- Asset Protection Trusts: These legal structures can shield assets from creditors and other claimants. They are typically established in offshore jurisdictions with favorable asset protection laws.
- Limited Liability Companies (LLCs): LLCs provide an alternate legal structure for asset protection. They offer limited liability protection, absolving owners from personal responsibility for LLC debts and liabilities.
- Offshore Banking: Offshore banking offers a possible approach to safeguarding assets from creditors and other claimants. However, it’s important to note that offshore banking can be complex and carries several associated risks.
- Asset Diversification: Asset diversification involves distributing assets across various asset classes and different jurisdictions. This strategy helps mitigate risks like market volatility and political instability.
- Privacy: Maintaining privacy serves as a critical asset protection tactic. Keeping your assets confidential makes it more challenging for creditors and other claimants to locate and seize your assets.
- Conduct Research: It’s crucial to thoroughly research and comprehend the associated risks and benefits before implementing any asset protection strategy.
- Seek Professional Assistance: Obtaining guidance from an experienced attorney or financial advisor is vital if you’re contemplating an asset protection strategy.
- Practice Patience: Asset protection involves a complex and time-consuming process. Demonstrating patience and collaborating with advisors to create a tailored plan that suits your needs is essential.
(1) Individual & Sole Proprietorship;
(6) Limited Liability Company;
(7) Retirement plan;
(8) Custodian under UGMA or UTMA; and
Individual ownership does not add any asset protection. There is nothing to insulate you from creditors. You are exposed to the world of creditors. However, assets in the decedent’s individual name are controlled by decedent’s will. If a decedent is single, the will controls everything in the decedent’s individual name. If the decedent is married, the will may not control all property in the individual’s name since it could be community property. In such a case, the will can only control the decedent’s one-half interest in the community asset. Even in a community property state, if the asset is a separate property asset (i.e., acquired either before marriage or during marriage by gift, inheritance, or earnings from a separate property), then the will can control all of it.
From an asset protection viewpoint, a corporation is a better business entity. A corporation can protect personal assets from business obligations and creditors. If pass-through taxation is desired, an S corporation can be adopted. However, many small business owners are unsophisticated and do not appreciate the benefits of asset protection.
Note: Incorporation can be the most valuable insurance you can buy. In most cases, sole proprietorships must rely on insurance to cover the risks of lawsuits, disability, and premature death. Personal service businesses are particularly sensitive to an owner’s disability. No services translates into no earnings. While accounts receivable may carry the business for a short time, unless the sole proprietor returns, the business is finished.
(1) Supplemental perils can protect a business from water damage and
(2) Credit insurance can ensure the collectibility of large debts;
(3) Accounts receivable insurance;
(4) Extended coverage for actions outside your business premises;
(5) Bonding insurance to cover embezzlement losses; and
(6) Business interruption insurance.
Corporations are powerful asset protection tools. When structured and maintained properly, the owners of a corporation (and its officers and directors) are not personally liable for its operations or debts. This means that an investor in the corporation only stands to lose the money or property that they put into the corporation.
Note: Corporations can even be used to shelter personal assets. Sometimes a corporation will be formed by one’s spouse or other family members for nominal consideration. Later, one might transfer assets to this corporation for a minority interest in the corporation. Even if subsequent creditors were to obtain your stock, it would only be a minority interest in the corporation and of limited value to creditors.
4. Always sign documents in the corporate name. The corporation must be the party contracting. Below the corporate name, you should designate your corporate title and only then enter your signature.
5. Don’t commingle personal funds or assets with those of the corporation. If you ignore the corporation, so will the legal system. Any transactions, such as loans, rentals, wages, or reimbursements, between you and the corporation should be fully documented.
(1) Loans for which personal guarantees or pledges of property are obtained; and
(2) Employment withholding taxes and sales taxes.
From a tax viewpoint, a regular corporation is generally not a desirable entity for holding investments. If an asset or investment is operated within a regular corporation, all income is attributed to the entity. If this income is then paid out or distributed to the shareholders as a dividend, the income from the investment will be taxed again.
This double taxation could be avoided by paying out the income as salary. However, such compensation can only be paid to employees providing services to the corporation and must be reasonable in amount.
