When is an assignee or judgment creditor taxed on partnership income?

• Author: Bakale, Anthony
• Position: Limited partnerships

Family limited partnerships (FLPs) have become part of the lexicon of tax planners, most commonly due to their transfer tax valuation advantages. However, FLPs have also been touted for their creditor-protection advantages. A judgment creditor must generally obtain a "charging order" from a court to give the creditor the right to any distributions that would otherwise be made to a limited partnership (LP) interest holder. A charging order is a court-ordered remedy that may also be obtained against a limited liability company (LLC) member. Some argue that the tax law serves as a buffer against an aggressive creditor, because, according to Rev. Rul. 77-137, with a charging order, the creditor will be taxed on all distributive-share income allocable to the LP or LLC interest. Further, an assignee of an LP interest will be treated as a substitute LP for Federal income tax purposes. While the ruling is only two paragraphs in length, creditor-protection advocates never discuss the reason for the holding, which, on close examination, does not support broad application to all assignments or charging orders.

In the ruling, an LP agreement permitted an LP interest holder to assign (without the general partner's consent) the right to share in profits and losses and to receive all distributions to which the holder was entitled. An LP interest holder made such an assignment and also agreed to exercise any residual powers in the assignee's favor. In general, residual LP rights can include the right to (1) vote on matters (such as a dissolution or merger of the partnership, a change in the partnership's business or removal of a general partner), (2) access to partnership records, (3) withdraw under specific circumstances and (4) sue a general partner for a breach of fiduciary duty. The ruling concluded that because the assignee had acquired "substantially all of the dominion and control over" the LP interest, the assignee would be treated as a substitute LP for Federal income tax purposes. The ruling offered no detailed explanation for the holding, which should be a warning for those who seek to broadly apply it to other fact patterns.

Before issuing the ruling, the IRS's Individual Tax Division asked the Chief Counsel's office to concur. General Counsel Memorandum (GCM) 36960, dated less than two weeks before issuance of the ruling, made a significantly more detailed assessment of the issue, agreeing with the ruling's conclusion. Although lacking the...