By: Edward D. Brown, Esq., CPA, LL.M
Mr. Streightoff, through his daughter acting under a power of attorney, assigned an interest in a Texas limited partnership to his revocable living trust. Mr. Streightoff then died, and the IRS determined the value of that interest in his estate was worth more than planned since it was viewed as a full-blown partnership interest (i.e., with all rights to vote the interest and other rights of a partner) as opposed to just an assignee interest (i.e., an interest that only allows the holder to receive distributions if and when made from the limited partnership, with the assignee having no voting rights or power to compel such distributions from the limited partnership).
Assignee interests have a lower value (and hence, lower estate tax significance) than an equivalent percentage of a full partnership interest.
Normally, when a limited partnership interest is assigned to a recipient and the other owners of the limited partnership never officially “admit” the recipient as a duly recognized partner, the recipient only has the lesser rights of an assignee. The IRS however viewed the revocable living trust recipient as a duly-admitted limited partner because the assignment instrument was worded as a transfer of all Mr. Streightoff’s rights (vs. just an assignee interest) coupled with the fact that the recipient was controlled by the same individual who controlled the limited partnership. Mr. Streightoff’s daughter served in both roles of management of the limited partnership (via the general partner) as well as the revocable living trust (as the trustee). The IRS ignored the requirements to admit the recipient as a partner, using a substance over form rationale. Since the recipient revocable living trust was managed by the same person who acted for the manager of the limited partnership, the recipient’s trustee held all necessary authority to have the revocable living trust admitted as a full limited partner.
What impact could this have on asset protection? The often-touted reason for using a limited partnership as an unattractive asset to a creditor (but attractive to the debtor) is the assumption that a creditor who seizes the limited partner interest obtains rights only as an assignee. This is typically a deterrent to a creditor, and should remain intact in most creditor situations since the creditor probably never served as a general partner of the limited partnership, and therefore has no powers to admit himself as a full partner. Without such powers, this transfer of the entity to the creditor should result in the likelihood that the creditor may end up having to pay income taxes on the limited partnership’s income, and yet have no right to demand distributions to cover the tax obligations.
Nevertheless, much stronger protections can be achieved by having such limited partner interests held in a properly designed asset protection trust as opposed to a revocable living trust (since then, the debtor partner is better shielded from the creditor in that the debtor is much less likely to be viewed as owning that partnership interest). Also, if certain offshore entities are used (for example, a Nevis LLC as opposed to a Texas limited partnership), even if a court were to use any substance over form rationale that the creditor did obtain voting rights to force distributions to the creditor, the properly selected offshore laws would likely dictate that the offshore manager ignore any ruling (e.g., by a US court) that such voting rights were transferred. This is especially pertinent in states in the U.S. that have a statutory basis to allow an assignee to benefit from a US court-ordered foreclosure of the partnership interest. The offshore manager again would likely not consider such an order to be binding in the manager’s jurisdiction, and therefore able to keep offshore assets owned by the LLC protected from creditors.
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