Asset protection proofing your limited partnership or LLC for the bankruptcy of a partner or member.

• Author: Wells, Thomas O.

Doctors, entrepreneurs, and officers and directors of public companies with exposure to potential, future claims of creditors sometimes create family limited partnerships and family limited liability companies (collectively referred to as FLPs) for estate planning and wealth preservation purposes in order to minimize their exposure to claims of potential future creditors. Through a combination of Florida laws and contractual provisions, creditors' rights are limited against assets of an FLP, including rights to foreclose upon or monetize a debtor partner's interest in an FLP. In bankruptcy, however, those laws and contractual provisions may not be recognized or enforced if the partnership or operating agreement of the FLP is found not to be an "executory contract."

This article provides lawyers with an outline of asset protection benefits provided by an FLP, analyzes how a bankruptcy proceeding by a partner in the FLP affects these protections, and suggests language to address the issues raised in In re Ehmann (Movitz v. Fiesta Investments, LLC), 310 B.R. 200 (Bank. D. Ariz. 2005).

Florida Law FLP Creditor Protections

An FLP has two types of creditors--inside creditors and outside creditors. Inside creditor claims arise from alleged actions or omissions of the FLP. Inside creditors may levy against the assets of an FLP, but generally cannot levy against the individual assets of limited partners or members of the FLP. Outside creditor claims arise from alleged actions or omissions by a debtor partner of the FLP. This article's focus is on the rights of outside creditors to the debtor partner's interest in the FLP.

Florida law generally restricts the rights of an outside creditor to a charging order imposed upon the debtor partner's FLP interest. (1) In contrast, in a general partnership, the debtor partner's interest may be judicially foreclosed if a debtor partner's interest is subject to a charging order. Therefore, practitioners often use limited partnerships or limited liability companies--and not general partnerships--to protect and maintain the integrity of the assets of the FLP. Another reason to use a limited partnership or a limited liability company for an FLP is that the parties may contractually restrict the transferability of a debtor partner's interest in the FLP. (2) Further, an assignee of the FLP interest is not allowed to become a new or substituted partner, review the books and records of the FLP, nor vote as a partner in the FLP. (3)

Bankruptcy Law Effects on an FLP

If a debtor partner files bankruptcy, both the FLP and the other partners of the FLP can be effected. Sections 541 (property of the estate) and 365 (executory contracts and unexpired leases) of the Bankruptcy Code are critical to the analysis. Both of these sections expressly restrict or override state law and contractual terms. For example, [section]541(c)(1) states:

[A]n interest of the debtor in property becomes property of the estate ... notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law--

(A) that restricts or conditions transfer of such interest by the debtor; or

(B) that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title ... and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor's interest in property. (4)

Similarly, [section] 365(e)(1) provides in pertinent part:

Notwithstanding a provision in an executory contract ... or in applicable law, an executory contract ... of the debtor may not be terminated or modified, and any right or obligation under such contract ... may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on--

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

On the authority of [section] 365(e)(1) that ipso facto clauses are unenforceable...