Once the property is sold, the net proceeds belong to the corporation and can only be paid out as dividends or compensation. Again, this will result in double taxation3. If this were not bad enough, deductions such as depreciation, cost recovery, tax credits, interest, property taxes, and losses do not pass through to the shareholders and can only be carried forward or back by the corporation. This means that the shareholders will not be able to obtain any of the tax shelters that the assets throw off in the form of write-offs. Moreover, corporations can no longer use accelerated depreciation or cost recovery to determine their earnings and profits and thereby pay dividends that are tax-free.
The S Corporation – §1361
The S corporation can now be used as a vehicle for holding passive investments and may realize up to 100% of its income from passive sources so long as it has no corporate earnings and profits (§1362(d)(3)). However, there is a tax at the corporate level on certain capital gains and “excess passive income” for S corporations that were previously C corporations (§1374 & §1375).
(b) Reducing unreasonable compensation problems;
(c) Splitting income among family members by way of gifts of stock; and
(d) Allowing shareholders to deduct business losses against outside income.
(1) A grantor or donor (creator of the trust),
(2) A trustee (manager of the trust assets),
(3) A beneficiary or beneficiaries (person or persons receiving the trust income and/or principal), and
(4) The property or funds (corpus) that go into the trust.
Trusts are used for many different purposes and come in a wide variety of formats. Some trusts are used solely for probate avoidance and estate or income tax savings. There are also trusts that are designed for protection against judgment creditors. Still, others try to combine all these objectives.
Types of Trusts
sense that one can always change its terms through the formal procedure of changing the will of which it is a part. Living and testamentary trusts become irrevocable at the death of the grantor.
Revocable trusts offer little or no asset protection. Since the grantor can easily transfer assets in and out of such a trust or revoke the trust entirely, creditors can likewise reach the assets in a revocable trust. The grantor’s creditors essentially stand in the same position as the grantor and can compel the grantor to re-transfer the asset for their benefit.
Note: The exact rights of the grantor’s creditors will, of course, depend upon the language of the trust and local state law. A few states provide that in the absence of a fraudulent transfer, creditors cannot reach assets in a revocable trust.
Some small asset protection benefit can be taken from the fact that creditors must generally proceed against the assets in the debtor’s name first before looking to the trust assets. In addition, the grantor’s assets may not be readily apparent to potential creditors when held in the trust name. While the trustor is alive, most trusts are revocable – i.e., it can be changed or terminated. Normally, when a person sets up a living trust, they want the power to change the trust during their lifetime. Testamentary trusts are also revocable since one can always change their will before death. After death, the trust is irrevocable and cannot be changed. When one has the right to revoke a trust, that person is its owner for estate (§2038) and income (§671 through §679) tax purposes.
Dan sets up a revocable living trust for his son, Ralph. Since Dan can revoke the trust, he will be taxed on all the trust income and capital gains during his lifetime, and the trust assets will be included in Dan’s estate on death.
irrevocable trust could be established for children or others. However, to avoid estate and income tax, the grantor cannot:
(1) Act as trustee,
(2) Receive income or other benefit from the trust, or
(3) Receive the assets from the trust (§2036 & §2043).
(2) Reserve any rights to take back property once transferred to thetrust;
(3) Have any authority on how trust property will be managed or invested;
(4) Have any control over income distributions from the trust; and
(5) Serve as trustee.
Unlike typical trusts that are used to hold and invest assets, business trusts are formed to operate a business and produce profit. Business trusts that have the characteristics of corporations will be taxed as corporations. Thus, the use of a trust does not offer the tax advantages of conduit trust taxation in most business situations4.
Note: One advantage of a business trust over a conventional corporation is that a business trust is a private agreement between the parties. It requires very little formal action to establish. The business trust involves no public filings and its trustees and beneficiaries remain private.
