By Richard Keyt

The Arizona family limited partnership (“FLP”) has been a popular estate planning tool for many years.  Estate planners frequently recommend that their clients create family limited partnerships and their close cousin, limited liability companies, as useful estate planning devices.  The FLP is a very popular entity because it can be used to control assets while simultaneously reducing the value of an estate and saving substantial amounts of federal estate taxes.

FLPs can be created for many reasons such as intra-family income shifting, consolidation of family assets, control over partnership assets, control over who can own partnership interests, efficient wealth transfer opportunities and divorce protection.  An FLP may also reduce the size and transfer tax value of a gross estate.  Partners may use “leveraged gifting” and “valuation adjustments,” to reduce or eliminate estate and/or gift taxes.  In addition to many good estate planning and other business reasons to adopt a FLP, the FLP can have the ancillary benefit of asset protection.  Although FLPs have come under increased scrutiny by the Internal Revenue Service for estate tax reasons, we believe that a properly drafted Arizona FLP remains a very viable estate planning technique.

A family limited partnership is a type of partnership created pursuant to Arizona law whose partners are members of the same family or one or more entities controlled by the family.  The primary purpose of the FLP is to assist the family in achieving its estate planning objectives.  A family limited partnership has two types of partners, general and limited.

In general, limited partners are not liable for the debts and obligations of the FLP, but the general partner has unlimited liability.  The liability of the general partner can be limited through a  variety of methods.   The general partner typically has complete management and investment control of the FLP.  One or more family members or a family controlled entity may be a general partner of the FLP.  The limited partners are family members or family controlled entities.  The partnership agreement should limit transfers of ownership interests to members of the family or family controlled entities.

Upon forming a FLP, the partners (generally the husband and wife or entities controlled by them), contribute investment assets to the FLP.  If somewhat risky assets such as rental property, are included, the family should form a single-member limited liability company to own the property with the FLP as the sole member of the LLC.  As a result, only “safe assets” are typically held inside the FLP.

The general partner manages the business of the FLP, its investments and its day-to-day activities over the course of the FLP’s existence.  As with any partnership, the profits and losses are passed through to the partners for income tax recognition on the partners’ individual income tax returns.  Although income and losses are passed through to the partners, many FLP agreements give the general partner complete discretion to distribute or not distribute any or all of the partnership’s cash available for distribution.  Therefore, it is possible in any given year that funds are withheld from partners that the partners may have to recognize taxable income on their profits, but not have any distributions of cash from the FLP to pay the associated income tax.  This concept of “phantom income” is one of the factors that enhances the asset protection feature of the FLP.

In today’s society, there are very few physicians who will avoid having at least one malpractice claim during their careers.  Obviously, medical malpractice insurance is a physician’s first line of defense against malpractice claims.  Asset protection vehicles such as the FLP in no way replace adequate malpractice insurance coverage.  A properly designed FLP can compliment a physician’s insurance coverage by providing some additional protection in the event the physician incurs a judgment that exceeds the limits of the physician’s insurance policy.

If a physician is sued and the creditor obtains a judgment greater than the amount of the physician’s insurance coverage, the creditor may record the judgment in any county in which the physician has property.  The recorded judgment then becomes a lien on all property of the physician in the county where the judgment has been recorded.  The creditor may subpoena the physician and the physician’s spouse for a debtor’s examination, swear them in under oath with a court recorder present, then ask questions about the type, location and nature of the physician’s assets.  When the judgment creditor find’s the physician’s assets, the creditor may use the legal process to seize the physician’s assets and sell the assets at a public auction to satisfy the judgment.  For example, if the physician owns an investment account or a rental home in his or her name, the judgment creditor can use the legal system to “foreclose” the creditor’s judgment lien and sell the investment account and the home to pay the debt.  However, if the investment account and the rental home were owned by a properly created FLP or by a limited liability company owned by the FLP, Arizona law prohibits the judgment creditor from seizing and selling the assets.  In essence, the FLP may provide a “cocoon” around a physician’s investment assets.

If a creditor obtains a judgment against a partner of an Arizona FLP, the creditor’s remedies to enforce the judgment against the FLP are severely limited.  Most FLP agreements provide that a creditor of a partner does not have the right to: (i) become a substituted partner in place of the judgment debtor, (ii) seize assets of the FLP, (iii) compel the FLP to liquidate and distribute assets to the partners, (iv) exercise power over or possession of any specific partnership property, or (v) demand that money or property be distributed from the partnership to the creditor or any other partners.

Arizona law provides that a judgment creditor of a partner of a limited partnership has only one remedy when attempting to collect a judgment from the partner.  The creditor’s sole remedy is a “charging order,” which is a court order served on the partnership directing it that all distributions that would otherwise go to the debtor-partner must instead go to the creditor.  Stated another way, the charging order provides that if and when money or property is to be distributed to the debtor partner, the partnership must instead deliver the money or property to the creditor  When the FLP agreement gives the general partner the sole discretion as to when and how much to distribute to the partners, the general partner may chose to refrain from making distributions when a partner has creditor problems, which means the creditor with the charging order would not get anything of value from the FLP.

The creditor with a valid charging order may not get any money from the FLP, but the creditor may get something from the FLP that the creditor does not want, namely phantom income and a corresponding income tax liability.  For federal tax purposes, the judgment creditor with a charging order is treated as the substituted partner in place of the debtor despite the fact that for state law purposes, the creditor is not recognized as a substituted partner.  This is where the issue of “phantom income” becomes important.  For example, if a FLP has $100,000 of profits for the year, a judgment debtor partner has a right to 50% of the profits and the general partner does not distribute any cash to the partners, the judgment creditor with a charging order will have $50,000 of phantom income on which the creditor must pay income tax.  This potential phantom income problem can deter many creditors from obtaining a charging order.

To further illustrate the concept of phantom income, suppose a physician is sued and a judgment that exceeds insurance policy limits is rendered against the physician. Further suppose that the judgment creditor obtains a charging order against the physician’s partnership interest in his or her FLP for the unpaid amount of the judgment. To the extent the physician has assets owned by the FLP, the judgment creditor merely has a right to receive any distributions that the physician becomes entitled to receive from the FLP.  As a general partner, the physician and his spouse decide to reinvest all of the income generated by the FLP during the current year.  The end result is that the judgment creditor receives a K-1 with the judgment debtor’s share of the FLP profits for the current year with no cash in the envelope to pay the income taxes.  Because a tax bill without corresponding cash to pay the tax is the last thing a judgment creditor would want, an FLP may be a substantial deterrent to an otherwise overly zealous judgment creditor.

As stated earlier in this article, asset protection may be an ancillary benefit of an FLP.  FLPs that are created solely for asset protection or to avoid known creditor claims will probably not provide much, if any, asset protection.  However, FLPs that are created for valid business purposes and that carry out those purposes in actual operation of the FLP should enjoy the ancillary benefit of asset protection.  Physicians seeking to adopt FLPs should consult with competent estate planning attorneys in their jurisdiction who are familiar with the laws affecting FLPs and who have substantial experience creating FLPs and drafting FLP agreements.