The Benefits of an IRA Trust

 Asset Protection, Elder Law, Estate Planning, Retirement Planning No Comments


An IRA trust can help you better control distributions after you pass away and restrict access to beneficiaries who might squander the funds of a large IRA. How? Let’s say your IRA is left directly to your beneficiaries outside of a trust. In this situation, your beneficiaries can immediately cash out your IRA and spend the money however they choose. The trouble is, when the IRA is cashed out, not only is the ability to stretch the required minimum distributions (RMDs) over the beneficiary’s lifetime lost, but all of the amount withdrawn will be taxable in the withdrawal year.

Or consider this scenario: If you name a minor grandchild as the direct beneficiary of your IRA, a guardianship or conservatorship will need to be established to manage the IRA until he or she reaches the age of 18. Then, when the grandchild reaches 18, he or she can withdraw all of what remains in the IRA. An IRA trust can put restrictions on how your IRA is spent, as well as when and how much a beneficiary can withdraw. This can provide important tax benefits if, for example, the beneficiary already has a taxable estate, since the IRA trust can be drafted to minimize or even eliminate estate taxes in the beneficiary’s own estate. In addition, the IRA trust has the potential to create an ongoing legacy for your family, because the IRA assets not used during a beneficiary’s lifetime can continue in trust for the benefit of the beneficiary’s descendants. If you are in a second marriage, an IRA trust can prove particularly valuable. In a typical second marriage situation, you’ll want to leave your spouse the annual IRA income, but after his or her death you may well want to make sure that the IRA goes only to your children, not the children from the spouse’s first marriage. An IRA trust can help you accomplish this.

Or what about a situation in which you dislike or do not trust your son or daughter in law? If you leave your IRA outright to your child, his or her spouse may be able to talk them into liquidating it. However, if you name a trust as the IRA beneficiary, your child won’t be able to liquidate the IRA—and suffer the potentially painful financial consequences. Similarly, if you fear that your son or daughter is not yet mature enough to handle the money in your IRA, but you hope one day they will be, an IRA trust can allow you to name them as beneficiaries but put restrictions on how they can utilize the money.

Finally, even though IRAs are protected from the claims of creditors in many states, when the IRA account owner dies and the assets go to an individual beneficiary, the IRA may lose its protected status. By putting these inherited IRA assets into a subtrust created for an individual beneficiary under the terms of an IRA trust, the assets will continue to be protected. The result? The IRA assets can remain intact for the benefit of the beneficiary in the event a lawsuit is filed against the beneficiary, if a married beneficiary later divorces, or if a single beneficiary gets married and later divorces. To determine whether you and your family would benefit from having an IRA trust as part of your overall plan, please contact us for a consultation.

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Don’t Let the Tax Tail Wag the Dog: Client Concerns, Not the Estate Tax, Should Drive Estate Planning

The fiscal cliff deal and the tax law changes it ushers in have received lots of attention in the press, but what clients need to do now is redirect their attention to everyday real concerns: protecting their families and assets; preserving the family business; making sure their children are provided for, educated and motivated; seeing that their loved ones have enforceable rights where the law may not grant them; and making sure their plans do not self-destruct for lack of proper maintenance. These are the enduring issues that drive estate planning, regardless of what the estate tax law may be at any given time.

In this post, let’s take a look at one of those client concerns — asset protection. With our increasingly litigious society, asset protection planning has become more important and is often a key motivator for clients who need other estate planning, too.

What is Asset Protection Planning?
Asset protection planning is not hiding or concealing assets. Rather, it is helping clients use existing laws appropriately to obtain the best possible level of protection for their assets against possible attack by creditors. The goal is to make planning decisions that are effective if and when needed because they have legitimate non-asset protection purposes and thus are defensible.

The best and most effective time to implement asset protection planning is before a claim arises, when the client is merely worried that someday there may be claims founded on possible events that have not yet happened. But even after a claim has been made, some opportunities (such as making a contribution to an ERISA qualified plan or doing a Roth conversion) may still be available to shield some assets.

Types of Client and Asset Risks
Almost every client would benefit from some asset protection planning, but like most things in life there is a cost to achieve the benefit. Asset protection planning is advanced planning and requires collaboration from a team of advisors, so sometimes the cost outweighs the benefit. Therefore it is important that each member of the advisory team be able to recognize the types of clients whose profile indicates they might be good prospects for asset protection planning. Here are a few of the main ones:

The clients who are the best prospects for asset protection planning are those most likely to be sued. At the top of the list are physicians, surgeons, dentists and other health care professionals. Running a close second are lawyers, architects and accountants. A third category is clients involved with business enterprises that pertain to health care, such as skilled nursing facilities and assisted living facilities. Builders, developers and others in construction are also at risk. Those who have already gone through a lawsuit will be keen to avoid the fear of loss associated with another one.

Planning Tip: A professional is liable for the consequences of his or her own negligence and everyone makes mistakes. Therefore, a professional’s liability protection should begin with adequate malpractice or errors and omissions insurance coverage.

In a general partnership, each partner is liable for the negligent acts of every other partner and every employee. It is rare to encounter a general partnership of medical professionals, but much more common with lawyers and architects. Plus, partnerships can come into existence without any paperwork as a business is started and then the clean-up sometimes doesn’t get done as the business grows.

Entrepreneurs and Executives
Attacks on entrepreneurs could come from business deals that have gone bad or tort claims. Management level personnel are exposed to claims for alleged improper employment practices, employment discrimination, or sexual harassment.

