The Benefits of Family Limited Partnerships (FLP) and Family Limited Liability Companies (FLLC)
Versatility Beyond Discounts –
The Benefits of Family Limited Partnerships (FLP) and Family Limited Liability Companies (FLLC)
Dateline: January, 2002
By: Deirdre R. Wheatley-Liss, Esq.
I. Overview
A. Introduction: Many planners think of FLPs and FLLCs (which will be used interchangeably throughout) in terms of one thing: discounts, discounts, discounts. While leveraging gifts or reducing the value of the estate may be a motivating factor in considering an FLP or FLLC for your client, the totality of the available benefits of these entities argue for their increased use in your practice. It is the “family” element of these business entities that sets them apart.
B. Benefits of FLPs and FLLCs:
1. Continued control of assets by the client to a limited extent
2. Asset Protection against the primary fears of estate planning clients
3. Ease of Transfer of Interests during life and upon death
4. Valuation Discounts – Gift and Estate Tax Savings
II. Control
A. Client Concerns: Estate planning clients have different motivations for establishing FLPs and FLLCs then business clients. Whereas business clients may be most motivated by the taxation of a form of business and liability concerns, an estate planning client may intellectually want to design a plan with the most favorable tax and asset protection strategies, but often have an emotional barrier to planning, no matter the size of the estate, because they fear losing control over their assets. Essentially, they want to have their cake and eat it too.
1. Investment Management - Older generations have different investment needs, strategies, and risk tolerance then their children.
2. Asset Protection - Clients have a very real concern that if they give assets to their children today, and those children are divorced in the future, those assets will then pass on to the spouse. Even where gifting may be appropriate for tax or Medicaid planning purposes, real or imagined concerns about their children’s marital situation may prevent gifts. (Discussed in more detail below)
3. Timing of Gifts - Where a client wants to take advantage of their annual exclusion to make gifts now, they may not want the children spending the money now. They may want the assets to essentially accumulate a nest egg for the child for his or her early retirement, or fund some other future goal.
B. Solution: Establish an FLP or an FLLC with a two-tier ownership structure – a management class and a non-management class. Even after the parents make gifts of the limited partnership (“LP”) interest or non-managing member (“NMM”) interest, they maintain control over the investments of all the assets owned by the FLP or FLLC. Restrict the transferability of LP or NMM interest in the operating agreement to make the interest unappealing to creditors. Consider establishing a trust to hold any assets gifted to the children – this allows the parents to make a pro-rata distribution from the FLP or FLLC to the owners, but the Trustee of the trust still acts as gatekeeper in releasing the distribution to the child/beneficiary of the trust. (Refer to Exhibit 1)
C. Brief Comparison of FLP and FLLC
1. FLP – The enabling statute is located at NJS 42:2A-1 et seq. To form an FLP, refer to the following web site for, fees and forms: http://www.state.nj.us/treasury/revenue/dcr/programs/corpfile.html
(a) An FLP by definition of two classes of management. There is a general partner (“GP”), as well as LP’s. The general partner manages the day-to-day affairs of the partnership. The FLP must have at least 2 partners.
(b) By definition, an LP cannot have a voice in the management of the partnership, nor can the LP compel distributions of the partnership interest.
(c) Traditionally, a GP has unlimited liability for the acts of the partnership, while an LP has liability only to the extent of his investment in the partnership. The concern about the unlimited liability of the GP is many times addressed through the creation of a corporate general partner.
(d) The ability to transfer an LP interest may be restricted in the partnership agreement so that the only permissible beneficiaries are family members.
(e) A creditor’s sole remedy is a charging order (see below).
(f) Taxed as a partnership under Federal and State law. All items of income, loss, gain and deduction flow through to the partners and are reflected on their personal returns. There is great flexibility in the to determine how these items are shared in the Income Tax Code.
(i) Practice Tip: In family situations clients are generally looking for simplicity in accounting and administration. Accordingly, it is appropriate to recommend to clients that they only make pro-rata distributions based on the partnership interest held by the partners.
2. FLLC – The enabling statute is located at NJS 42:2B-1 et seq. To form an LLC, refer to the following web site for fees and forms: http://www.state.nj.us/treasury/revenue/dcr/programs/corpfile.html .
(a) The Limited Liability Company is a relatively new form of entity that was introduced in New Jersey in 1993. The statue gives the members great flexibility in determining the ownership, management, and transferability of membership interest in the LLC.
(b) The operating agreement determines the management structure of the entity. An LLC may be managed by its members, by a general manager, by a management committee (echoing a board of directors of a corporation), or by a managing member class of interests which is separate and distinct from a non-managing member class of interest. This final variation mimics the GP/LP distinction of an FLP.
