One of the major concerns people have is how to protect their home in the event of a lawsuit. Many states have limited homeowner protection for personal residences and other states, such as Texas and Florida, have unlimited protection. Repeatedly the fear of losing one's home is enough to make a defendant settle even if the defendant doesn’t feel that the lawsuit has merit or is legitimate. Lawyers know this and many lawsuits are filed in this country because the lawyers know that they can get a settlement. They know that the fear of losing one's home or other assets will bring the defendant to the settlement table.

For years limited partnerships have been used by the astute to protect their homes and other assets in the event of a lawsuit. Attorneys and promoters have been selling them nationwide for the past 10 - 15 years. The reason for this is that limited partnerships have something called "charging order protection". Most states have adopted similar charging order language for the limited liability company statutes. Under the Uniform Limited Partnership Act (ULPA) and the Revised Uniform Limited Partnership Act (RULPA), a creditor cannot reach the assets of the partnership. The creditor must obtain a charging order from the court. Such charging orders restricts the creditor to distributions if and when they are made. The creditor is not entitled to any voting rights, and therefore cannot force a distribution. The debtor controls the voting rights and consequently has the sole power to decide if and when a distribution will be made.

Another feature of a partnership or a Limited Liability Company (LLC) that is classified as a partnership is the ability to give phantom income to the creditor. Under Revenue Ruling 77-137, the IRS held that an assignee of a limited partnership interest was the beneficial owner of such interest and by itself "must report the distributive share of partnership items of income, gain or loss, deduction, and credit attributable to the assigned interest... in the same manner and the same amounts that would be required if [the assignee] was a substitute limited partner". So, even if the limited partnership or LLC does not make distributions to the partners, according to the IRS ruling the creditor may be liable to pay taxes on undistributed profits. This fact has kept many creditors from asking for charging orders.

The charging order is one and, possibly, the only remedy in some states. Other states allow foreclosure on the partnership interest as well. Some states allow a foreclosure by statute and others by case law. Arizona, Oklahoma and Alaska are the only states that prohibit foreclosure for both limited partnerships and limited liability companies. Nevada and Delaware do not prohibit foreclosures by statute, but there has been no case law supporting it. California and Texas among others have allowed foreclosure by case law.

It has been questioned whether or not the limited partnership is the correct vehicle to protect the personal residence. There has been uncertainty whether a partner in a limited partnership may deduct mortgage interest under Code Section 163 (h) (3). Many different tax authorities interpret the Code in different ways. One book will say that it is permissible to deduct mortgage interest for a personal residence held in a limited partnership, while another book, written by a different tax authority, will take the opposite view. Also, under Section 121, it appears that only an individual or a grantor trust would be entitled to exclude from gross income up to $500,000 from the sale of a personal residence. Many people are willing to put their homes in a limited partnership and risk losing the mortgage interest deduction because they feel it is better to deal with the IRS than risk having their home taken from them by a creditor. People are willing to wait until the legal crises has passed, and then deed the property back into their own name for a couple of years then sell the property and thus qualify for the $500,000 exemption.

The nonentity single member LLC can be a solution to these concerns. Under Treasury Reg. 301.7701-3 a wholly-owned LLC can "check to box" so as to be taxed as a nonentity. This single member LLC would be disregarded for tax purposes and taxed as if the individual owned the asset. Most states now allow one person LLC's. Since LLC's have all of the charging order protection that was mentioned previously, this allows the creditor to have the best of both worlds. They can deduct mortgage interest and qualify for the exclusion, as well as having charging order protection.

Under this scenario a married couple would have two choices: They can either transfer the home into a single entity LLC and have that entity owned by the less risky spouse, or they can form two single entity LLC's and have each spouse own one of them. Then, they can have each single entity LLC hold a 50% interest in the property.

If you would like more information regarding asset protection, trusts, family limited partnerships or the subject of this article please call or email our office.