Clients who own residential rental properties have often acquired them one-by-one over time. Frequently they are owned in the landlord’s name. Every residential property exposes its owner to premises liability claims, such as for injuries from fires and slip-and-fall accidents. Legal structures can be set up that isolate a property from these risks associated with another property and separate the landlord from all the risks.

The Wealthy
The wealthy are exposed to more risk of lawsuits because they have the ability to pay and juries are often sympathetic to the plaintiff when the defendant is rich. Also, they often have staff, multiple properties and multiple vehicles and those impose claim risks, too.

Lifestyle-Based Candidates
Clients who have had more than one spouse are statistically at higher risk of divorce than those in first marriages. Many a business has collapsed as a result of an ex-spouse claiming an ownership interest in the business.

A client’s child who engages in risky or antisocial behavior creates a risk of future unnecessary dissipation of a family’s wealth; often leaving the child destitute with no one to turn to once the parents are gone.

Levels of Asset Protection
Every asset protection plan is a unique creation designed to meet the particular client’s needs, risks and concerns. Typically, an asset protection plan employs a combination of strategies. Because asset protection planning is a process that frequently takes months to fully implement (and because wisdom dictates building the foundation before starting on the roof) in general asset protection planning should be implemented by levels, starting at the lowest. The lower rungs on the ladder don’t get you very far off the ground, but they are dangerous to skip. Asset protection planning works the same way. A typical planning level strategy that would be presented to a highly compensated professional in a high risk profession would be:

Level 1: Exemptions
Level 2: Transmutation or Tenancy by the Entirety Agreements
Level 3: Professional Entity Formation (PA/PC/PLLC)
Level 4: FLP/FLLC to Own and Lease Practice Assets
Level 5: FLP/FLLC to Own Non-Practice Assets
Level 6: Domestic (U.S.-Based) Asset Protection Trusts
Level 7: Offshore Asset Protection Trusts

Below we discuss each of these seven levels.

Planning Tip: The plan presented should include levels above those that the client will probably choose. This gives the client appropriate control and decision making responsibility and also avoids the risk of the client legitimately complaining that particular strategies were not offered.

Level 1: Exemptions
Some assets are automatically protected by state or federal exemptions. State exemptions can include personal property, life insurance, annuities, IRAs, homestead, and property held in tenancy by the entirety. Each state protects its citizens’ assets differently and the amounts of the exemptions will also vary greatly from state to state. For example, some states have an unlimited homestead exemption; many states protect all IRAs; and many non-community property states recognize tenancy by the entirety, which is sometimes a great way to shelter the interests of both the spouse who is at risk and the spouse who is not.

Federal exemptions include ERISA which covers 401(k) and 403(b) plan accounts, pensions, and profit-sharing plans. Creating and funding qualified retirement plans for clients can provide excellent shelters against creditors’ claims. Typically these plans must also include one or more non-owner employee participants in order to be covered by ERISA. Skillful pension actuaries can be very helpful with this.

While the federal Pension Protection Act protects up to $1 million in IRAs and Roth IRAs for bankruptcy purposes, the level of non-bankruptcy protection afforded by the states to their citizens’ IRAs varies widely.

For a client who lives in a state with weak IRA protection, it might be best to move unprotected IRA assets into an ERISA qualified retirement plan which is unreachable by third-party creditors during the pay-in period (some portion of required minimum distributions may be reachable by creditors). For the client who lives in a state with strong IRA protection or who has not used all of the IRA protection available in their state, converting a traditional or roll-over IRA into a Roth IRA and paying the taxes with non-IRA funds can be an excellent asset protection strategy that is easily and quickly implemented.

Planning Tip: With today’s low interest rates, defined benefit plans are becoming popular again. Instead of the required annual fixed contributions of the past, the IRS now allows almost as much flexibility with defined benefit plan contributions as it does with profit-sharing plans. Contributions can also be increased dramatically to allow for the use of life insurance within the plan. Life insurance can be an especially valuable asset because death benefits are not subject to income or capital gain tax, and if the policy ownership and control is done right, the death benefit is not part of the insured’s taxable estate.

Planning Tip: Sometimes it is possible to convert non-exempt assets into exempt assets. For example, cash (a non-exempt asset) can be used to pay down a homestead mortgage and increase exempt home equity. This is a strategy for clients who live in states with a large or unlimited homestead exemption.

Planning Tip: Because home mortgages and home equity lines of credit can be hard to obtain, a qualified personal residence trust (QPRT), established as an ongoing trust to benefit younger family members, can also be used. However, because it is a self-settled irrevocable trust, some states have limitations that can reduce a QPRT’s effectiveness for asset protection. Also, putting an unprotected home asset into a QPRT when there is a known or anticipated claim could be held to be a fraudulent transfer.

Planning Tip: The exemption level asset protection strategies may even be available to the client who has already been sued.

Level 2: Transmutation or Tenancy by the Entirety Agreements
There are asset protection strategies for married clients that depend on how title is held to an asset. In most of the states, the available technique is converting jointly held property to tenancy by the entirety property. In the nine community property states, the technique of choice is the agreement to transmute community property into separate property. Both techniques have legal consequences beyond asset protection that must be explained to, understood and accepted by the client.

