Statutory Protections Afforded to Limited Partners of Partnership
While the judgment creditors of a shareholder may attach, via judgment, the corporate stock of such shareholder, the partners of a limited partnership and the members of a limited liability company are protected from such attachment, as the only remedy under statute that a judgment creditor may receive against the interest of a partner in a limited partnership or a member of a limited liability company is a charging order against such interest. Rooted in English law, the charging order developed as a way to prevent the creditor of one partner from holding up the business of the entire partnership and causing injustice to the other partners. To prevent the clumsy method of proceeding, the English rule forbidding execution sale of a partner’s interest in the partnership to satisfy a non-partnership debt was codified in the Uniform Partnership Act and English Partnership Act of 1890. Under the revised English rule, the creditor’s remedy against a partner was limited to receiving the partner’s share of the partnership’s profits and
When a creditor of a limited partner receives a charging order against such limited partner’s partnership interest, the creditor’s interest in the partner’s share of the partnership is limited to that of an assignee. While the creditor may enjoy the partnership distributions that would have been distributed to the debtor partner in the absence of such creditor, the creditor does not receive the rights of such partner. As an assignee of a partnership interest, the creditor may not become a limited partner unless all other partners consent, something unlikely to occur. The creditor cannot vote on partnership matters, inspect or copy partnership records, or even obtain from the general partner business and tax information regarding the affairs of the limited partnership that are usually available to limited partners as a matter of law. Moreover, in a family limited partnership, the general partner will likely be a family member sympathetic to the plight of the partner who has been subject to the creditor’s charging order. Thus, it is unlikely that the general partner would elect to make a cash distribution to partners which would entitle the creditor/assignee to a distribution.
Even though the judgment creditor of a limited partner has no rights with regard to the partnership, other than receiving an income distribution, the IRS has long taken the position that an assignee acquiring substantially all of the dominion and control over the interest of a limited partner is treated as a substituted limited partner for federal income tax purposes.56 Since the income of a partnership flows through to the partners, the partners are taxed on the income whether or not they actually received it. Further, only the general partner of the partnership may make distributions to the limited partners. As a consequence, well advised creditors of limited partners will not seek satisfaction of judgments through charging a limited partnership interest for fear that they will be required to pay income taxes on partnership income not distributed to them.
The limited liability company offers its members a similar level of protection from creditors as the limited partnership. Practitioners have been slow to replace the limited partnership with the limited liability company as the centerpiece of an estate plan, perhaps because the limited liability company is relatively new in the United States and, as a consequence, does not have a depth of case law supporting its use as an asset protection tool. The limited liability company has replaced the corporation as the entity of choice for serving as a general partner of a limited partnership. In the past, corporations typically served as the general partner of limited partnerships, as the shareholders of a corporation were protected from the liabilities of the corporation. However, this arrangement failed to protect the limited partners from the creditors of the shareholders of the corporate general partner because the creditors could attach the stock of the corporation and gain control of the partnership. The limited liability company offers the benefit of protecting the members from the liabilities of the company. Moreover, the limited liability company is protected from the judgment creditors of its members in much the same way as a limited partnership. Consequently, because control of the limited liability company cannot be transferred to the judgment creditors of a member, the limited liability company is preferred over the corporation as the entity of choice to serve as general partner of a limited partnership.