How Family Limited Partnerships Can Protect Assets
A family limited partnership can provide flexibility in managing assets, gift and estate tax advantages, and protection from creditors. This article shows how to structure such a partnership with asset protection features.

by KATHRYN G. HENKEL, Attorney

KATHRYN S Henkel of the Texas Bar. isa partner in the Dallas law firm of Hughes & Luca, LL.P. She isa fellow of the American College of Trust and Estate Counsel and is Vice-Chair of the Com mittee on Estate and Gift Taxes of the ABA ts Section of Taxation. Ms. Henkel isa frequent speaker and author on estate planning.

A limited partnership is an attractive ve hicle for the management of family enterprises and other investments since it can be custom-designed to fit family objectives regarding property manage ment and profit-and-loss sharing. Certain fam ily partnership structures may also protect part nership assets to some extent from creditors of the partners.

Example. Parent owns an interest in a farm or other business that he wishes to keep in the family. Parent is afraid that if he finds himself in financial trouble in the future, his creditors or bankruptcy trustee may be able to seize the property.

His estate planner advises that the property be conveyed to a family partnership, with the par ent and trusts for his children as the limited part ners, and a friendly family member as the general partner If a creditor or bankruptcy trustee comes  into the piaure, the general partner can simply refuse to distribute anything. Moreover,rhe cred itor or bankruptcy trustee may be subject to in come tax on the Parent's share of the undis tributed partnership income. Under these circum stances, the creditor may settle on a favorable basis, or the bankruptcy trustee may either aban don the partnership interest or sell it to the Parent ent or a family member at a low price since no one else will want to buy it.

Parent has a number of questions about his adviser's suggestion.

Creditors' rights
Can a creditor or bankruptcy trustee of a limited partner reach partnership asset? Gen erally, no, under a well-drafted agreement. A creditor outside of bankruptcy has limited remedies: assignment, a charging order, and foreclosure. Creditors may exert pressure on Parent to assign his partnership interest to them. An assignee of a partnership interest, however, does not ordiharily have any right to force distributions from the partnership.²
A judgment creditor of a limited partner is entitled under state law to apply to a court to have the interest of the debtor/partner charged with payment of the unsatisfied amount of a judgment debt, plus interest (i.e., a charging order). To the extent that the charging order is in effect, the judgment creditor has only the rights of an assignee of the limited partnership interest.³

If a creditor forecloses on a partnership inter est, the interest will be treated as having been assigned to the creditor.
A bankruptcy trustee's remedies are greater, but are still restricted. The bankruptcy of a lim ited partner does not dissolve the partnership. If, however, the partnership agreement does not prohibit a limited partner from withdrawing and receiving the fair market value of his lim ited partnership interest, a bankruptcy trustee holding a limited partnership interest may be able to do so)

The partnership agreement should provide that no partner will receive the value of his share upon any event of withdrawal until the partnership is dissolved. Practitioners should be sure that this provision is not triggered solely by changes in a partner's financial condition or a partner's bankruptcy, as such a provision may be attacked as an unenforceable ipso facto clause.

A bankruptcy trustee has the power in cer tain situations to sell jointly owned property and remit the nonbankrupt joint owner's share of the proceeds to him.⁵ There is some authdrity that this power applies to property held by ten ants in partnership.'

In the case of a dissolved general partnership, there may be some rationale for treating the partnership assets as jointly owned property. In the case of a limited partnership not dissolved by the bankruptcy of a limited partner, this ra tionale should not apply.

A general partner acts in a fiduciary capacity toward the limited partners. Even if the partner ship agreement gives the general partner broad discretion in conducting partnership affairs, the general partner must have legitimate business reasons for his decisions. If the general partner acts in a manner that is contrary to the best in terests of the limited partners, a limited partner may seek judicial dissolution of the partnership. A bankruptcy trustee holding a bankrupt lim ited partner's interest may have standing to compel such a dissolution. Such a power could become particularly important where the gen eral partner withholds distributions attributable
- to the interest held by the bankruptcy trustee while making distributions to other partners, or unnecessarily withholds all distributions.