(c) All members of an LLC, no matter the characterization of their ownership as management or not, have limited liability for the debts of the LLC. Many practitioners view the LLC as the preferred planning vehicle over the limited partnership because of the liability protection afforded to all of the owners. Liability protection is especially important in situations where there is real estate involved because real estate ownership involves large potential liability issues, both from an environmental and a tort perspective, that individuals may want to insulate themselves and their families from.
(d) An LLC may be formed with one or more persons. Accordingly, a client could establish a single member LLC currently, and later convert it to a multi-member LLC by making gifts of interests to family members.
(e) Similar to an FLP, the ability to transfer an LLC interest may be restricted in the operating agreement so that the only permissible beneficiaries are family members.
(f) Like an FLP, a creditor’s remedy is a limited to a charging order (discussed below).
(g) The entity may elect to be taxed as a sole proprietorship (if there is only one member), a partnership (if there are 2 or more members), or a corporation (if there are one or more members). Under the default rules in a family situation, a single member LLC will generally be taxed as a sole proprietorship and a multi-member LLC as a partnership.
(h) Unlike the body of law addressing corporations and partnerships, the body of law addressing the limited liability protections afforded members of LLC’s is much less diverse. Accordingly, some practitioners feel that there may be an inadvertent action that may allow the courts to “piece the corporate veil” of limited liability protection. This makes them wary of the LLC as a planning tool. In addition, there are certain concerns regarding the valuation of LLC interest versus FLP interests, discussed below.
III. ASSET PROTECTION
A. Charging Order Sole Remedy: The FLP or FLLC is an inherent asset protection vehicle because a creditor’s sole remedy against a debtor who owns an LP or LLC interest is to receive a charging order against that interest. This charging order allows the creditor to step into the shoes of the debtor, and to receive whatever distributions the debtor may have received. The creditor has no management rights. If no distribution is made on the debtor’s interest, no distribution is made to the creditor. Charging orders allow creditors to satisfy their judgments out of the partnership profit distributions, but only in a manner that minimizes the disruption to the partnership itself. Accordingly, unless the claim is against the partnership itself, partnership property may not be seized to satisfy any partner’s obligation.
1. Statutory Authority for FLP Asset Protection
(a) 42:2A-47. Assignment of partnership interest; rights of assignee: Except as provided in the partnership agreement, a partnership interest is assignable in whole or in part. An assignment of a partnership interest does not dissolve a limited partnership or entitle the assignee to become or to exercise any rights of a partner. An assignment entitles the assignee to receive, to the extent assigned, only the distribution to which the assignor would be entitled. Except as provided in the partnership agreement, a partner ceases to be a partner upon assignment of all his partnership interest. Notwithstanding the foregoing, a general partner who assigns all of his general partnership interest shall cease to be a general partner only upon the filing of a certificate reflecting that fact in accordance with this chapter. (emphasis added)
(b) 42:2A-48. Rights of judgment creditor of a partner: On application to a court of competent jurisdiction by any judgment creditor of a partner, the court may charge the partnership interest of the partner with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the partnership interest. This chapter does not deprive any partner of the benefit of any exemption laws applicable to his partnership interest. (emphasis added).
2. Statutory Authority for FLLC Asset Protection
(a) 42:2B-45. Rights of judgment creditor of member: On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the limited liability company interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the limited liability company interest. An action by a court pursuant to this section does not deprive any member of the benefit of any exemption laws applicable to his limited liability company interest. A court order charging the limited liability company interest of a member pursuant to this section shall be the sole remedy of a judgment creditor, who shall have no right under P.L.1993, c.210 (C.42:2B-1 et seq.) or any other State law to interfere with the management or force dissolution of a limited liability company or to seek an order of the court requiring a foreclosure sale of the limited liability company interest. Nothing in this section shall be construed to affect in any way the rights of a judgment creditor of a member under federal bankruptcy or reorganization laws. (emphasis added).
