During a marital divorce, a couple can work cooperatively to divide the assets in their marital estate, including the interests they own in private businesses. Things become much more challenging in divorce proceedings, however, when one spouse seeks to retain control of marital assets by continuing to control interests that are held by the couple in family limited partnerships, LLC’s, or other private companies. In this Blog Post, we focus on various exit strategies that a spouse who is a Limited Partner or other minority member may use in a divorce action to secure control over their share of the assets in the marital estate.
Defining the Family Limited Partnership (FLP)
An FLP is simply a limited partnership formed by the members of a family. Families form FLP’s for many reasons, including to achieve tax savings in an estate plan, to protect assets from creditors, to help manage family assets, and to simplify annual gifting. As in any partnership, the General Partners of the FLP manage and control the activities of the partnership, and they are therefore liable for all partnership debts and obligations. The General Partners also owe a fiduciary duty to the Limited Partners, who have few or no rights to manage or control the entity, and who have no liability for for any partnership debts or obligations. Often, the FLP is structured so that the founders and controlling General Partners are senior family members who transfer assets into the FLP. Younger family members usually receive limited partnership interests, and may contribute some of their assets in exchange.
LLCs can be used the same way and for the same purposes. In an LLC, however, the members (owners) of the LLC can be given the right to participate in management of the entity. This is known as a member-managed LLC. In the marital context, problems can arise when one spouse is the sole manager of the LLC and has the right to make all management decisions for the entity without input from the non-manager spouse.
What is the FLP/LLC Problem?
- Control is Not Shared Equally
An FLP can provide significant benefits, but it can also be used as a vehicle by one of the spouses to secure and maintain permanent control over marital assets. If one spouse is the General Partner, he or she may seek to continue controlling marital assets even after the divorce by continuing to control the FLP. Texas is a community property state, meaning that most of the property spouses acquire during the marriage must be divided equally between them in a divorce. Texas also subscribes, however, to the entity theory in partnership law, which holds that partnership assets belong to the entity and not to the individual partners. When a couple divorces, therefore, the FLP’s assets are no longer community property and those assets are not subject to division by the family court. The General Partner spouse may insist that Limited Partner spouse is permitted only to divide his or her ownership interest in the partnership itself and cannot force a division or distribution of any of the actual assets held by the FLP.
Once again, this is similar to an LLC in which one spouse is appointed to serve as sole manager of the entity. The sole LLC manager may effectively operate with the powers of a general partner and the other spouse, who is merely an LLC member, will not have access to or the rights of control over any of the assets held by the LLC. Another problematic provision in the LLC agreement may be that the non-manager spouse will not have the right to remove the manager from office.
- General Partner Or LLC Manager Controls All Distributions
In addition to the General Partner’s right to manage and control the FLP, most FLP agreements also provide that whether to declare distributions and in what amount are matters that are within the General Partner’s sole and absolute discretion. FLP agreements also often restrict the transfer of partnership interests to ‘keep it in the family.’ Similarly, most LLC agreements restrict sale of membership interests and provide the manager with the sole control rights in regard to distributions.
The net effect of the FLP and LLC structures is that the Limited Partner or minority member has surrendered complete control to the General Partner over all community assets held by the FLP. In effect, the marital assets are locked into the FLP and only the General Partner has the key. A shrewd and financially-savvy spouse who is planning a divorce may have an FLP drawn up ostensibly to protect the family assets. In reality, however, the spouse’s goal in forming the FLP is to change the character of the community assets so that they will be controlled by and accessible solely to the controlling spouse who acts as the General Partner or sole manager. The question then becomes whether the family court has been deprived of its power to divide the community assets in ‘a just and right manner.’
Getting What You Need – Action Plan for Limited Partners and LLC Members
Every marriage is different and there is no cookie cutter response to the problems that arise from the way the couple structured their investments in private companies. A legal solution requires a thorough analysis of the specific facts and investments held by the couple. What follows in this Post, therefore, are general guidelines for spouses who are Limited Partners and/or LLC members and who are attempting to secure a divorce in which they regain control over their share of community/marital assets.
