Sunday, April 11, 2010

The Power of Charging order Protection

Family Limited Partnerships, the power of

Start a sole proprietorship business and everything in the business and everything you personally own is at risk. Government created Business entities such as corporations and limited partnerships allow individuals to group together to invest money in new businesses. Investors in a corporation are shielded from the liabilities of the business and their risk is limited by the amount of the capital investment. The business creditor is limited to the assets of the business only, and he generally cannot pursue any other assets of the investor. The liabilities of the business are “inside liabilities,” and the creditors are “inside creditors”.

But what happens when the owner(s) are sued for non-corporate activity? Your son runs over somebody while driving to Church. As far as the corporation is concerned, this is “outside liability” having nothing to do with the corporation. But, the lawsuit can take away everything you own including your stock in the corporation. Under the law, creditors of an investor-owner are treated much differently than the creditors of the business itself. The law has no desire to protect a debtor’s interest in a business from personal creditors. On the contrary, if an owner has debts, then he or she should pay those debts even stock or partnerships interests in a company that otherwise did nothing wrong. Thus a closely held corporation can disappear into the void of lawsuit Hell nearly as easily as a sole proprietorship. This is why the common middle class "protection" of putting stock, company assets, etc. “in the wife’s name” only shifts risk, but never eliminates it.

A creditor may simply attach the corporation shares of the debtor’s stock to gain all the rights that the debtor had in the business, and may even bring derivative actions against errant corporate officers and directors. One Doctor put everything in his wife’s name. A patient sued. “Hah-Hah can’t touch me,” said he doctor. I guess he forgot, his medical practice listed the wife as secretary for the corporation. She was sued as an officer. They lost everything. She couldn’t even use his malpractice insurance, she wasn’t a doctor, just his ill conceived asset protection plan.

Everybody who has anything they don't want to loose needs a firewall between both business “inside liabilities” and their, general day to day “outside liability.” Setting up corporations and LLCs to limit, allocate and isolate risk is a must! Next build the first line of defense and a powerful firewall: the Family limited partnership.

A Family Limited Partnership (FLP) is different from a corporation. Invented in the second decade of the 20the Century, Limited Partnerships (LPs) have an established and judicially recognized history in both English and American Law. Family Limited Partnerships are a type of Limited partnership just allowing family members as partners. Interests in LPs can be sold and negotiated implicating state and federal securities laws. There can be significant business benefits to making interests tradable but most family asset planning doesn't need to get so involved in the expense, paperwork and legal requirements. FLP can do most everything you need.

The most remarkable benefit of a limited partnership stems from the relationship of partners. Limited partners have no liability for the actions of the partnership beyond their actual investment. A limited partners investment in the partnership is only at risk if the partnership does something wrong. Wrongful acts by the partnership or caused by a partnership asset (a car crash by someone using the partnership vehicle for instance) can lead to liability and loss of investment. This “inside liability” can never reach the limited partners other assets.

That may seem simple enough, So where is the asset protection? If the partnership does something wrong then I could loose all the assets “inside” the FLP. Answer: Never have assets in the FLP which can cause a lawsuit loss. Stocks, bonds, bank accounts, ownership various trusts which themselves could contain potential “Inside liabilities” like real estate trusts can be kept safe inside the FLP.

But what about Outside liability. My son hits somebody can’t they take my interest in the FLP just like my stock in the closely held business. Sometimes, especially if all the general and limited partners are subject to the “family car doctrine” in this example. Additional firewalls and protections can be built against that eventuality and will be discussed in the future, but for now lets say no and here’s why: The law protects the innocent limited partners and will grant only a limited form of relief called a “charging order.”

A partnership interest is unlike holding shares in a corporation. A change in ownership may disrupt the operations of the partnership and force non-debtor partners into an involuntary partnership with the creditor. The partners have rights that includes the rights to distributions and the rights that are set out in the operating agreement. The partner may or may not be required to perform certain duties in order to receive the rights outlined in the partnership’s operation agreement.

The partner who has an “outside claim” against him passes just the rights to distributions, if any, from the FLP. Creditors cannot simply attach the partner’s interest as if they were shares in a corporation.

The comments to the Uniform Partnership Act and LLC Act describe the charging order as “in the nature of a garnishment.” Rather than allowing a seizure of the asset the creditor only gets an “assignment of income” equal to any distribution from the partnership to the person who lost the lawsuit or is otherwise deemed a debtor.

“Charging Order Protection” is somewhat of a misnomer. A charging order is a remedy that is affirmatively sought by a creditor. A better term may be “anti-invasion protection” because the benefit sought from a charging order protection is making any invasion by a creditor of the assets within the FLP very difficult indeed!

The beauty of the charging order in the FLP context is if there are no distributions, and a properly drafted asset protection plan can limit distributions, then the creditor gets nothing! BUT! {here’s the juicy part} the IRS requires all partnership income to be allocated! The creditor will get a K-1 ( partnership version of a “1099 like” IRS form) and have to pay tax on the income he didn’t receive. This surprise happens either at the Charging order stage or (more likely) upon foreclosure of the charging order. Pursuing a charging order, unlike a seizure, thus becomes a trap for a creditor. The tax liability (unaware creditors’ and their attorneys can get “K.O.’d by the K-1”). The winning client, and his lawyer now facing a possible malpractice claim, “no longer want the cheese; they just want out of the trap.” An empty handed departure or favorable settlement is much more likely.

An FLP is the legal entity that can offer great, affordable, asset protection to most every family even with much less than $500,000 in total assets. Think you’re too small to use this? What would a $100,000 lawsuit do to your family’s modest lifestyle? If you have Millions in assets, early planning becomes even more crucial.

Charging Order Protected Entity (COPE) is the term used to describe entities for which external creditors are usually limited to the charging order remedy, they may protect the back door (against outside creditors) not just to Limited Partnerships (LP) but Limited Liability Company (LLC), Limited Liability Partnerships (LLP), Limited Liability Limited Partnerships (LLLP), as well as the new series LLC from Delaware and Oklahoma. How these other entities may be used will be addressed in he future.

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