This is my third column about the various entities under which you can do business and protect your assets. In part three, I explain Family Limited Partnership and the first of three types of Trusts, the Irrevocable Trust.
Family Limited Partnership
A “family” limited partnership is a variation of a limited partnership. The term “family” comes from a provision of the Internal Revenue Code that applies to the shifting of income between family members.
Generally, a family limited partnership (“FLP”) is a limited partnership formed among family members. For example, you and your spouse create a limited partnership to hold your family’s liquid investment assets ($300,000 in stocks, cash, CDs and mutual funds). Your partnership agreement could state that your spouse will act as general partner with a 2% share and your contributions constitute a 98% limited partnership interest. The partnership agreement could state further that the limited partnership shall have the right to buy out the general partner’s (your wife) share of the partnership and replace her with a new general partner.
A creditor sues you and obtains a $50,000 judgment against your name. The creditor can attach your limited partnership interest, but only to the extent of your income as a limited partner. A creditor cannot force the general partner, your spouse, to distribute income. She stops paying the limited partners’ distributions because she has decided that the limited partnership would be better served to reinvest the capital.
One year later, the creditor still has a $50,000 unsatisfied judgment. Better yet, the partnership sends the creditor an IRS form K-1 for the creditor’s share of your “phantom” income (which is $30,000, based on a 10% annual return, according to our example). The creditor would have to pay approximately $10,000 in income taxes! If the creditor does not pay the tax, then the IRS will come after the creditor. You will be in a strong position to force your creditor to settle his claim for a fraction of its value.
Let’s suppose a creditor sues your spouse and tries to attack your spouse’s general partnership interest. At that point, the partnership exercises its power under the partnership agreement to buy out her general partnership interest in the amount of $2,000 or 2%. The partnership then finds a new general partner. With proper planning, this may not be considered a “fraudulent” conveyance because the general partner received full compensation for her partnership share. As you can see, the limited partnership is one of the few entities, which affords control over your money, yet still provides you with asset protection.
Irrevocable Trusts
Irrevocable Trust: With proper planning, an irrevocable trust can insulate your assets from claims of outside parties. The trust, as a separate entity from you, owns the assets. If the trust contains a “spendthrift” provision, then the trustee has authority to withhold distributions of income and principal. To the extent the trustee can withhold income from you; he can also withhold it from your creditors.
In most states, you cannot be the trustee or beneficiary of the trust, if you want to protect completely the trust assets from the claims of creditors. A sibling or in-law is a good choice because they are beyond your legal control, but (hopefully) protecting your best interests.
Keep in mind that these types of trusts are irrevocable, that is, once you place the assets into trust you cannot retrieve them. Typically, these types of trusts are created primarily for estate planning, so you may wish to forego using them if you are younger than 40. Even beyond that age, you may choose to use an irrevocable trust for select items of property, such as your residence or life insurance policy.
If you do choose to create an irrevocable trust, make certain that you use an attorney and/or CPA who is well versed in estate planning, gift and income tax law.