Converting jointly held property into tenancy by the entirety can make it inaccessible to an at-risk spouse’s creditors while the other spouse is living. Transmutation agreements allow clients to convert community property assets into the separate property of the spouse not at risk. Make sure the client is aware that property once transmuted stays separate property unless and until another transmutation agreement converts it back to community property. Separate counsel for each spouse may be needed to make a transmutation agreement binding. Plus, there may be enhanced risk of loss of property in case of a divorce.

Level 3: Professional Entity Formation (PA/PC/PLLC)
General partnerships and sole proprietorships under which a professional is conducting business should be restructured as a professional association or corporation (which depends on state law) or a professional limited liability company. By so doing, each professional will become protected from personal liability for the errors of other professionals and employees. Putting that protection in place is a good second step beyond having adequate malpractice insurance.

State laws will vary on this. If available, a PLLC is usually more desirable because of the charging order limitations that prevent a professional’s creditor from seizing any assets from the entity, limiting the creditor to only receiving distributions that would have been made to the affected debtor-member. In addition, the creditor may have to pay tax on any income that is distributed under a charging order. This is often enough to discourage a creditor from pursuing a claim or to make settlement on a favorable basis possible. Establishing the entity under the laws of a state that has the charging order as the sole creditor remedy, when that is possible, should also be considered.

Level 4: LP/LLC to Own and Lease Practice Assets
An LP or LLC can be created to own the specialized or valuable equipment and/or real estate that is used in the professional practice. “Lease back” agreements can then be created between the professional practice and the property owning LLCs. This strategy allows the professional to isolate valuable real estate and equipment from malpractice exposure. In some cases, a factoring arrangement can put the value of the practice’s accounts receivable in the LP or LLC and thus beyond the reach of a malpractice creditor.

Planning Tip: Creating an LP or LLC to own practice assets also allows for good estate planning by providing the opportunity for gifting or sale of LLC/LP interests to irrevocable trusts established for the benefit of children or other family members.

Level 5: FLP/FLLC to Own Non-Practice Assets
Consider the formation of a family limited partnership or family LLC in a favorable jurisdiction that has the charging order as the sole remedy to own non-practice assets. This entity would hold personal use real estate, investment accounts, cash or bank accounts, and investment real estate. Having a multi-member LLC increases the charging order protection because a bankruptcy judge cannot collapse a multi-member LLC that was formed in a favorable jurisdiction.

Level 6: Domestic (U.S.-Based) Asset Protection Trusts
Historically, creditors were able to reach assets that their debtor had placed into an irrevocable trust for the debtor’s benefit. Such trusts are called “self-settled.” Starting with Alaska in 1987, several states have adopted laws that allow the assets of certain self-settled trusts to be protected from the grantor/beneficiary’s creditors. These trusts are called asset protection trusts. Because they are formed under a state’s jurisdiction as opposed to the jurisdiction of another country (see Level 7, below) this kind of trust is commonly referred to as a Domestic Asset Protection Trust (DAPT).

The time between creating the DAPT or placing an asset in the DAPT and the DAPT affording protection to that or all DAPT assets varies from state to state, with the shortest time being two years. In like manner, the states have different lists of creditor or claim classes to which the DAPT’s asset protection does not apply. The most popular states for DAPT formation are, in alphabetical order, Alaska, Delaware, Nevada and Wyoming.

In Level 6 planning, the client establishes a DAPT in the selected jurisdiction and funds it with non-practice, non-leasing LLC assets.

Each DAPT state has its own rules that will need to be satisfied for a DAPT established under its laws to be effective. For example, the state’s DAPT law may require that a trustee have an office in that state or that some of the trust assets be held there. Associating local counsel in the chosen DAPT jurisdiction may be appropriate.

Planning Tip: Because clients today are often living into their 90s, it is wise to build flexibility into a DAPT or other irrevocable trust to accommodate changes in a client’s needs and family over several decades. To do this, the trust can be made changeable by an independent third party of the client’s choosing. This role is commonly referred to as the “Trust Protector.”

Planning Tip: A trust can be designed so that transfers to it are, for gift and estate tax purposes, completed or incomplete gifts. Incomplete gifts are included in the grantor’s estate for estate tax purposes and get a basis adjustment at death. The opposite is true for completed gifts that are not brought back into the grantor’s estate under what are called the “string” sections of the Internal Revenue Code (26 USC §§ 2035-38 and 2042). Be sure to determine what is best in each case.

Level 7: Offshore Asset Protection Trusts
The highest (and most expensive to establish and maintain) level of asset protection planning is founded on one or more asset protection trusts established under the laws of a foreign jurisdiction. (The Cook Islands, the Bahamas, Bermuda and the Channel Islands are all popular choices.) With an offshore trust, the assets are in the hands of a local trustee and are outside the reach of any U.S. court. However, there may be tax issues. Also, if the court orders the assets repatriated and they can’t be, the client could be cited for contempt and even jailed.

Planning Tip: An offshore asset protection trust should not hold assets in the United States over which a U.S. court could exert jurisdiction.

Implementing the Asset Protection Plan
The advisors independently and collectively will make a list of the client’s assets and determine what needs to be done with each one to implement the levels of planning selected by the client. It can easily take six months to a year to design, implement and fully fund a comprehensive asset protection plan, and it’s usually done in steps and pieces. During the process, it’s very important to keep the client informed and keep everyone on a timeline.