(b) 42:2B-44 Company interest assignable; rights of assignee. a. A limited liability company interest is assignable in whole or in part except as provided in an operating agreement. The assignee of a member's limited liability company interest shall have no right to participate in the management of the business and affairs of a limited liability company except as provided in an operating agreement and upon:
(1) The approval of all of the non-assigning members of that interest, if any, of the limited liability company; or
(2) Compliance with any procedure provided for in the operating agreement.
b. Unless otherwise provided in an operating agreement:
(1)An assignment entitles the assignee to receive the distribution or distributions, and to receive the allocation of income, gain, loss, deduction, or credit or similar item to which the assignor was entitled, to the extent assigned;
(2)A member ceases to be a member and to have the power to exercise any rights or powers of a member upon assignment of all of his limited liability company interest; and
(3)The pledge of, or granting of a security interest, lien or other encumbrance in or against, any or all of the limited liability company interest of a member shall not cause the member to cease to be a member, to become dissociated or to fail to have the power to exercise any rights or powers of a member.
c. An operating agreement may provide that a member's interest in a limited liability company may be evidenced by a certificate of limited liability company interest issued by the limited liability company.
d. Unless otherwise provided in an operating agreement and except to the extent assumed by agreement, until an assignee of a limited liability company interest becomes a member, the assignee shall have no liability as a member solely as a result of the assignment.
e. An assignee shall have no authority to seek or obtain a court order dissolving or liquidating a limited liability company. (emphasis added)
B. Income Taxation: Partnership taxation indicates that the partners are individually taxed on their share of the items of income, gain, loss and deduction generated by the partnership (generally pro-rata). Per Rev. Rul. 77-137, 1977-1 CB 178, even though the holder of a charging order is treated as an assignee of the partnership distributions under state law, it is treated as a partner for income tax purposes. Accordingly, where the FLP or FLLC produces items of income or gain, a creditor with a charging order will be responsible to report its share of those items on its tax return, even though no distribution has been made. As a result, the creditor may have to pay taxes on money it does not actually receive. Since the income tax consequences of a charging order are so onerous, there are significant settlement opportunities between a debtor LP or LLC member and his creditors.
C. Bankruptcy: The bankruptcy of an LP or LLC member does not affect the FLP or FLLC directly because creditors only have access to the partnership interest. The bankruptcy trustee has power to sell the partnership interest/membership interest. However, this does not affect the asset protection aspects of the entity because under a properly drafted partnership agreement or operating agreement, the purchaser will just be a mere assignee. In addition, if as a result of the restrictions on transfers built into the partnership agreement or operating agreement the value of the entity is discounted, family members may purchase the interest from the bankrupt partner at a relatively low price.
D. Dissolution of Marriage: Many times a family owns assets with the intention of distributing those assets down the lineal family tree. It is common for non-blood relatives to be excluded from the distribution scheme. A concern is that in the event of a divorce a spouse may receive an interest in family assets, contrary to the wishes of the family plan. Use of an FLP or FLLC to gift interests in the entity, rather then outright ownership of assets, effectively combats this problem.
1. Equitable Distribution - In New Jersey, upon divorce the assets are divided by equitable distribution. Inheritance and gifts from family members are exempt from equitable distribution, so long as the party can trace the asset to the inheritance and or gift. Many times parents are concerned about giving assets to their children because the children will put them into a joint investment, or use the assets for joint purposes, thus transforming their exempt status to “included” status. An interest in a properly drafted FLP or FLLC is non-transferable, and accordingly should remain outside the reaches of equitable distribution.
2. Support - Notwithstanding, many family law practitioners have found that the court considers all of the assets in determining support payments, and may consider any income that one spouse is receiving from an inheritance or gift in structuring a support order even though the underlying asset itself is not subject to equitable distribution. By having an FLP or FLLC, the GP or Managing Members can effectively control the income flow to the child. Compare this to a gift to a trust with mandatory income.
E. Medicaid:
1. Spend-Down - As a general rule, prior to a person qualifying for Medicaid to cover the expenses of long term care, that person’s assets must be spent down to no more then $2,000. Certain assets are excluded from the spend-down, such as the family home, if a spouse continues to reside there, and “unavailable assets”. (A complete list of excluded assets can be found in N.J.A.C.10:71-4.4)
2. Unavailable Assets - Unavailable assets are resources that the applicant cannot convert to cash. These unavailable resources are not included in the assets that must be spent down before a person qualifies for Medicaid. (See 20 C.F.R. 416.1201(a)(1); N.J.A.C.10:71-4.4.) Examples of unavailable resources are those that are not accessible to the individual through no fault of their own. An example of such an assets in the Administrative Code is real property that cannot be sold because of the refusal of the co-owner to liquidate. See N.J.A.C.10:71-4.4.6. Presumably, a properly structured FLP or FLLC should be deemed an unavailable asset since the Medicaid beneficiary has no right to liquidate their interest or to withdraw from the FLP or FLLC.
3. Practice Tip - Be aware when utilizing this technique to protect assets from Medicaid, that if the FLP or FLLC was funded primarily with a person’s assets, and gifts were of interest in the entity made to beneficiaries within 3 years of the Medicaid application (5 years if the gifts were made to a trust) the transfer of those interests will cause a penalty period for Medicaid.