With respect to investment activities, risk management strategies primarily revolve around using a family limited partnership (or “FLP”) and limited liability companies (or “LLC”) to encapsulate risks and insulate assets from risks. Before discussing those entities, we should understand where the risks lie. Understanding the nature of the risk we are trying to manage will help with understanding how these entities help.
We consider two types of liability called “inside liability” and “outside liability”. Inside liability is liability that arises because of the nature of an asset itself. For example, any real estate (such as a commercial or residential investment property) is subject to risk because someone might have an accident at the property (such as a slip-and-fall or electrical accident) that subjects the property to satisfaction of claims and judgments. That is, you can expect that if someone has an electrical accident at a property you own they are going to try to use the property itself to satisfy a judgment against you for the injury.
Outside liability is the risk that an asset might be subject to satisfaction of claims and judgments from matters unrelated to the asset. For example, if you cause a car accident and someone obtains a large judgment against you personally, investment real estate could be foreclosed upon in satisfaction of the judgment (remember that in many states, including Washington, judgments automatically attach as a lien against all real estate that the judgment debtor owns).
In addition to the two above categories of liability, we can also divide assets into two types, “risky assets” and “safe assets”. Safe assets are assets that do not by their nature subject you to any risk of liability. For example, shares of a mutual fund are safe assets because you would not expect to be sued for the fact that you own those shares. However, rental real estate is regarded as a risky asset because the asset itself can expose you to liability (such as the above mentioned slip-and-fall accident at an investment property).
As you can see, then, risky assets are subject to both inside and outside liability, whereas safe assets are typically only exposed to outside liability. The following diagrams illustrate the above concepts. For convenience, blue lines show ownership of assets, red lines show claims of liability, and green lines show potential flow of assets in satisfaction of claims and judgments.
This first diagram illustrates the position you would be in if an outside liability event occurred now, without asset protection planning. In our example, we use a car accident caused by you or a member of your family. As you can see, all of your assets would be subject to satisfaction of the claim.
The next diagram illustrates an event of inside liability without asset protection planning. In the example, we again return to the slip-and-fall accident occurring at an investment property. Again, all of your assets are subject to satisfaction of the claim.
As these diagrams illustrate, our goal is to separate you and your safe assets from inside liabilities associated with risky assets, and to separate all of your assets from outside liabilities arising from your other personal activities. We can reach these goals through the use of a FLP and LLCs. We will start with describing the FLP.
A Limited Partnership is a partnership having at least one partner whose liability for the enterprise is limited to his or her investment and at least one partner with unlimited personal liability for the entity (the “general partner”). In a limited partnership, the general partner manages the partnership’s business and has personal liability for the partnership’s activities. Limited partners have limited liability without any authority to manage the partnership’s business activities. In other words, a limited partner is a passive investor whose rights are similar to those of a shareholder in a corporation. To illustrate, if a corporation goes bankrupt, its shareholders only lose the current value of their stock. Likewise, a limited partner would not ordinarily have personal liability for partnership obligations.
An FLP is a limited partnership in which family members or family controlled entities own a majority or all of the limited partnership interests. These family members usually include a parent or parents, one or more children, and often include trusts created for children or descendants of children. The phrase “Family Limited Partnership” or “FLP” cannot be found in any statute on business entities. It is merely a term of art; an FLP is a limited partnership sanctioned under state law and is treated as a legal person. It is typically structured to give maximum authority to the general partner and minimal legal rights to the limited partners. Most FLPs are structured so that the general partner owns one percent (1%) or less of the partnership interest with ownership of the remaining interests held by the limited partners.
Key to any success with this type of planning is the understanding that a family limited partnership is a business entity and must be run as a business. The business conducted may be passive in nature, such as managing stocks, bonds, and mutual funds or similar assets, or as complex as managing investment real property or an operating business enterprise with employees. Some FLPs are structured to own a mix of different assets that include passive holdings as well as an active business enterprise.