Protecting the Advisor Team
Asset protection planning can pose a risk to the advisor team members’ assets. Those risks need to be avoided. One risk is the client who, when his or her assets are under attack, will forget that no advisor guaranteed the plan’s success. The other risk is that the client’s creditors, who just want money and don’t care who pays, may try to bring the asset protection planning team members into the fray under “fraudulent transfer” allegations.

Tempering Expectations and Documenting the Agreement
To deal with the first risk, it is important to set some reasonable expectations for the client and for the client to be educated about what asset protection is, how the laws work, and what the client can reasonably expect to achieve. For example:

  • Most people would like to have a high degree of certainty of the outcome. The advisors have to temper that expectation by explaining how the law works and that there may be circumstances that nobody can effectively control. Asset protection is time consuming, but worthwhile. The end result should be considerably better than if the client had done no planning at all.
  • Many clients want to maintain control rather than shift assets to some unknown third party in a foreign land. The preferred approach is to maintain control or at least oversight over the assets.
  • An effective plan will discourage lawsuits from the outset. We cannot make our client’s assets appear not to exist, but we can create a structure that will make it less attractive for a potential plaintiff to go after our client than to go after someone who has done no planning. And we can enhance our client’s ability to negotiate a favorable settlement if liability is established.

We very highly recommend that a detailed written asset protection engagement agreement be signed in all cases. The agreement should spell out the plan goals, limitations and potential risks and negate the idea of there being any guarantee of success.

Avoiding Fraudulent Transfer Exposure
The natural tendency of the debtor is to hide assets to frustrate the creditor who would seize them. To deal with that problem, there are “fraudulent transfer” laws. Each state has one and there is one in the Bankruptcy Code. In general they allow a creditor to unwind certain transactions in which the debtor has transferred assets to another for anything short of full and fair consideration with the intent of hindering or defrauding creditors. These laws also impose personal liability on anyone who aids or abets the debtor in these activities. Therefore, the advisor team members all want to make sure that they have a good defense to any frustrated creditor’s claim that they took any action that was reasonably calculated to aid their client in implementing a fraudulent transfer.

The key to the advisor team members avoiding exposure to a claim of abetting fraudulent transfer is to make sure to gather financial and objective information and to build a relationship with the client before designing or implementing the asset protection planning. Once the facts are known, no matter how bad they are, some level of asset protection planning can probably be done. Without knowledge of the facts, the asset protection plan designed by the advisors is likely to fail.

Planning Tip: Because the natural tendency of many is to procrastinate, often the client who seeks asset protection planning already has a claim pending or impending against them.

Planning Tip: Because asset protection planning is most attractive to those who have a higher than average risk of being sued, it is critically important to determine early in the planning process how much information the client is willing to share and should share with various members of the advisor team. For example, it may be vital to preserve attorney/client privilege about some things and therefore not share specific risk information with non-attorney advisors who could be subpoenaed. Short of being sued, there is not much worse for an advisor than to be called to testify against a client!

Planning Tip: Clients may misrepresent their legal difficulties, and none of us wants to subsidize a plaintiff’s claim through the use of our own malpractice insurance because of not asking the right questions or doing a thorough discovery. An excellent practice is to have in your file a solvency certificate from your client in which the client represents to you in writing that their net worth is a positive number and that the planning they are going to do will not render them insolvent. In some instances it is useful to obtain permission from the client in order to do due diligence and independently investigate to make sure you know the information provided is accurate.

Asset protection planning is just one client concern that can be the impetus that gets the client to do estate planning. While it is highly important that the advisor team members know and understand the current estate tax laws, nobody knows what those laws will be in the future when the client’s planning “matures.” Other than in very rare cases, the current tax laws themselves are irrelevant to, and are rarely the motivating factor for, our clients’ planning. What our clients want and need is predictability coupled with flexibility. Members of the advisory team who are aware of the enduring concerns clients have will find many opportunities to work together for the benefit of the team members and their clients.

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Planning for Advanced Asset Protection

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Asset protection is vitally important in our ever more litigious society, and more wealth planning teams are needed who understand the intricacies of this area and can collaboratively implement advanced strategies. Whether creating an entire plan for the client or creating additional asset protection measures added on to an existing plan, you want to know with a high degree of certainty that the plan will be effective if an attack ever comes.

Asset protection planning is designed to provide increasing levels of protection, starting with where the client is today and moving to where he or she would like to be. Planning appropriately includes making sure there is neither too little nor too much planning.

In this issue of The Wealth Counselor, we will review and build on a prior issue (“Asset Protection Planning — Teamwork Is Required for Success”). We will also include some specific advanced asset protection strategies that will strengthen the plans you and your colleagues create for your mutual clients.

The Advisor Team Approach: The Three-Meeting Strategy
Asset protection planning is advanced. It is anything but “one size fits all”! Therefore, it requires both an in-depth understanding of the client and a collaboration of all the professionals involved. Therefore, we highly recommend that an asset protection engagement proceed deliberately and with a structure agreed to in advance by the client and the team members. The recommended and proven structure is:

1. Initial Meeting with Advisors and Client: The purpose of this meeting is to gather financial and objective information and to build a relationship with the client. To preserve the attorney/client privilege, it may be necessary to excuse non-attorney advisors from part of the meeting so the client and attorney can talk freely. It is also important to set some reasonable expectations and explain what asset protection is, how the laws work, and what the client can expect.

