Jim also liked the attorney’s advice that each of the five properties be put into five separate limited partnerships. It was explained to him that the strategy today is to segregate assets. If someone gets injured at one property and sues, it is better to only have one property exposed. If all five properties were in the same limited partnership, the person suing could go after all five properties to satisfy his claim. By segregating assets into separate entities the person suing can only go after the one property where they were injured.
An added benefit to segregating assets in Jim’s case was the boys were interested in different activities. One of the properties housed a batting cage business and another Laundromat. He could see Bob being interested in the batting cage business and Aaron meeting girls while owning the Laundromat. (Jim owned nothing that would currently appeal to Chris.) As the boys got older he could gift more of one limited partnership to one boy and more of another to another.
Jim liked the control and protections afforded by the limited partnership entity and proceeded to immediately form five of them.
To organize a limited partnership you must file a certificate of limited partnership, otherwise known as an LP-1, with your state secretary of state’s office. This document contains certain information about the general partner and, depending on the state, limited partners and is akin to the filing of articles of incorporation for a corporation or articles of organization for a LLC.
As with the LLC, the LP offers certain unique advantages not found in other entities. These features include:
LIMITED LIABILITY
Limited partners are not responsible for the partnership’s debts beyond the amount of their capital contribution or contribution obligation. So, as discussed, unless they become actively involved, the limited partners are protected.
As a general rule, general partners are personally liable for all partnership debts. But as was mentioned above, there is a way to protect the general partner of a limited partnership. To reduce liability exposure, corporations or LLCs are formed to serve as general partners of the limited partnership. In this way, the liability of the general partner is encapsulated in a limited liability entity. Assume a creditor sues a limited partnership over a business debt and seeks to hold the general partner liable. If the general partner is a corporation or LLC, that is where the liability ends. No one’s personal assets are at risk.
A chart helps to explain this concept:
In the scenario on the left, with Joe Dokes as an individual general partner, he is personally responsible for all activities of Dokes, LP. All his personal assets are at risk. In the scenario on the right, Dokes, Inc. carries all of the liability. Joe’s personal assets are not exposed.
As such, many, if not most, limited partnerships are organized using corporations or LLCs as general partners. In this way, both the limited and general partners achieve limited liability protection.
RETAINED MANAGEMENT
Because by definition limited partners may not participate in management, the general partner maintains complete control. In many cases, the general partner will hold only 2 percent of the partnership interest but will be able to assert 100 percent control over the partnership. This feature is valuable in estate planning situations where a parent is gifting or has gifted limited partnership interests to his children. Until such family members are old enough or trusted enough to act responsibly, the senior family members may continue to manage the LP even though only a very small general partnership interest is retained.
RESTRICTIONS ON TRANSFER
The ability to restrict the transfer of limited or general partnership interests to outside persons is a valuable feature of the limited partnership. Through a written limited partnership agreement, rights of first refusal, prohibited transfers, and conditions to permitted transfers are instituted to restrict the free transferability of partnership interests. It should be noted that LLCs can also afford beneficial restrictions on transfer. These restrictions are crucial for achieving the creditor protection and estate and gift tax advantages afforded by limited partnerships.
PROTECTION FROM CREDITORS
Creditors of a partnership can only reach the partnership assets and the assets of the general partner, which is limited by using a corporate general partner which does not hold a lot of assets. Thus if, for example, you and your family owned three separate apartment buildings, it may be prudent to compartmentalize these assets into three separate limited partnerships, using one corporate general partner whose sole purpose is to manage all three LPs. If a litigious tenant sued over conditions at one of the properties, the other two buildings would not be exposed to satisfy any claims. This is an attack brought directly against the property, and will be discussed further in Chapter 5.
There is a second attack to be concerned with: One against not the LP itself but against the owner of the LP (or LLC).
Creditors of the individual partners can only reach that person’s partnership interest and not the partnership assets themselves. Assume you’ve gifted a 25 percent limited partnership interest in one of the apartment building partnerships to your son. He is young and forgets to obtain automobile insurance. Of course, in this example, he gets in a car accident and has a judgment creditor (a person who sued and won) looking for assets. This creditor cannot reach the apartment building asset itself because it is in the limited partnership. He can only reach the limited partnership distribution interest through a charging order procedure. A charging order allows the creditor of a judgment debtor who is in a partnership with others to only reach the debtor’s partnership distributions without dissolving the partnership. Charging orders are not favored by creditors because it forces them to wait to be paid. (Lawyers who take on contingency cases do not like to wait for payment, either.)
The state laws of Nevada and Wyoming offer the best charging order protections. California offers the weakest protection. A strategy then is to form your LP (or LLC) in Nevada or Wyoming and then qualify in California. (Qualifying is the process of registering your out-of-state entity to do business in your home state and includes paying the same annual fees as if you have started the entity in your home state to begin with.) An even better strategy is to form several LLCs in California and have them be owned by one Wyoming or Nevada LLC. By using a Nevada or Wyoming LLC or LP to hold your Home State LLCs you can obtain the benefit of a better asset protection law. This strategy is discussed further in Chapter 4.
FAMILY WEALTH TRANSFERS
With proper planning, transfers of family assets from one generation to the next can occur at discounted rates. As a general rule, the IRS allows one individual to give another individual a gift of $13,000 per year (at this writing).
Any gifts valued at over $13,000 are subject to a gift tax starting at 18 percent. In the estate planning arena, senior family members may be advised to give assets away during their lifetimes so that estate taxes of up to 55 percent are minimized.
By using a limited partnership for the management and gifting of family assets, gifting can be accelerated with an IRS-approved discount. As discussed, because limited partnership interests do not entitle the holder to take part in management affairs and are frequently restricted as to their transferability, discounts on their value are permissible. In other words, even if the book value of 10 percent of a certain limited partnership is $16,000, a normal investor wouldn’t pay that much for it because, as a limited partner, they would have no say in the partnership’s management and would be restricted in their ability to transfer their interest at a later date. So, instead of valuing that limited partnership interest at $16,000, the IRS recognizes that it may be worth more like $13,000.
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