Real estate and certain other ventures may be organized in a trust form, with the trustee as manager and the grantors as beneficiaries. However, there is a strong likelihood the trust will be characterized as a corporation for tax purposes (Morrissey v. Comm., 296 US 344 (1935); Reg. §301.7701- 4(b); R.R. 78-321). Nevertheless, if the trustee is passive or management decisions require the approval of all beneficiaries, it may be characterized as a trust (Wyman Building Trust, 45 BTA 155, acq., 1941-2 CB 14; Elm Street Realty Trust v. Comm., 76 TC 803 (1981), acq.). However, characterization as a true trust may not be beneficial based on the income tax rates applicable to any income retained by the trust.
We will find that the major use of a trust is in the gift and estate tax area.
Foreign Trusts – §679
Under §679, a U.S. citizen or permanent resident, who sets up a foreign trust which can make any payments to a beneficiary in the United States, is the owner for income and estate tax purposes and is taxed on all of the income and capital gains.
Asset Protection Trusts – APTs
(1) The Bahamas,
(2) The Cayman Islands,
(3) The Cook Islands,
(4) The British Virgin Islands,
(8) The Isle of Man, and
(1) Favorable debtor protection laws,
(2) Availability of professional services,
(3) Stable economy and politics,
(4) Liability of trustees for errors, omissions, and malfeasance,
(5) Favorable tax laws, and
(6) Modern computer and telecommunication equipment.
(1) Gifts to family members,
(2) A domestic irrevocable trust,
(3) A charitable remainder trust,
(4) A grantor retained income trust,
(5) Life insurance, and
(6) An irrevocable life insurance trust.
(1) Creditors will encounter difficult legal and practical hurdles in recovering assets from the trust (even if the creation of the trust is held to be fraudulent);
(2) Foreign trusts are less likely to be automatic targets for litigation against the grantor (i.e., the debtor);
(3) Foreign jurisdictions are more protective of debtors’ assets; and
(4) Foreign trusts provide probate avoidance, privacy, favorable taxation, and a vehicle for global investment.
Note: Foreign trusts must file Form 3520 on or before the 90th day after the creation of the trust or the transfer of any money or property to the trust by a U.S. person. Form 3520-A is required to be filed annually by the U.S. grantor of a foreign grantor trust treated as such pursuant to IRC §679.
If the APT is a foreign trust, its U.S. source interest, dividends, rents and other “fixed or determinable annual or periodical gains, profits, and income” will normally be subject to 30% withholding. Regardless of the trust’s status as foreign or domestic, the APT is usually drafted so that the grantor retains powers that result in the trust being treated as a grantor trust (§671 through §678) under federal income tax law. Thus, the trust’s income and deductions are attributable to the grantor.
Estate & Gift Tax
(1) A foreign judgment creditor commences their action from the beginning in the courts of the foreign jurisdiction;
(2) A creditor prove not only fraudulent intent but that the transfer rendered the debtor insolvent; or
(3) A creditor’s claim must arise before the transfer of assets to the APT.
As an alternative to attacking the APT, creditors might pursue the resident grantor debtor and their advisors. In some states, it is a crime to make or assist someone in making a fraudulent transfer. Moreover, a creditor could attempt to obtain a judgment requiring the debtor to turn over assets transferred to an APT. Should the debtor fail to do so, a contempt of court order may be obtainable.
Some APTs anticipate contempt proceedings and leave the grantor without any power to cause a rescission of the trust. The debtor would then argue as a defense that they are unable to obey the court order. However, such a defense is normally unavailable where the inability to obey is caused by the party’s own willful conduct.
Grantor Retained Income Trust
Note: Choosing the wrong co-ownership format can increase your exposure to creditors beyond what you would have faced if you had owned the property in your name alone. It can also double your estate tax on death.
Tenancy in Common
Note: A tenancy-in-common with more than 3 to 4 co-tenants becomes difficult to operate and greatly increases exposure to creditors. Other entities, such as partnerships, limited liability companies, and certain corporations, work better for such large numbers of owners.
Since a tenant-in-common owns their interest separate and apart from the other co-tenants, this would at first appear to be an asset protection advantage. The creditors of one co-tenant would only be able to reach that cotenant’s interest and not the interests of other tenants-in-common. However, tenant-in-common interests are undivided interests and once a creditor obtains such an interest they can bring an action to force a sale of the property and divide the proceeds. If the creditor elects not to force a sale of the property, you end up with a stranger for a co-owner.