2. Advisors’ Meeting: After the initial meeting, the client’s involved advisors (attorney, CPA, financial advisors, insurance advisors, etc.) meet without the client present to review the client’s objectives, discuss various legal and financial solutions, and determine a consensus solution. During this meeting, it is important to lean on the expertise of specific advisors to determine a comprehensive solution. All potential ideas and concerns should be discussed and explored and differences of opinion ironed out here, not in front of the client.

3. Client Solution Meeting: Here the advisor team presents a unified solution plan, including all legal and financial components, to the client and gets the clients’ approval to proceed with plan implementation.

Talking Points for the Initial Meeting
It is important to explain to clients that asset protection is not about hiding or concealing assets. Rather, it is using existing laws appropriately to obtain the best possible level of protection for their assets. The goal is to take advantage of planning opportunities in a way that they can be as defensible as possible if and when the time comes that they are needed.

Client objectives typically include:
*    High degree of certainty of the outcome. While there may be circumstances that neither client nor advisors can control, the end result should be considerably better than if the client had done no planning at all.
*    Maintain control of their assets and their destiny. This is typically especially important to professionals and entrepreneurs.
*    Discourage lawsuits from the outset. Rearranging business affairs and asset ownership can make clients less likely to be personally liable. For example, rental properties that are owned individually or in a revocable living trust can be moved to an asset protected arrangement like a limited liability company (LLC).
*    Avoid liability “traps” like partnerships and joint ownership. It’s one thing to be responsible for your own actions, but quite another to have your assets vulnerable to the actions of another.

Types of risks faced by clients often include:
*    Professional liability: As a general rule, you cannot limit your own professional liability. Also, most states do not permit nonprofessionals to own a portion of a professional practice. Professional liability protection therefore begins with adequate malpractice or errors and omissions insurance coverage.
*    Professional liability of a partner or employee: In a partnership, each professional is exposed to liability for the malpractice of every other partner and employee. The practice can be legally structured in such a way that each professional is protected from personal liability for the errors of others.
*    Non-practice personal liabilities: These could come from business deals that have gone bad or tort claims (auto accidents, etc.). Within the practice, there could be non-professional liabilities from employment practices, employment discrimination, premises liability, and sexual harassment claims. Again, structures can be set up that isolate clients and client assets from these risks.
*    Estate planning risks: These can include unnecessary or excessive income and estate taxes; a partner’s next spouse who might be a problem with ownership interests; children’s spouses and their behavior which can lead to loss of family assets, etc. These can be dealt with in general estate planning.

The best and most effective time to plan is before a claim arises, when there are only unknown potential future creditors. But even with an existing claim, some options (such as making a contribution to an ERISA qualified plan or doing a Roth conversion) may still be available to shield assets.

Planning Tip: Be aware of potentially fraudulent transfers. Also, because clients often submit incomplete information, obtain a solvency certificate and seek permission to independently investigate their financial situation through online/court house records and other advisors.

Levels of Asset Protection
Level 1: Exemptions: Certain assets are automatically protected by state or federal exemptions. State exemptions include personal property, life insurance, annuities, IRAs, homestead, joint tenancy or tenancy by the entirety. Different states protect assets differently and amounts of the exemptions will vary greatly. Federal exemptions include ERISA which covers 401(k), pension and profit sharing plans. The Pension Protection Act protects up to $1 million in IRAs for bankruptcy purposes.

Planning Tip: Sometimes it is possible to convert non-exempt assets into exempt assets. For example, cash can be used to pay down a mortgage to increase home equity. An IRA that is not well protected under state law could be put into an ERISA qualified retirement plan that is absolutely protected from creditors. Outside cash can be used to pay taxes on a Roth conversion, thereby increasing the net protected asset pool.

Level 2: Transmutation agreements (in community property states): Separate property assets of the “safe spouse” generally are not reachable to pay certain creditors of the “at risk spouse.” Community property assets can be converted to separate property for the spouse not at risk, but once transmuted, the property may not become community property again in some states.

Planning Tip: Commutation of community property to separate property will have consequences, including the loss of stepped-up basis on the death of the non-owner spouse. Also, in the event of a future divorce, these assets would already be owned by the “safe spouse.” It is important to explain these implications and possible consequences to the clients in writing. Be sure to evaluate commutations from a fraudulent transfer perspective before the transfer.

Level 3: Professional entity formation (PA/PC/PLLC): State laws will vary, but if available, a PLLC is usually more desirable than other forms of entity because of the charging order limitations that prevent a creditor from seizing the creditor’s ownership interest in a multi-member entity. Instead, the creditor is often limited to the distributions that would have been made to the affected member. Income tax consequences for the creditor and debtor must also be considered. Using a jurisdiction that makes the charging order the sole creditor remedy is highly desirable.

Planning Tip: Using separate entities or a PLLC can limit liability for a partner’s malpractice claims.

Level 4: Equipment and Premises Leasing LLCs: LLCs can be created to own specialized or valuable equipment and/or real estate to remove these assets from the business or professional practice. Lease agreements can then be created between the professional practice and the asset holding LLCs. It is important to segregate real estate, equipment and securities accounts from malpractice exposure and it may be desirable to separate them from each other. The state in which the LLC is formed is very important, as a jurisdiction that allows the charging order as the sole remedy is highly desirable.

Planning Tip: Accounts receivable, which can be significant, can be protected by pledging them to a friendly creditor or factoring them. In the event an unfriendly judgment creditor appears in the future, the unfriendly creditor will not be able to attach to the receivables because they are already pledged or factored to another creditor.

