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Funding the Partnership

Funding the Partnership

In making the decision about funding the partnership, it is important that you understand the distinction between Safe Assets and Dangerous Assets.

Safe Assets are those which do not, by themselves, produce a high degree of lawsuit risk. For instance, if you own investment securities such as stocks, bonds, or mutual funds, it is unlikely that these assets will cause you to be sued. Mere ownership of investment assets, without some active involvement in the underlying business, would probably not cause a significant degree of lawsuit exposure.

Dangerous Assets, on the other hand, are those which, by their nature, create a substantial risk of liability. These are generally active business type assets, rental real estate, or motor vehicle ownership, any of which may cause you to be sued.

The reason for the distinction between Safe Assets and Dangerous Assets is that you do not wish to have the FLP incur liability because of its ownership of a Dangerous Asset. If the partnership does incur liability, it will be the target of a lawsuit and all of the assets in that partnership will be subject to the claims of the judgment creditor. This is exactly the situation you are trying to avoid. Dangerous Assets must either be left outside of the partnership or must be placed in one or more separate entities. Dangerous Assets must be isolated from each other and from Safe Assets, in order to avoid contaminating the Safe Assets.

Dangerous Assets
An example of a Dangerous Asset is an apartment building. The liability potential of apartment houses is particularly high. Although liability insurance coverage is usually available, the amount of coverage may not be sufficient. A fire in a densely populated building may cause severe injury or death to many tenants. The potential liability for such a tragedy could easily reach into the millions of dollars, exceeding by far the amount of your insurance coverage.

Apartment owners can also be held responsible for the acts of the resident managers. If the resident manager engages in race or sex discrimination in renting to tenants, or is guilty of sexual harassment, this liability may be imputed to you as the owner of the property. Acts such as these may not be covered under your standard insurance coverage.

If this asset is transferred to the same Family Limited Partnership that holds all of your other assets, that partnership, as the owner of the property, will face a high degree of lawsuit exposure and all of your assets will again be at risk.

Instead, the best approach for a Dangerous Asset such as an apartment building is to transfer that property to its own separate entity. Generally the Limited Liability Company is the proper way to hold Dangerous Assets. Since no individual member of an LLC can be sued for an LLC related obligation, the liability associated with the Dangerous Asset can be contained and insulated in the LLC. If a number of Dangerous Assets are owned, each should be placed in a separate entity. Once we formed thirty-two different LLCs for a client, each holding one apartment building. If a disaster occurred, only the LLC which owned that property would be sued. The other properties and family assets were safely insulated and shielded from liability under this arrangement.

Some types of commercial real estate may also constitute Dangerous Assets. Office buildings, hotels, restaurants, nightclubs, or any other building where many people work or gather, all have the potential to produce stratospheric liability in the event of some type of disaster.

A physician client owned a medical office building in his Professional Corporation. His medical practice and the property were both Dangerous Assets and a liability produced by either would jeopardize the other. For example, a problem arising from the building would produce a claim against the equipment, accounts receivable, and cash in the corporation. The office building should have been separated from the medical practice by holding it in a separate LLC. Dangerous Assets must be kept separate from each other asset. We will discuss details about the use and operation of the LLC.

Safe Assets
Safe Assets with a low probability of creating lawsuit liability can be maintained in a single Family Limited Partnership.

Although the family home is a Safe Asset, with liability issues generally covered by insurance, there are a number of tax issues which arise with respect to the transfer of the family home into the Family Limited Partnership. The first problem concerns the availability of the income tax deduction for home mortgage interest. Section 163 of the Internal Revenue Code permits a deduction for “qualified residence interest.” A “qualified residence” is defined as the “principal residence” of the taxpayer. The only requirements appear to be that (1) the house is the principal residence of the taxpayer; (2) interest is paid by the taxpayer; and (3) the taxpayer has a beneficial interest in any entity that holds legal title to the property. Based upon the language of the statute, the deduction for mortgage interest would, therefore, not seem to be adversely affected by a transfer into the Family Limited Partnership. However, until the law on this issue has been conclusively decided you should not risk the consequences of a disallowance of your mortgage interest deduction.

Similar tax issues concern the ability to avoid up to $500,000 of the gain from the sale of your home. It is likely that a transfer of your residence into the FLP would cause you to lose this tax advantage. For these reasons, we do not recommend using the FLP to hold the family residence.

An alternative is to use a specially designed trust to own the home. All of the tax benefits will be preserved and the highest level of protection can be maintained.

Bank and Brokerage Accounts
These types of accounts do not create any potential liability and can be transferred into the Family Limited Partnership. In order to open these accounts in the name of the partnership, you will present the financial institution with a certified copy of the Certificate of Limited Partnership. The institution will also require the Taxpayer Identification Number issued to the partnership by the Internal Revenue Service.

Interest in Other Entities
The Family Limited Partnership is an excellent vehicle for holding interests in other business entities. The reason that we mention these other business entities is that the Family Limited Partnership must not ever be engaged in any business activities. You do not want the partnership to buy or sell property or goods or to enter into contracts. If the partnership does business, then the partnership can get sued. And if the partnership gets sued and loses, all of the assets that it holds can be lost.

Case Example
For example, a client of ours entered into a contract to purchase a shopping center. Previously, we had set up a Family Limited Partnership for him. Without our knowledge, the “Buyer” under the purchase contract was the Family Limited Partnership. During the pre-closing escrow period, financing became unavailable and the client failed to complete the deal. The seller sued the partnership for damages for breach of contract and was awarded $600,000 wiping out a substantial portion of our client’s assets. The seller sued the partnership because the partnership was the named party to the contract.

This transaction should not have been handled in this manner. The proper way to conduct this type of business activity is through a separate LLC or partnership arrangement. By using the proper planning techniques, potential liability can be significantly reduced and valuable personal assets can be protected from a dangerous lawsuit. Had this arrangement been used, our client would not have lost $600,000. Instead, the buyer and seller would probably have re-negotiated the terms of the purchase in a way that was mutually satisfactory to each side.

This example illustrates the necessity for conducting business activities through an entity other than the Family Limited Partnership so that family assets are not exposed to the risk of liability. The proper role of the Family Limited Partnership in this context is to hold the interests in the business entities that are themselves subject to risk. The FLP can hold these interests, providing asset protection and estate planning advantages in a single integrated package.

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