Are partnership assets protected from Par ent's creditors if Parent is a general partner? Not generally, Parent's creditors or a bankruptcy trustee would not be able to reach partnership assets as a whole if Parent were general partner. Such a power would interfere with the rights and interests of the non-debtor partners who joined with Parent in establishing the partnership. (This joint action makes a part nership distinct from a trust created by Parent alone for the benefit of himself and others, the assets of which may be reachable by Parent's creditors.) Nevertheless, because the iaw.re garding the effect on a partnership of the bankruptcy of a general partner is extremely complex and in many respects unsettled, the .non-debtor partners cannot -be assured of main tarnmga bankrupt general parents share of the assets in the partnership and remaining free from interference by the bankruptcy trustee.'

If Parent is a general partner and goes bankrupt, the partnership may dissolve, enti tling the bankruptcy estate to a distribution of the value of Parent's share of the assets.³ Alter natively, the bankruptcy trustee may -be able to withdraw from the partnership and receive a distribution,' or to assume Parent's rights and obligations under the partnership agreement, including the right to manage the partnership in certain circumstances.
If the general partner is a corporation, that corporation should not be controlled by Parent.

A judgment creditor or bankruptcy trustee ac ceding to a controlling interest in the stock of the corporate general partner could gain man agement control of partnership assets.

If the general partner is a trust, Parent should not be the trustee of that trust. If Parent is the trustee, the assets of the trust should not be
-available for distribution to Parent's creditors.¹⁰ Since Parent has legal title to the trust assets, however, the general partnership interest and other trust assets could be brought into the bankruptcy proceedings until it is determined by the court that Parent has no equitable title, resulting in delay and expense in trust adminis tration. Although the bankruptcy trustee should not be able to step in as trustee of the trust, there is scant authority on the issue)'

Structuring the partnership
Can Parent's Spouse be the general partner? Use caution. When Parent is advised that he should not be a general partner of the family partnership, he may want his spouse to be the general partner. This tactic may not accomplish anything because if joint debts should ever exist, or if Spouse's property should be liable
-forany of Parent's debts under state law, Spouse could go into bankruptcy along with Parent, or Spouse's general partnership interest could be subject to Parent's creditors. Addition-. ally, if Spouse is the nominal general partner but Parent actually performs the functionsof general partner, the arrangement may be viewed as a fraud on creditors.

If Spouse is the general partner Spouse's general partnership interest should consist of her separate property. Parent should take no part in partnership affairs. Spouse's partner ship distributions should be kept completely separate in an account accessible only by her and should not be used for Parent's or the family's expenses. In this respect, practition ers should be aware of the concealment doc trine discussed below.

Can the partners enter into an enforceable agreement that a bankrupt partner's -interest> will be forfeited or purchased by the other partners at a low value? No. An agreement that modifies or terminates a debtor's interest in property that is conditioned on the insolvency or financial condition of the debtor or on the filing of bankruptcy is not enforceable in bankruptcy. 12 In: addition, such an agreement may present gift and estate tax problems under Section 2703.
If the family wishes to purchase the partner ship interest of a bankrupt partner, the buy-sell agreement should be drafted so that it is trig gered on any event of withdrawal (not just bankruptcy), and a fair market value purchase price should be set. Normally, discounts for lack of control and lack of marketability aie permissible in setting such a price.

Transferring assets
Can Parent's transfer of asset to the part nership be voided as a fraudulent conveyance? Yes, under certain circumstances. A transfer made with the intent to hinder, delay, or de fraud creditors may be voidable. Subject to the applicable statute of limitations, a transfer to a family partnership will be voidable by a present or future creditor or bankruptcy trustee if the· - transfer is made with actual intent-to hinder, delay, or defraud creditors Since direct evidence of intent is rarely obtained, certain types of transfers are considered "badges" of fraud, evidencing such intent.' A transfer to the partnership followed by an arrangement (e.g., lease, employment contract, power of attor ney) whereby Parent retains actual possession or control of the transferred assets may be a badge of fraud.