Planning Tip: One structure to consider is creating an irrevocable life insurance trust (ILIT) and funding it with a life insurance policy that is designed to have significant cash build up over time. Using a conventional trust structure that works in every jurisdiction, the insured is not a beneficiary, but the spouse and descendants can be. (If the insured is to be a beneficiary, a self-settled asset protection trust would need to be used.) The ILIT trustee (an independent party) can use discretion and enter into a credit line arrangement with the insured (the business owner/professional). In exchange for granting the credit line access to the cash value of the insurance policy, the insured would need to pledge significant assets to secure the potential drawdown. These pledged assets can include accounts receivable. There are turnkey accounts receivable protection plans that include bundling (creation and funding of the ILIT with a particular insurance product, along with the proper documentation) or the advisor team can create one. Either way, be sure to document carefully.

Level 5: FLP/FLLC to own non-practice assets: Consider forming a family limited partnership (FLP) or family limited liability company (FLLC) to own non-practice assets. These can include personal use real estate, investment accounts, cash or bank accounts, investment real estate and highly valued collectibles (vehicles, artwork, etc.). These can be leased back to an individual for personal use. Again, a favorable jurisdiction that has the charging order as the sole remedy is preferred.

Planning Tip: Ownership interests can be gifted, often at discounted values, and the current $5.12 million gift tax exemption provides an exceptional opportunity to transfer assets this year. Should this exemption decrease to $1 million in 2013, as the law currently states, the ability to make lifetime gifts will be significantly affected.

Planning Tip: With a personal residence, one option would be to borrow the maximum on the mortgage (through a home equity line of credit) and transfer the loan proceeds to an asset protection trust (APT) which then becomes a member of the FLP/FLLC. (Establish the APT first for interim protection.) A second option would be to sell the residence to an intentionally defective grantor trust (IDGT) in exchange for a note that is structured in such a way that it would be unattractive to a creditor.

Planning Tip: A qualified personal residence trust (QPRT) can also be used. Under a QPRT, the grantor retains the right to live in the home for a pre-determined number of years. At the end of the term, the home is owned by the trust beneficiaries, which can include the descendants of the grantor. Because it is a self-settled irrevocable trust, some states have limitations that can reduce its effectiveness for asset protection during the primary term. Also, the funding of a QPRT when there is a known claim could be considered a fraudulent transfer. However, there may be other reasons to use a QPRT, including the ability to do significant gift planning and asset value freezing.

Level 6: Domestic asset protection trusts: Non-practice or leasing LLC assets transferred to a DAPT before any claim arises may provide additional charging order protection. The downsides include having to fund the trust in the jurisdiction that allows it (e.g., Nevada, Delaware, Wyoming, Alaska, etc.) and the need to have a resident trustee in that jurisdiction, which may be a significant ongoing cost. There is also the risk under the Bankruptcy Act of a 10-year clawback for transfers to a DAPT.

Planning Tip: The creator of a non-APT trust cannot be a beneficiary and still achieve asset protection. However, the spouse and children can be the beneficiaries. A flight provision can be included so the assets could go to another jurisdiction if the trust is attacked. A trust protector can oversee the trustee, change the trustee, direct the trustee to move the trust to another jurisdiction, and even be able to decant and move the assets to another trust for the benefit of the same beneficiaries. The alternative is to establish a DAPT in a jurisdiction that allows them, so that the grantor can be a discretionary beneficiary and still achieve asset protection. (Alaska, Delaware, Nevada and Wyoming are often the most popular.)

Level 7: Offshore asset protection trusts: These are established under the laws of a foreign jurisdiction. With an offshore trust, the assets are in the hands of a foreign trustee and are outside the reach of any U.S. court. However, there may be tax issues. Also, if the court orders the assets repatriated and they can’t be, the client could be cited for civil contempt and even jailed. In addition, offshore trusts are expensive to establish and maintain.

The Risks of Doing Asset Protection
Proceed with caution when doing asset protection planning for your clients. Be aware of potentially fraudulent transfers, concerns of solvency, and that there may be creditors you don’t find out about. It will be much better for you if the client will let you do some level of due diligence. Make sure your client understands the issues and has some reasonable expectations of what the asset protection planning may or may not accomplish. Sometimes the advisors will conclude that it may not be possible to do everything the client wants to do.

Asset protection planning is a challenging and rewarding area in which the advisor team has many opportunities to work together for the mutual benefit of their clients and themselves.

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How to Use an LLC to Transfer a Family-Owned Business

 Asset Protection, Estate Planning, Life Insurance No Comments


For many of my clients, a family-owned or closely held business forms a major part of their estate. While business exit and succession planning can be challenging because of tax issues, family dynamics and emotions, it can also be exceedingly gratifying for clients and their families.

In the discussion below, I will examine a case study that uses a Limited Liability Company (LLC) in the transfer of a family business to the next generation.

[Please note: This discussion is technical in nature and therefore intended for my friends and colleagues in the legal, accounting, insurance and financial planning professions. I am not rendering legal advice. Please retain a lawyer before acting upon any of the matters discussed below.]

Case Study Facts

Frank (age 62) is married to Betty (age 58). Frank has an older son, Tom, from a previous marriage who is active in Frank’s business. Betty has a daughter, Susan, from her previous marriage. Together they have a son, Charlie, who is a minor. Betty, Susan and Charlie are not involved in Frank’s business.

