Limited partnerships and limited liability companies (LLCs) are two of the most powerful asset protection tools an attorney has. Their unique asset protection capabilities are based on the concept of a “charging order.” A charging order protects assets of the limited partnership or limited liability company against creditors of the partners in the limited partnership and members of the LLC. A creditor can come in many forms. It may be the guy who wins the lawsuit against you or the guy you owe money to, including the bank that is foreclosing on one of your properties. The object in this article is to show you how to use a limited partnership (that will usually be a family limited partnership–FLP) or limited liability company to protect your assets.
One of the advantages of using an LLC or FLP over a corporation is the fact that when a limited partner in the FLP or a member in an LLC is personally in trouble through a lawsuit or bad financial situation, the assets in the FLP or LLC can be protected to a great degree. Note that corporations are powerful legal tools and often used in preference to an FLP or LLC, but for “family” planning or “closely held” business structuring, the LLC and FLP may have advantages. For most situations today, I recommend the LLC. It has flexibilities and shielding that you can’t get in an FLP.
I am getting a lot of calls from my students that have bought a number of pieces of property, and due to the rotten real estate markets in some states, they are losing one or more of their properties. They may end up as a debtor with large foreclosure judgments against them. When a creditor gets the judgment, they will try to collect from your assets, including the property you “own.” The debtor can hold the properties in land trusts, LLCs, FLPs or corporation. If the properties are held in different land trusts, the foreclosure judgment creditors will simply go from land trust to land trust until they can satisfy their judgment. If the properties are held in corporations, they will simply get the stock that the debtor owns in each corporation to satisfy the judgment and then have full access to the properties. If however, the properties are held in a limited partnership or LLC, the creditors can only obtain a charging order against the debtor’s limited partnership interest in the FLP or their membership interest in the LLC.
But wait, you say. The property being foreclosed on is held in a corporation or LLC, and the creditors can only attack the assets of the single entity holding the property. You are correct, if the loan was given to the entity, but even the subprime loan idiots required personal signatures from the “owners” of the entity, i.e., you. That means the foreclosure creditor can not only look to the entity for satisfaction, but also look to all of your other assets for satisfaction as well. Your assets include your stock in all of your other corporations or your interests in partnerships and LLCs.
As an aside, hopefully only one spouse signed the loan. If at all possible, never have both spouses sign the loan. If only one spouse signed, then the assets of the spouse that didn’t sign the loan should be outside the creditor’s grasp. You should always clearly separate ownership of assets between husband and wife. When the assets are separated, then all of the family assets may not be at risk when disaster strikes. (This does not work in a community property state, where spouses are considered to be one ownership unit.) Hold the separated assets in living revocable trusts, a “his trust” and a “her trust,” so that the surviving spouse doesn’t have to probate the assets when the other spouse dies.
When the creditor starts to collect his debts from you, the best asset you can have to “offer him” is an interest in a limited partnership or LLC. The laws have evolved over the past hundred plus years to protect limited partnerships from the creditors of individual limited partners, and those laws have been extended to LLC members. The bottom line is, assets held in your LLC or FLP are largely protected from your creditors.
The laws associated with LLCs and FLPs are very well defined by “uniform acts” that have been adopted by almost every state. These laws all state that when an interest in a limited partnership or LLC is attacked, the most the attacker can get is the economic interest the owner has in the entity. The “management” interest is specifically, by law, protected from the creditor’s grasp. The most the creditor can do is “charge” the interest of the owner with the debt. Thus, the creditor gets a “charging order.”
Historically, when a creditor took a limited partner’s interest, the creditor walked in and seized the partnership assets. That put the other partners out of business. It wasn’t fair to the other partners. To maintain business functions, it was recognized that the partnership had to be protected, so the laws of charging orders were developed. They basically say that the only thing that the creditor can get is the right to any economic benefit the debtor had in the partnership. The creditor can’t affect the management of the partnership or directly access any of the assets of the partnership. The Uniform Limited Partnership Act was updated in 2001 and the Uniform Limited Liability Company Act in 1996. They both clearly make the creditor’s only remedy a charging order. There isn’t any transfer of rights other than the economic interest, i.e., the expectation of a distribution of profits
Well, if you are the manager of the entity and have just lost your rights to all distributions from the entity, how often are you going to make distributions of the profit? I am sure you will figure out a way to eat all of the “profits” in wages for yourself and other limited partners or LLC members. The partners and members are usually your family members, so it’s still “all in the family.” The LLC has a major advantage over the FLP. The accounting rules of an LLC make it possible to selectively distribute profits to only the family members and not the creditor. (Nice flexibility!) The creditor has absolutely no say (by law) over whether or not a distribution is ever made. The creditor can’t affect the management of the LLC, even though they have the economic interest because of the charging order.
The limited partnership agreement and the operating agreement of the LLC are critical documents, because the courts will honor those documents in almost every situation. If the operating agreement says that no distributions will be made to an “assignee” or “transferee” of a member’s interest, many of the state courts will honor that. The creditor might not even get the economic interest. That means that the charging order is totally worthless. Your agreements should have language that restricts the assignment of a member’s interest. Such as: “No interests may be assigned.” “Any assignment of an interest requires approval of all other members/partners or the consent of the LLC manager.”
A note needs to be added about single member LLCs. A Colorado court decided a case where an LLC had a single member. They gave the creditor the right to take both the economic interest and the management interest of the member. The court reasoned that charging orders were developed to protect the other members/partners in the business activity. Since there was only one member, there wasn’t any need to protect anyone else, so the court gave the creditor everything. The court was wrong and no other court has followed, but it has raised a concern about single member LLCs. The problem is easily solved. Just give someone else a tiny part (1%) of the membership interests in the LLC. That could be a spouse. However, in a community property state you should use a child or someone other than the spouse, because the spouses are considered to be a single ownership unit.
The bottom line is, even if you know the lawsuit is coming, you can start putting assets into LLCs and FLPs to protect them. If this is done more than two years prior to a bankruptcy and the LLC or FLP documents are written properly, the assets can even be protected from the bankruptcy trustee. The most the bankruptcy trustee can do is get a charging order. In other cases, the state’s fraudulent conveyance laws will control, but there is still a good chance you can comply with the fraudulent conveyance laws and get the property out of the creditor’s reach.
Yes, when a creditor gets a charging order, it is possible to shift income tax burdens to the creditor without ever making an actual distribution of cash to the creditor. This is an unpleasant situation for the creditor to be placed in. With no right to ever force a distribution, no right to manage or vote, and the possibility of getting phantom income that creates a tax liability, most creditors simply don’t try to collect through a charging order. They will settle their dispute with you and walk with next to nothing, because that’s as good as they can get. The charging order aspect of the limited partnerships and LLCs is one of your most powerful asset protection strategies. Learn how to use them, and you can sleep a lot better at night, because your assets are protected from the business liabilities and many of your personal liabilities as well.