While there are many reasons that people use FLPs, our main concern here is liability protection. FLPs are very useful tools in protecting from both outside and inside liabilities. With regard to outside liabilities, our goal is to insulate your financial and business assets from claims made against you that are unrelated to those assets. An FLP can protect assets from personal lawsuit creditors because a judgment entered against a partner individually cannot generally lead to seizure of any assets of the FLP in satisfaction of that judgment. Creditors of an individual partner have at best only the rights of the partner, i.e. the right to receive distributions make with respect to the partnership interest (that is, dividend-like distributions). This occurs because limited partnership statutes generally provide a creditor with only one way to collect a judgment; this is what is referred to as a “charging order.”
A charging order allows the creditor to seize partnership distributions actually made. But there is no way for the creditor to force the general partner to make a distribution. The creditor would be forced to wait until a distribution was actually made to the debtor-partner.
An FLP permits the General Partner to discontinue making any FLP distributions to partners and accumulate partnership revenues for the reasonable needs of the FLP. Under IRS rules, even if a creditor does not receive payments from the withheld partnership share, the creditor would be required to pay all the income tax associated with that share. This leaves the creditor in the unenviable position of paying taxes on money not received.
At this point we might return to the first illustration above to see how the FLP protects your assets from outside liability. Again using a car accident as the example, we see that if someone did get a judgment against you, they cannot reach the assets directly; the best the judgment creditor can hope for is a charging order (the yellow line represents the charging order).
The above structure also provides protection for you from inside liability associated with risky assets (such as an investment property). If we return to the slip-and-fall example at the investment property (the risky asset), interposing the FLP in the scenario would insulate you personally from a judgment; the claim would be made directly against the property owner (in the above illustration, the FLP). As you might guess, however, that does leave one remaining issue. While we have protected the financial (safe) and commercial (risky) assets from outside liabilities, we have not yet insulated them from each other. The problem with this scenario is that if someone gets a judgment against the FLP, all of the assets the FLP owns would be subject to satisfaction of that judgment. Therefore, the remaining issue is to determine how to insulate and protect your safe assets from outside liability associated with risky assets.
Insulation is accomplished through use of LLCs. An LLC is similar to a corporation in that ownership of the company is established through representative shares. Rather than stock we call LLC shares “units”; people that own units are called “members” rather than stockholders. Like a corporation, members are generally protected from the company’s liabilities and are only exposed to losing the amount that they have invested in the company. For example, if someone owns 100 shares of WidgetCo, Inc. stock and a WidgetCo, Inc. creditor obtains a judgment so large that it bankrupts the company, the worst thing that could happen to the investor is that he or she would lose the investment. The investor usually need not worry that the creditor will come to the investor’s doorstep and ask for more money if the company’s assets were insufficient to pay the judgment (with respect to the shareholder, this is known as the “corporate veil”).
The LLC provides protection by acting as an independent encapsulated entity with regard to the assets that it holds. For example, if you own two assets, a commercial building and a bank account, your bank account would be at risk if someone sued you for an accident at the commercial building. However, if you had created an LLC and transferred the commercial building into it in exchange for all of the units of the company, the bank account would be insulated from the outside liability associated with the commercial building. If someone sued the company for an accident that happened at the building, the worst thing that could typically happen is that the company would go bankrupt and lose its only asset in satisfaction of the judgment (assuming that the judgment exceeds the value of the building). As a mere member that only holds units, you would not generally be subject to the excess liability and the bank account is thereby protected.
Adding to the immediately preceding illustration, then, we can see that if someone were to make a claim with respect to the investment property, the LLC would insulate you, the FLP and the other FLP assets from liability associated with the claim.
As discussed above, there are other uses and aspects of planning with family owned business entities. From an asset protection perspective, they provide solid protection from nearly every direction that liability could come from.
Please keep in mind that this discussion is purposely general and that not every situation is the same or warrants the specific entities and strategies discussed here. Even where these strategies are applicable, every individual’s specific plan must be carefully tailored to address their personal, family and financial situation. Please feel free to contact Lineberry Kenney, PLLC for more information.