Frank owns 100% of an S-corporation. It has a fair market value of $10 million and generates very good cash flow. Frank and Betty have significant other assets, including a home and investments. They own some jointly and Frank brought some into the marriage — they are held in his individual name. Their $5 million lifetime gift/estate/GSTT exemptions are fully available.

Consequences of No Planning
If Frank does nothing, according to the probate laws of the state in which they live, Betty will receive 50% of Frank’s estate including the business; his son Tom will receive 25% of Frank’s estate including the business; and Charlie will receive 25% of Frank’s estate including the business. Because Charlie is a minor, Betty will control his share until he is 18. So, in effect, Betty will control 75% of the business if Frank dies intestate. Susan, Betty’s daughter, will receive nothing.

Planning Objectives
Frank would like to ensure that ownership of the business will go to his son Tom, and Tom would like the security of knowing that one day the business will be his. Tom does not have the cash to buy the business. Frank would also like to control the timing of the transfer of the business and he would like to treat his stepdaughter and younger son fairly. He is concerned about maintaining enough cash flow to support himself and Betty now, and providing for Betty if he dies first. And he would like to minimize estate taxes.

Recommended Plan

Phase 1: Reorganize and Recapitalize the S-Corporation
In a tax-free reorganization, the S-corporation is converted to an LLC that is taxed as an S-corporation. The LLC is organized under the laws of a “charging order only” state. Frank’s ownership is changed from 100% voting shares in the corporation to 1% voting and 99% non-voting memberships in the LLC. Frank still effectively owns and controls 100% of the business, but now it is comprised of 10 LLC membership units (1%) that are voting units and 990 (99%) that are non-voting units.

Phase 2: Create Dynasty Trusts
Frank next establishes three irrevocable trusts, one for each child, in a jurisdiction that permits perpetual trusts. The trusts (irrevocable grantor trusts, aka intentionally defective grantor trusts) are disregarded by the IRS for income tax purposes, but not for estate and gift tax purposes. (Alternatively, one trust with three separate shares can be established.) The trusts are also designed to own life insurance on Frank’s life.

Frank makes an initial gift of $600,000 to each trust. These are taxable gifts that must be reported on Form 709, but no gift tax will be due because it will be applied to Frank’s and Betty’s lifetime gift tax exclusions. $600,000 of their generation skipping transfer tax (GSTT) exclusions will also be allocated to each trust, giving each a zero inclusion ratio – so that it is not subject to GSTT in the future.

The trustee of Susan’s and Charlie’s trusts uses their initial gifts to purchase life insurance policies on Frank and/or Betty, providing substantial assets upon Frank’s or their deaths.

Phase 3: Tom’s Trust Buys All Non-Voting Units with an Installment Note
A business valuation is performed to determine the fair market value of Frank’s business. As part of this process a qualified valuator first values the assets the business owns (real estate, equipment, good will, inventory, etc.). The valuator then determines whether and to what extent the value of the assets should be adjusted due to lack of control, liquidity and marketability.

When these valuation adjustments are applied to non-voting interests in an LLC, the fair market value is often depressed by a significant amount when compared to the fair market value of the entire business: in this hypothetical case, 40%. In other words, the non-voting units will each have a value of $6,000, making the total value of the 990 non-voting units $5,940,000. Alternatively, voting units will have a premium value to reflect the control value. In this hypothetical case, the voting units have an appraised value of $12,000 per unit, making the total value of the 10 voting units $120,000.

Tom’s dynasty trust buys Frank’s 990 non-voting units for $5,940,000 using a 20-year installment note, payable annually. Based on the current IRS published interest rates, the trust will pay Frank $447,197 every year for 20 years. The note is adequately secured by the LLC units and the $600,000 of other assets in Tom’s trust. The cash flow from 99% of the business is more than sufficient to cover the note payments.

Planning Tip: The installment note should be handled just like an installment sale to a non-family member or a loan from a bank. A pledge or security agreement should be signed, required taxes should be paid, required filings should be made, etc. A fully documented paper trail should exist for the transaction and the payments made on the note. 

Why Reorganize the Corporation to an LLC?

Corporate stock is freely transferable, making it very easy for a judgment creditor to foreclose on corporate stock and become a shareholder. In most states, the percentage required for shareholder voting to liquidate a corporation is less than 100%, generally ranging from 51% to 80%. If a judgment creditor forecloses on enough shares of stock to allow the creditor to liquidate the corporation, the creditor would be able to seize the assets of the corporation to satisfy the claim.

Alternatively, LLC interests are usually not transferable without the consent of all members. Due to this limitation on transferability, an LLC offers much greater asset protection from creditors. Many states limit a creditor’s remedy to a “charging order” on distributions to LLC members. (Only when a distribution is made will it go to the creditor; when the claim has been repaid, the charging order is stopped.) The creditor can never become a substitute member, and will only become an assignee with no ability to vote on admission of new members or the liquidation of the LLC. In most states, it takes a 100% vote of all members to liquidate an LLC. Because a creditor can never become a member, it can never vote on liquidation of the LLC.

Outcome of the Planning

Frank owns the 10 voting units, giving him 100% control of the business and 1% of the equity. Tom’s dynasty trust owns 990 non-voting units, giving Tom no control over the business and 99% of the equity. Tom’s trust also has $600,000 in cash that Frank gifted to it as seed capital. This cash is invested, and the income tax attributes of income, gains and losses are passed through to Frank to be reported on his tax return, as is the income, gains and losses attributable to Tom’s trust’s 99% ownership in the business.

