It works in much the same way that an LLC protects assets. A limited partnership is a COPE or charging order protected entity. A limited or general partner's creditor cannot seize the debtor's limited partnership interest. The judgment creditor can only have the court issue a charging order against the debtor's limited partnership interest. The charging order gives the creditor only the right to profits or liquidation proceeds actually paid to the limited partner. As with the LLC, the charging order creditor doesn't become a substitute partner in the limited partnership. Nor does the creditor gain other partnership rights, other than the right to profits or distributions payable to the debtor-partner. For example, the partner's creditor cannot sell or auction the partnership interest or vote as a limited partner. Nor can the creditor inspect the partnership books. The creditor becomes only a limited assignee of the limited partnership interest, and only for purposes of collecting profits or distributions voted by the general partners and actually distributable to the limited partner.
And as with the LLC, the reason the partner's personal creditor is restricted to the limited charging order remedy is to protect the partners uninvolved in the debts of the debtor-partner. The objective is to prevent a partner's personal creditors from unduly interfering in the affairs of the partnership. In contrast, a corporate shareholder's personal creditors can claim the debtor-shareholder's shares. They then become a successor stockholder, with all the rights of a stockholder. For these reasons the LP or LLC are so useful in our planning to safeguard personal wealth.
Because the creditor's right to distributed profits or liquidating proceeds is the creditor's sole remedy, you might ask how effective that remedy is. Consider its limitations. Partnership profits can be illusive, particularly when the limited partnership is family-owned and the interests of the partners are closely aligned – as is true with most limited partnerships. Second, the decision to distribute profits belongs exclusively to the general partners. A member's creditor cannot force distributions. A limited partnership can then defer profit distributions until the charging order creditor loses patience and favorably settles. This deferred distribution strategy deprives the debtor-partner from ever receiving partnership funds subject to seizure. However, in the interim, the debtor-partner can accept loans, salaries, consulting fees or payments for other assets sold to the limited partnership. The debtor-partner also has a number of legal ways to divert profits to other family entities that may transact business with the limited partnership and can thus be a protective conduit for the partnership earnings. These distributed funds would not be subject to the charging order because they are not distributed profits from the limited partnership. Interestingly, you can also structure your limited partnership to allocate a greater portion of profits to non-debtor partners who may own a proportionately smaller partnership interest. For example, you can own 90 percent of the limited partnership and, by agreement, be entitled to only 10 percent or less of its profits. You can see there are many opportunities to defeat a charging order creditor.
We generally don't want a debtor-partner to be a general partner because we would not want a court to order him to make profit distributions, which is altogether possible if the same debtor-partner is a significant limited partner. Oftentimes it is advisable to set up an international LLC to be the general partner. International LLC managers further insulate the LP management from U.S. court directives.