A limited partnership is a partnership that has at least one limited partner and one general partner. Most states require the filing of a certificate with the state in order to be recognized as a limited partnership.
The limited partners generally have no liability beyond their contribution to the partnership. If the limited partnership business fails, the creditor cannot go after the limited partners for debts (there are a few minor exceptions to this rule that are not difficult to avoid). Furthermore, limited partners are not personally liable for wrongful acts committed by the other partners. In exchange for this limited liability, the limited partners give up their right to participate in the control and management of the partnership.
The general partners run the management of the partnership. The general partners control the cash distributions to the partners. The general partners also have unlimited liability, as in a general partnership. Creditors of the partnership can look to the general partners' personal assets if the limited partnership's assets are insufficient. Furthermore, the general partners are liable to third parties for wrongful conduct within the partnership business (e.g., a “slip and fall lawsuit”). Thus, a corporation is usually better for pure liability protection for its owners.
The limited partnership does not pay taxes as an “entity.” It files an informational tax return to the IRS. It issues a form K-1 to the partners who include the partnership income or loss on their personal tax returns. The partners must pay income tax on all gains whether or not the profit is distributed.
Creditors of individual partners cannot take a partner's place in the partnership. A creditor may garnish the partner's share of income (called a “charging order”), but has no right to participate in the management or utilize partnership property. Thus, if a limited partner's income is garnished by a creditor, the general partner (who should be under the limited partner's control) can frustrate the creditor by not distributing income to the partners. Since a partner is required to pay taxes on his share of the income whether or not the income is distributed, guess who gets the tax bill? You guessed it, the creditor! If your assets are held in a limited partnership, they are virtually judgment-proof!
The Family Limited Partnership
Let's look at a variation known as a “family” limited partnership. Suppose that you and your spouse create a limited partnership to hold your family's liquid assets. Your limited partnership contributions are all of your stocks, cash, CD's and mutual funds totaling $300,000. Your partnership agreement could state that your spouse will act as general partner with a 2% share (the size of the general partnership share does not affect the general partner's power to manage the partnership's affairs). You agree in writing that your contributions constitute a 98% limited partnership interest.
The partnership agreement could further state that the limited partnership shall have the right to buy out the general partner for his share of the partnership and appoint a new general partner to replace her (the “you” in this example is the husband; we are making the wife general partner because we assume that husband's risk of getting sued is higher; if the opposite were true, then we would arrange the partnership accordingly).
Let's say that you are sued and a creditor 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 (called a “charging order”). The creditor who attaches a limited partnership interest cannot participate in the management of the partnership, and thus cannot force the general partner, your spouse, to distribute income. As general partner, your spouse stops paying the limited partners' distributions, because in her discretion the limited partnership would be better served to reinvest the capital.
One year later, the creditor still has a $50,000 unsatisfied judgment. Just to top it off, the partnership sends the creditor a form “K-1” for the creditor's share of your “phantom” income (In our example, the partnership assets are worth $300,000. At a 10% annual return, your share of income would be approximately $30,000 – the creditor would have to pay income taxes in the ballpark of $10,000! If the creditor does not pay the tax due on your undistributed share of income, the IRS may 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 say 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.
“Family” LLC's – To Good to be True?
Another similar tool for protecting your wealth is the LLC or “Limited Liability Company.” An LLC is like a cross between a corporation and a limited partnership. All of its partners (called “members”) have limited liability and all of its members can participate in the management of the LLC without suffering any liability.
Any assets you hold in an LLC are protected from creditors in the same way your assets are protecting in a limited partnership (i.e., the creditor's remedy is limited to a “charging order”). In addition, since all members are shielded from liability, an LLC may be an excellent device for holding investment real estate – the members are protected from tenant lawsuits and the equity of the members is protected from other creditors.