bring proceedings against you personally or against your property or accounts and you would incur legal expenses to fight that.

Get your assets out of your personal name

DANGERS OF OWNING ASSETS IN YOUR OWN NAME

Image of a home inside of a safeIf you lose a lawsuit that has been filed against you personally then the winning party obtains a court judgment.  That judgment is then enforceable against any accounts or property owned in your name.  Thus, if you operate a business in your individual name (instead of the business being operated in the form of a corporation) and if you lose a lawsuit against that business then the judgment is enforceable not only against the business assets but also against your home and take accounts in your name personally.

WHAT IS ASSET PROTECTION?

A better term for this is asset preservation planning. It’s not what you actually own but what you control which is important. The law allows you to build up a defense against liabilities and lawsuits that could occur in the future. The law allows you to limit your risk in various situations. The most common asset protection plan is to form a corporation to conduct a business enterprise. If the corporation is properly maintained, the debts and liabilities of the Corporation are not passed through to the shareholders.  In other words, the corporation’s owners (shareholders) are not personally responsible for the corporation’s liabilities.  Only the actual money invested by the shareholders in the corporation is at risk and liable to pay the corporation’s debts.

STAGE 1 PROTECTION

Instead of owning the money and assets in your own name you instead own shares of stock in a corporation or LLC or other interests.  To accomplish that your form one or more legal entities under California law such as a corporation, limited liability company, family limited partnership or permanent trust.  Transfer into the entities the business assets, or professional practice assets, or real estate assets which may incur debts, claims and lawsuits. Open bank and securities accounts in the name of the entity.  Each entity should stand on its own and have separate accounting records, its own tax id# and file its own income tax returns.  These steps are all normal business practices followed by nearly all ongoing business enterprises.

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