Tenancy in common is frequently used when several people go together to buy real property. When two or more people hold title as “tenants in common,” they own an undivided interest in the property. A person’s will controls only their share of assets held as tenants in common.
Dan and his brother, Ron, purchase a house. Dan puts up 60% of the money and Ron puts up 40%, taking title as tenants in common to reflect their unequal interests. Tenants in common title will also allow their wills to transfer their respective shares.
Joint Tenancy with Right of Survivorship
For example, it is a gift to put real estate or any form of securities into joint tenancy.
Tenants by the Entirety
Right of Partition
California does not recognize such registration. General partnerships are partnerships in which each partner involves himself or herself in the management of the company. Each general partner has joint and several liability for the actions of any other partner within the scope of the partnership business.
Note: Distinctions are sometimes made between general partnerships and joint ventures.
Limited partnerships have both general and limited partners. General partners manage the entity and limited partners are not permitted to participate in the day-to-day management of the company. However, limited partners generally have their liability limited to their capital investment.
Note: A partnership is not taxed as a separate entity but determines its income and files its return (Form 1065) essentially the same as an individual. While the partnership does file a return, this return is for informational purposes only (§6031). Each partner reports and is taxed on his or her share of the income and loss from the partnership (§702)10.
Section 704 of the Uniform Limited Partnership Act (1976) provides: “An assignee of a partnership interest, including an assignee of a general partner, may become a limited partner if and to the extent that (i) the assignor gives the assignee that right in accordance with authority described in the partnership agreement, or (ii) all other partners consent.”
Phantom Income to Creditor
Income Tax Savings
Limited Liability Company
Note: No other entity provides all of these benefits. In a general partnership, the partners received pass-through taxation, but are jointly and severally liable for partnership liabilities. In a limited partnership, partners have passthrough taxation, but only limited partners have limited liability. S corporations provide shareholders pass-through of tax attributes, limited liability, and control over the business without risk that management participation will jeopardize limited liability. However, such benefits are available only if restricted eligibility requirements are met.
Note: Corporate plans usually get a full exemption, while IRAs and Keoghs are exempt only for retirement income needs.
Retirement Fund Protection in Bankruptcy
Both acts simplify family income and gain shifting. They permit a gift to be made to a minor with an adult serving as custodian. Usually, a parent who made the gift is also named custodian12. The custodian is permitted to sell or redeem and reinvest the principal and to accumulate or distribute the income, provided there is no commingling of the child’s income with the parents’ property. The income or gain of the custodianship is taxed to the child, subject to the “kiddie tax” unearned income rules for children under 19 or 24 if full time students.
Custodian accounts under either of the uniform acts should be good asset protection tools assuming completed gifts are made. Even though the custodian can exercise control over the assets in the account, such control is exercised in a fiduciary capacity.
However, in the case of a partnership interest a guardianship may be required. Using the parent as the custodian can be dangerous and result in the funds being included in the parents’ estate on death if the parent can use the custodianship funds to satisfy a support obligation to the child. Caution may suggest that another relative (e.g., grandparent) be used instead.
On an individual’s death, a probate estate will typically be established. While most consider probate a time consuming and expensive process, probate can offer substantial asset protection.
Probate courts have traditionally viewed the protection of spouses and family members as more deserving than that of creditors (Hurlimann v. Bank of America, 141 CA 2d 801 (1956)). Most probate statutes bar creditor claims not filed within the time provided by law. This period is generally 4 to 6 months after the executor is appointed and notice given to creditors. The disadvantage, however, is that your estate must typically give actual written notice to all known creditors to invoke this protection.
Note: Many states permit similar protection for trusts to cut off creditors’ claims against trust assets (e.g., Calif. PC §19000 et seq.). The trustee must publish notice of the grantor’s death and mail notice to known creditors. Those creditors who do not file claims within the appropriate period are barred from collection against trust assets.
Subchapter J of the Code governs the income taxation of estates (and trusts. Estate income is taxed to the estate or to its beneficiaries to the extent they receive income from the estate. This creates a modified conduit principle. Whoever receives the income is liable for the tax. The executor of the estate is responsible for filing Form 1041 and paying any income tax due.