1 The following uniform acts arc used as references, the Uniform Partnership Act (UPA), rhe Revised Uniform Umited Partner ship Act (RULPA), the Uniform Fraudulent Transfer Act (USIA), and the Uniform Fraudulent Conveyance Act (UFCA).
2 RULPA Section 702.
3 RULPA Section 703.
4 11 U.S.C.A. Section 541(a)(1); RULPA Sections 603 and 604.
5 11 U.S.C.A. Section 363.
6 E.g., Fads v. Prohasco (In re Fads). 69 BR. 730 (Bankr. CA-9,
1986), affid in part, re&d in pare. In re Pro basco, 839 F.2d
1352 (cA-9, 1988). Contra Manning v. Nuthatch Hill Assoc.
(In re Manning), 831 F.2d 205 (CA-b, 1987).
7 For a good summary of this topic, see Cherkis, collier Real Es
tote Transactions and the Bankruptcy Code ¶4~07[1J (King ed., 1991).
S UPA Sections 31(5) and 38; RULPA Sections 402(4), (5), 801, and 804; In re Sunset Developers. 69 B.R. 710 (Banks. D. Idaho, 1987).
9 11 U.S.C.A. Section 541(a)(1); UPA Sections 31(1), (2), and 38; RULPA Sections 602 and 604.
10 11 U.S.C.A. Section 365(c)(IXA); Kupetz v. U.S. (In ,-e Cali fornia Trade Technical Schools. Inc.). 923 F.2d 641 (CA-9, 1991).
11 For an opposing view, see 4 Collier cn Bankruptcy ¶541.13 (Sthed., 1988).
12 11 U.5.C.A. Section 365(e)(1).

Clients should avoid a transfer where, as a practical matter, nothing changes except legal title. Moreover, it is not usually advisable to transfer personal use assets frequently used by


A transfer of assets to the partnership made with the intent to hinder, delay, or defraud creditors may be voidable.

Parent to the partnership, but if this occurs, Parent should pay fair market value rental for the use of such assets.
Concealment of the transfer is a badge of - fraud. To avoid this problem, the limited partnership nership should be registered with the appropriate ate state authorities. An assumed name certifi cate can be filed, if-necessary. Aeni altpossession
- of tangible property should be transferred to.. the general partner, and the transferted prop erty should be held out to the public as prop erty of the partnership. When the transfer is made, Parent's financial statement should be revised vised immediately.
The transfer of substantially all of-Parent's assets to the partnership may be a badge of fradd, as is concealment of any interest in the transferred assets. After-Parent transfersassets to the--partnership, any continued control or management of the assets by Parent, any adequately quately compensated use of the assets by Par ent, and any use of partnership income not attributable tributable to Parent's share to pay Parent's personal sonal expenses can be evidence that the Parent has an actual retained interest in the assas. If such an "interest" is omitted from a financial statement, a badge of fraud may exist.
A badge of fraud will-exist if the value of the. partnership interest received by Parent is not reasonably equivalent to the value of the prop erty transferred to the partnership. Clients
should consider obtaining an independent ap praisal verifying the equivalence in value of the interest received and the property transferred.
A badge of fraud may exist if the transfer to the jartnership is made (1) when Parent is insol vent, or shortly after Parent becomes insolvent; (2) after Parent has been sued or threatened with suit; or (3) shortly before or shortly after Parent incurs a substantial debt. Other badges of fraud include transfer to an insider, transfer before absconding, transfer that removes assets from the jurisdiction, transfer to a straw person, and transfer accompanied or followed by un usual methods of transacting business.
As a planning pointer, practitioners should be able toshow that there are valid business rea Sons for establishing and maintaining the part nership aside from asset protection and valua tion discounts. The partnership business should be conduaed in abusinesslike manner, as if un related third parties -were involved4
Certain transfers are voidable without regard to Parent's intent. Transfers by Parent to the partnership which are automatically voidable, subject to the applicable statuteof limitations, may include the following:

1. A transfer of tangible personal property without adequate consideration, unless a deed of gift is recorded, or actual possession of the property is surrendered.
2. Any transfer, if a bona fide purchaser's ih terest in the transferred property can be per fected against the partnership.
3. A transfer without reasonably equivaleht consideration if Parent is insolvent at the time or Parent becomes insolvent as a result of the transfer. -
4. Any transfer, if Parent is engaged, or about to be engaged, in business and Parent's capital remaining after the transfer is unreasonably small.'⁵

For planning purposes, if tangible personal property is transferred to the partnership, it is prudent to record an assignment and surrender actual possession. Transfer to f -realty to the partnership should be recorded. Proper assign ments of titled property should be executed and delivered.