- Map the Route
Most spouses going through a divorce who are Limited Partners or LLC members want to take their share of the marital assets with them upon departing. To obtain this freedom, the first step for any Limited Partner or LLC member is to review and fully understand the terms of the partnership agreement or LLC agreement. These agreements will govern the operation, termination, and transferability of the partnership and LLC.
- Secure a Third-Party Valuation
Most often, the next step is for the Limited Partner or LLC member to obtain an expert valuation of their ownership interest in the entity (or entities). In this regard, there may be substantial discounts that apply to the ownership interest of the Limited Partner or LLC member due to the restrictions on transferability and inability to participate in management. The Limited Partner and LLC member spouse will also want to discuss with experienced divorce counsel the possibility of adding the entity as a party to the divorce proceeding. Finally, the departing spouse must seriously consider the tax implications of removing assets from the FLP or LLC.
- Ask The Family Court to Exercise its Broad Equitable Power
- Request Rescission of Entity
Under Texas law, spouses owe fiduciary duties to each other. The Limited Partner or LLC member should therefore carefully review the circumstances under which the partnership or LLC was formed. Depending on what the spouse who is the General Partner or Manager said to induce the other spouse to sign the entity agreements, the Limited Partner or LLC member may have a claim for fraud. Upon a mere finding of unfairness, the family court has the authority to rescind the documents that created the FLP. A Texas court of appeals has upheld the rescission of a shareholder’s agreement based on a jury finding that the shareholder’s agreement was unfair due to the husband’s violation of his fiduciary duty to his wife, the husband’s benefit at the expense of his wife, the husband’s inside knowledge of the corporation, and the wife’s lack of independent legal counsel.
- Seek Appointment of Receiver
The family court also has broad, discretionary powers under the provisions of the Texas Family Code to appoint a receiver, who will act to preserve and protect marital property. In Norem v. Norem, a wife requested that the family court appoint a receiver over shares of stock that were community property. The family court, affirmed on appeal, acknowledged that the corporations holding the stock were not parties to the divorce action. The family court nevertheless appointed a receiver on the basis that it had jurisdiction over the community property shares of stock in the corporation.
- Move for Dissolution of the Entity
The Limited Partner or LLC member spouse may have an argument that the entity should be dissolved under Section 11.314 of the Texas Business Organizations Code, which governs the involuntary winding up and termination of Texas partnerships and is non-waivable. This section authorizes a district court to order the winding up and termination of a partnership if the court determines that the economic purpose of the partnership is likely to be unreasonably frustrated. The standard is not an easy one to meet, but may apply in some situations.
- Pursue an Equitable Division/Award
Another measure the Limited Partner or LLC member spouse may wish to consider is asking the family court to award the entire partnership interest to the one spouse and awarding assets of comparable value to the other spouse. Of course, this division of assets will not work if the largest percentage of the value of the marital assets are held in the FLP or LLC.
There are numerous advantages for couples in negotiating a thoughtful, informed division of their assets in order to avoid the significant uncertainties involved if a court determines at trial how to value and divide the community assets. When the controlling spouse refuses to participate in negotiations or to agree to a reasonable division of the marital assets, however, the non-controlling Limited Partner or LLC member does have legal and equitable remedies the family court can enforce to preclude one spouse from continuing to control the marital assets after the divorce concludes. Even when they can’t secure all they want, in most cases, a spouse who is a Limited Partner or LLC member can often get what they need from the family court so that their assets do not remain controlled by their spouse following the divorce.
 Harris v. Harris, 765 S.W.2d 798, 802 (Ct. App. – Houston 1989).
 See Miller v. Miller, 700 S.W.2d 941, 942 (Ct. App. –Dallas 1985).
 Id. at 946-49.
 Norem v. Norem, 105 S.W.3d 213, 216 (Ct. App. – Dallas 2003)(the Family Code controls the appointment of a receiver in a divorce suit, not the Texas Civil Practice and Remedies Code).
 Id. at 215.