In this ever more litigious society, business owners often look for ways to limit their liability. One method is to reorganize the business, using one or more entities, usually limited partnerships and limited liability companies ("LLCs"). There can be potential savings in economies of scale, efficiencies of organization, estate planning and tax efficiencies, as well as liability and wealth conservation benefits. These benefits and the use of a particular entity, especially the use of both limited partnerships, and LLCs are complex and subtle. While each entity provides limited liability for owners, the substantive rules and procedural applications of legal liability theories can result in different outcomes for similar conduct. Further, an entity does not protect an owner-employee from that person’s acts since a person is always liable for his or her acts or omissions. This means that if an owner should commit a negligent act while in the scope of employment, that owner, as well as the entity, can be held liable for these acts.
A limited partnership is created under state law, with at least one general partner and one or more limited partners. The general partner usually has a 1% ownership interest, with the remaining 99% being held by one or more limited partners. The limited partnership must have as its primary purpose the holding, managing, and administering of property, that is a business function. It cannot be formed solely to avoid creditors or taxes.
There are two types of creditors who bring claims. One directly attacks the entity itself or its owners for an act or omission of the entity, such as a breach of contract or injury. The second attacks an individual for an act committed in its individual capacity.
If creditor with a claim against the entity wins a judgment, then that creditor can try to collect its judgment out of the entity’s assets. If the claim is brought and a judgment won against an owner in its individual capacity, then the creditor can attempt to collect against any nonexempt assets of the owner, including its interest in the entity.
One benefit of a limited partnership is the fact that creditors of a general or limited partner cannot directly reach the partnership assets. If such a creditor tries to satisfy a judgment against a general or limited partner, it does not become a partner; it becomes only an assignee of a limited partnership interest, and is entitled only to a "charging order" against the partner’s interest in the partnership. A charging order gives the creditor a right to any distributions made to the partners. Although the law provides this is the exclusive remedy, some creditors try to obtain a turnover order for a limited partnership interest. Nevertheless, this normally does no more than give a creditor an additional means for obtaining assignee status, and should not, give the creditor of a limited partner any greater rights than that of an assignee. Under the Texas Limited Partnership Act, a creditor cannot sell an interest unless the limited partnership agreement so provides; a creditor cannot replace the limited partner in the partnership; a creditor cannot cause a partition of the partnership; and a creditor cannot require the limited partnership to pay him the judgment. He can only wait for income to be paid. If the limited partnership agreement so provides, the general partner has the absolute discretion to not pay any income to the limited partner.
Although no assurance can be given that using a limited partnership will absolutely prevent a creditor from reaching the interest of a partner in a limited partnership, it is unlikely that a creditor will be interested in becoming an assignee of a limited partnership interest when an assignee has no role in management, is restricted solely to distributions of profits (if the general partner decides to make distributions), and is required to pay tax on the income of the partnership, even if no distributions are made. This prospect of having to pay taxes but not receiving income makes being a creditor of a limited partner extremely unattractive. Under the current partnership law, a general partner does not have to distribute partnership income, yet under current tax laws, a creditor who has obtained a charging order or a turnover order probably has created responsibility for federal income tax liability. Because creditors can create liability for paying taxes on phantom income, and yet not be able to obtain partnership assets or take part in partnership management, they may not be interested in obtaining a charging order or a turnover order and becoming an assignee of a limited partner interest.
A well drafted limited partnership agreement can provide that a high percentage of the interests of the limited partners must consent to an amendment, change or dissolution of the limited partnership. This prevents a creditor from forcing a dissolution of a partnership and a sale of the partnership assets. It also prevents a creditor from removing the general partner of the limited partnership, resulting in a creditor having no voice in how the limited partnership’s property is managed or its income distributed. It follows that when a creditor becomes an assignee of an interest in the limited partnership, it effectively can do nothing with the assets of the limited partnership. The limited partnership agreement should also be drafted to prevent assets from being transferred to third parties through rights of first refusal and buy-sell provisions. Even if a creditor seeks the appointment of a receiver to take the debtor's share of the partnership's profits, the receiver should not be able to reach the partnership assets nor force any distributions from the partnership. The general partner can restrict partnership distributions, make loans to the partners, and create phantom income, thereby persuading the creditor to settle the claim or sell the assignee interest to the partnership or another partner at a substantial discount.
In order for the foregoing to be effective, the limited partnership must have been formed before the claim against the partner arose, otherwise the transfer of assets is susceptible to being set aside under the Texas Uniform Fraudulent Transfer. This act prevents the transfer of property with the intent to "defraud" creditors. To prevail, the creditor must prove that the claim as in existence and the assets were transferred by the debtor/partner to avoid the creditor’s claims. If the claim clearly arose after the creation of the partnership, then, unless the creditor can prove the partnership was created with the intent to avoid creditors, the creditor should not be able to prevail on this claim.
Because creditors of a limited partnership can make a claim against its assets, many businesses organize an operating company or partnership. This is normally the entity having the most liabilities or potential exposure to third parties. It can be organized as a limited liability company or limited partnership and would be the initial buffer to a lawsuit. It can be organized to own the minimal equipment and assets necessary to do those business functions it cannot readily outsource to an affiliate. If the equipment and assets are readily expendable and have a short useful life, such as office supplies and miscellaneous day-to-day items, such can be owned by the operating entity. Caution must be taken to prevent the operating entity from having so few assets, compared to its actual liabilities, that it is insolvent. It should always be solvent based on a balance sheet test and be able to pay its bills in the ordinary course of business. Big-ticket items, such as buildings, heavy machinery, or expensive pieces of personal property or equipment that have long useful life can be owned by another entity and leased to the operating entity. In this way, those assets may be protected from direct exposure to the creditors and liabilities incurred in connection with the business of the operating entity, yet may be used to generate income. The entity owning the valuable assets can enter into a management services agreement with the operating entity and provide the services needed to run it.
In 1992, Texas passed a statute allowing an entity to be formed as a limited liability company ("LLC"). An LLC can look like a corporation for liability limitation purposes but can be taxed as a partnership using the applicable "check the box" regulations. If an LLC is used as a limited partnership's general partner, then effectively all owners will have the potential for limited liability.
The use of separate limited partnerships or LLCs to own separate properties or businesses can also benefit the owners. For example, a business can reduce liability exposure by placing different operations in separate limited partnerships, with the general partner of each limited partnership being an LLC.
An LLC makes an excellent general partner because the LLC's ownership is not limited to certain types of shareholders as in an "S" corporation. The LLC may also provide additional creditor protection and in pass-through federal income-tax treatment if it elects to be taxed as a partnership. The LLC provides creditor protection because, like a limited partnership, a judgement creditor can obtain only a charging order on the judgement debtor's membership interest in the LLC and does not obtain any rights to manage the LLC. It should provide that no member may transfer its interest to a substitute member without the consent of all remaining members and have managers who serve without term limits.
For more information, please see the accompanying articles Choice of Entity, Corporations and Corporate Responsibilities, Texas Limited Liability Companies-Formation and Advantages, Benefits of a Limited Partnership, Registered Limited Liability Partnerships and Limited Liability Companies, Conversion of a Corporation to a Limited Partnership
This informational memorandum from the law offices of Thomas D. Solomon, P.C. is provided as a courtesy to our friends and clients to provide them with items of interest in the asset protection area. It is not and is not intended to be an exhaustive treatment of its subject matter, but rather an overview of some of the pertinent elements of such a transaction. It is not intended to be legal advice or a legal opinion and should not be relied on in making legal or business decisions. If you have any questions, please call us.