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From an asset protection standpoint, is there any reason Parent should not transfer assets to a family partnership? Yes. Under certain cir cumstances, a transfer or concealment of assets with the intent to hinder, delay, or defraud cred itors can result in the denial of Parent's dis charge in personal bankruptcy, or even a crimi nal conviction.
Parent should be able to clearly demonstrate that the transfer to the partnership is not made with any such intent. In addition, if the conceal ment of an actual retained interest in trans ferred assets continues within the 12 months before a bankruptcy petition is filed, Parent's discharge in bankruptcy could be denied even if the actual transfer was made long before the bankruptcy filing.
What assets should be used to fund the part nership? Business and investment assets. Most state laws provide that a partnership must carry on a business." Section 7701(a)(2) states that a partnership includes a syndicate, group, pool, joint venture, -or other unincorporated organi zation through or by means of which any busi ness, financial operation, or venture is carried on, and which is not a trust, estate, or corpora tion. Personal assets (those not used for busi ness or investment purposes) are therefore not the best choice to fund the family limited part nership.
Can Parent own substantially all the part nership interests? It is best if other parties have a substantial interest in the partnership. As sume Parent owns, for example, a 99% limited partnership interest and 49% of the stock of the corporate general partner, leaving his chil dren with a 0.51% interest in the partnership through their ownership of stock in the corpo rate general partner. In such a case, a - bankruptcy court might set aside transfers of interests to the children as de minimis or sham transfers, and treat the entire partnership as owned by Parent.
If other family members cannot purchase their own partnership interest, Parent can give them limited partnership interests Parent could then argue that making such gifts is an indica tion that the limited partnership is being used for estate planning objectives and family busi
ness purposes rather than as a device to hinder creditors.

Tax issues
Will a creditor or bankruptcy trustee be taxed on the undistributed income of Parent's partnership interest? Possibly. A bankruptcy trustee will be taxable with respect tb such in come. As long as the partnership interest is part of the bankruptcy estate, the bankruptcy estate will be subject to tax on the estate's share of the partnership income, whether or not the income is distributed.'⁷
A creditor exercising state law remedies may also be taxable. Income frpm a partnership inter est that has been assigned to a creditcir should be taxable to the assignee, den -if the assignee is not admitted as a partner." After fore closure on a partnership interest, the creditor will be treated as an assignee of the interest and will be subject to tax on its share of partnership income. -
It is unclear who will be taxable on the in come of a partnership interest that is subject to a charging order. A judgment creditor has the rights .of an assignee of a partnership interest to the extent that the interest is so charged. Never theless, the partner still maintains many of the benefits and burdens of ownership, and may be tax6d on thedistributive share of partnership in come that will ultimately be paid to the creditor.
Partnership.. classification. Practitioners should take care that the entity is classified as a partnership for tax purposes. It will usually be undesirable if the organization is taxed- as a cor poration.. If aft-entity has more-than two of the following four chatacteristics, irAviIl be taxable as a -corpotation for Federal income tax pur purposes centralization of management, -limited liability continuity of life, and free transferability of insterests (A thorough discussion of this


13 Ii U.S.C~A. Section 548(a)(t); UFTA Section 4(a)(1); UFcA Section 7.
14 UFTA Section 4(b).
15 See, e.g.. ii U.S.C.A. Sections 548(a112). 548(d)(1); UFTA Sections 4(a), 5(a); UFCA Sections 4, 5.
16 (SPA Section 6.
17 Sections 1398(b)(2) and 1398(c)(1).
18 Rev. RuL fl-137, 1977-1 CB 178; Evans. 447 F.2d 547, 28 AFTR2cI 71-5465, 71-2 USTC ¶9597 (CA-7, 1971).
19 See generally Reg. 301.7701-2.
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- concept is beyond the scope of this article A modified form of free transferability of interests can be as damaging as free transferability in its unadulterated form because modified free trans ferability, in combination with two other corpo rate characteristics, results in an entity's having more than two corporate characteristics.
A limited partnership with a corporate gen


Practitioners should take care

eral partner will possess the corporate charac teristic of limited liability if the corporation has no substantial assets (other than its interest in the partnership) and is merely a dummy of the limited partners. There is no history of applying this concept to a trust general partner. Could the theory be extended?
Should the corporate general partner be sub stantially capitalized? Most family limited part- - nerships have centralizatio&bf 1ii~hi~ffient and do not- have continuity of life. In a family partnership, the fact that the parties are closely related raises the issue of whether the general partner is amenable to the will of the limited partners.
If the general partner is so viewed, the corpo rate characteristic of limited liability might be found to exist on the theory that the general partner is a "dummy." Similarly, the corporate characteristic of free transferability of interests might be found to exist on the theory that the requirement of consent of the general partner to a transfer (often used to demonstrate that free transferability does not exist) is meaningless. (In addition, a requirement that the general partner consent to a transfer may result in certain part ners not being recognized as partners for in come tax purposes.) Substantial capitalization of the general partner assures that the corporate characteristic of limited liability is not present, even in the event that the general partner is con sidered amenable to the will of the limited part ners.²⁰
Income allocation. The allocation of partner- ship income tax purposes is governed by special-rules~ If partnership interests of family meni,bers are created by gift or by purchase from Parent; the provisions of Section 704(e), govern ingfamily partnerships, must be considered. The donee/purchaser of an interest in a family part nership will be respected as a partner for income tax purposes if he is the "real owner" of a capi tal interest in a partnership in which capital is a material income-producing factor. A variety of considerations are taken into account in making
this 21
Any limitation imposed by the donor on the donee/purchaser's rights to liquidate or sell his interest in the partnership without financial detriment may be viewed as a negative factor in determining whether the donee/purchaser is a partner especially if there is no compelling business reason for the limitation. Such a situation tation may suggest that the donor has retained enough control over the transferred interest - that the donor should be treated as cootinving to be the owner of the interest. Since a limited partnership with asset protection features often does not allow the limited partners to liquidate their interests, the limited partners should be free to sell their interests.
-When gifts or purchases of partnership inter ests from Parent are involved, partnership in- - come is taxed according to special rules in the Tax Code, regardless ofthe allocation of incorhe under the partnership agreement. Parefit must be illdeated income sufficient to compensate- him for services rendered to the partnership The dontdP _A~Ai~ijr also be allocated enough-income to compensate him for services rendered. After that, income must be allocated in--proportion to retained and donated capital.
Transfers to the partnership. Under Section S-21-(aj, Patent generally does not recognize gain' ordoss as a result of a transfer of property to the partnership in exchange for a partnership interest est_There are, however, a number of exceptions to this rule. For example, gain may be recog nized on the transfer if Parent's liabilities are as sumed by the partnership or if the partnership takes property subject to Parent's liabilities)'
Moreover, nonrecognition treatment does

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-not apply to contributions to partnership "in vestment companies.'"-' A partnership is an "investment company" for this purpose if over 80% of its value (excluding cash and certain debt obligations) consists of readily marketable stocks or securities (or interests in regulated in vestment companies or RElTs) held for invest ment. There appears to be an exception to this rule in circumstances where the contributions do not result in diversification of the contribu tors' interests. If different family members plan to contribute marketable securities to a part nership, practitioners should consider this rule.
Nonrecognition treatment does not apply to transfers that are "disgifised ~a1es" under Sec tion 707(a)(2). If within a two-year period, Par ent transfers. property to the partnership;and the partnership transfers to Pareftt money—or other property that is, in substance cdfdera ti6n-for Parent's transfer, the -transfer is pre sumed to be a sale of the property to the part nership unless the facts clearly establish that the transfer is not a sale? If any property-trans trabsfers by Parent to the partnership is dis tributed to another partner within five years of the transfer, Parent:generally-must recognize gain or loss from the "sale%f the property."
Gift and estate tax issues. In certain circum stances, partnership interests are valued for gift tax purposes at amounts that are much higher
· than their real values)6 The harsh special valua tion rules of Chapter 14 do not apply if there are no differences in the rights of the trans- - ferred and retained interests except nonlapsing differences with respect to management and limitations on liability, and none of Parent's in terests in the entity constitutes equity for Fed eral -tax purposes aside from his stock in the general partner, if any, and his limited partner ship insterest For purposes of Section 2701, nonA&psixig provisions necessary to comply with partnership allocation requirements of the Tax Code ar&5dapsing differehc~jWith-re spect 5 limitations on liability.
Dis66iints~reflecting (4) lack--of marketability or (2) lack of-control may-reduce the gift, es tate, and generation-skipping transfer tax value of transfers of partnership interests to family members. The partnership agreement typically
provides that Patent cannot withdraw and re ceive, the value of his interest until the partner ship is otherwise dissolved. It is unclear whether Parent's limited partnership interest is eligible for a discount due to this inability to liqtdate his interest. A limitation on the ability to liquidate the partnership (in whole or in part) that is-more restrictive than the limitations that would otherwise apply under stat⁵ law is disregarded in valuing a transferred interest in the partnership under certain circumstances." If a limited partner's ability under state law appli cable in the absence of agreement to withdraw on sx months' notice to the general partner and receive the value of his interest is consid ered an ability to partially liquidate the partner ship, any₁, more restrictive limitation in the part nership agreement will be disregarded for gift, estate, and generation-skipping transfer tax purposes. Although the point has not been ruled on, a power to withdraw should not gen7.:
erally be regarded as a right to partially liquidate the entity."

Other considerations
- When representing business partners or co owners, problems of conflicts of interest can arise. The same can happen when representing spouses or different family members. Also, a lawyer or CPA may not participate in, or advise a client to participate in, a fraud on creditors. Planners should also take care not to assist clients in removing or concealing assets subject to levy for non-payment of tax, or,they may
-run afoul of the tt&fraud provisions. Additional features that can be added to the
basic limited paftnership. Some planners advo cate extra features, such as the following:

20 Reg. 30i.7701-2(d)(2).
21 Reg. i.704-1(e)(2). --
22 Sections 707(a)(2flB). 752, 731(a)(1), and 741.
23 Section 72i(h)~ S. Rept No. 938. 94th Cong.. 2d Sess.. in. 2 at43 (1976).
24 Reg. 1.707-3(cfl 1).
25 Section 704(c)(1)(B).
26 Section 2701.
27 Regs. 25.2701-1(a)(1) and 25.2701-1(c)(3).
28 Section 2704(b); Reg. 25.2704-2.
29 Cf. Sectinn 2704(a) and Reg. 25.2704-1(a)(2)(v) with Section
2704(b) and the Regulations thereunder.

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enters into a contract to employ Parent to man age the partnership assets.
2. Shareholders' agreement. The corporate general partner's shareholders enter into a shareholders' agreement agreeing to elect Parent or Parent's appointees as director(s).
3. Salary. All or most of the partnership in come is used to pay Parent a salary for manag ing the partnership assets.
4. Benefit plans. All or most of the partner ship income is used to establish a pension plan for Parent as a partnership employee, or a wel fare plan to pay for Parent's medical and other benefits on a deductible basis. Planners should keep in mind the tax rules applicable to retire ment plans (e.g., the nondiscrimination rules) and should consider the potential applicability of ERISA in determining whether this feature

would be suitable for a particular partnership.

Each new element adds risks. If a plan is too aggressive, it is possible that the entire arrange ment will be viewed as a retention of an actual interestinterest in the transferred assets and therefore a fraud on creditors. The consequences of such a characterization may include a particular facet of the plan not working, the whole plan not

working, denial of a discharge in bankruptcy, or a criminal conviction.

Conclusion

Use of a family partnership with a well-drafted partnership agreement can provide flexibility in management and sharing ownership of family assets, gift and estate tax advantages, and pro- tection of family property from creditors. ·

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