Income Tax Reporting
As long as Frank is deemed the owner of Tom’s dynasty trust for purposes of reporting trust income, the dynasty trust does not have to file a Form 1041 fiduciary income tax return. A corporate income tax return (1120S and K-1) is filed for the business and Frank reports the trust’s income on his tax return.

Income Tax Effect of Sale of Units
Because Frank is the deemed owner of the trust for income tax purposes, the sale of the LLC units to Tom’s trust is a non-recognition event; i.e., a sale by Frank to himself. No gain or loss is recognized on the sale. No interest income is recognized on the installment note payments and no interest deduction is allowed to the trust.

Planning Tip: Include a “toggle” provision to turn each dynasty trust’s grantor status off or on as needed, so that the income being taxed to Frank can be stopped if that should become undesirable later. Consider giving this power to a trust protector. 

Pass Through Dynasty Trust Income
Income from the LLC will be allocated to the unit holders based on their ownership percentages. Let’s assume the business has $500,000 in net income. Frank owns 10 voting units, equal to 1% of the equity, so he will be allocated $5,000 on the 1120S as K-1 income. Tom’s dynasty trust owns 990 non-voting units, which is equal to 99% of the equity. So Frank, on behalf of the trust, will also be allocated $495,000 on the 1120S as K-1 income.

Because the dynasty trusts are grantor trusts for income tax purposes, Frank must pay the income tax on all their income, including the S-corporation income that is allocated to Tom’s trust. But that is what he was doing before the sale, so he is paying the same income tax before and after.

Planning Tip: Frank’s payment of income taxes in dynasty trust income is not an additional gift to the trusts, so every year he is effectively transferring additional estate assets to the trusts for the children without additional transfer tax. 

How the Dynasty Trust Makes the Required Note Payments
In this case study, we assume that the LLC will have $500,000 per year of cash flow to distribute to the unit holders. Tom’s dynasty trust will receive a cash distribution of $495,000 ($500,000 times 99% = $495,000). At the end of the first year, it will have $1,095,000 in cash ($495,000 from the LLC plus $600,000 that Frank gifted to it as seed capital). The trustee uses this money to pay the $447,197 note payment to Frank.

Planning Tip: If the business does not make enough income to pay the note, the payment can be deferred until the business recovers or the term or interest rate of the note can be adjusted. 

Results after One Year

At the end of the first year, the note has been reduced to $5,745,847 and Tom’s trust has a cash balance of $647,803. This cash can be invested and saved, distributed to Tom (gift tax-free), or used to buy and pay for a life insurance policy on Frank’s life.

Frank has received $5,000 from the LLC and $447,197 from the note payment for a total of $452,197 in income. He pays income taxes on the full $500,000 of S-corporation income. If, after all deductions, he has a 25% effective income tax rate, he would pay $125,000 in income taxes, leaving him with $327,197 in income to support his and Betty’s lifestyle.

Planning Tip: A higher income tax rate means less net income, but the client can also receive additional (reasonable) compensation as an LLC manager or as a Director. If he needs less income, his salary can be reduced, but ensure that it is not so much that he loses benefits. 

When Frank Dies

Frank and Betty also establish estate plans, so the assets in Frank’s estate will pass as planned, not according to the state’s default rules.

If Frank and Betty have consumed or gifted the net after-tax proceeds of each note payment from Tom’s dynasty trust, only the unpaid balance of the note will be included in the value of his taxable estate. Tom’s dynasty trust is GSTT exempt, so its assets will never be subject to estate, gift or GST taxes. Frank’s estate plan leaves the 10 voting units to Tom’s dynasty trust, giving Tom 100% ownership of the business. The dynasty trusts for Susan and Charlie are also GSTT exempt, and the life insurance proceeds will be exempt from probate and income, estate and GST taxes. Betty will continue to receive the remaining note payments for her support.

Estate Tax Results
Frank has removed 0.99 x $10,000,000 + 3 x $600,000 = $11,700,000 of appreciating assets from the value of his gross estate that, at his death, would have been subject to estate taxes. He and Betty have used $1,800,000 of their lifetime gift/estate/GST exemptions. (Remember, unless Congress acts before the end of 2012, the top estate tax rate in 2013 is scheduled to go back to 55% with a $1 million exemption.)

Frank has received an asset (the $5,940,000 note) that, in his estate, may have a discounted value due to lack of marketability, etc., and that will not appreciate; in fact, the note is depreciating because the principal will decrease over the 20-year term.

If Frank does not accumulate the note payments, at the end of the note term he will have completely removed the $10,600,000 and all future appreciation from his gross estate without making a taxable gift other than the initial $600,000 seed capital gifts to the dynasty trusts.

The trust assets are not subject to generation-skipping transfer tax, will be protected from creditors, and will not be included in the children’s or grandchildren’s or great-grandchildren’s gross estates at their deaths.

Objectives Met

All of Frank’s objectives have been met. His son Tom will receive the business without having to buy it, and Frank can control the timing of the business transfer. He was able to provide for his other children and his wife, and he saved substantial estate taxes.


While this kind of planning can be complicated, the above example demonstrates that the rewards are many. I enjoy helping my clients solve their problems, strengthen their family relationships, save money and have peace of mind. This type of planning is truly a win-win opportunity.

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How to Leave Your Roth IRA to Kids & Grandkids

 Asset Protection, Estate Planning, Retirement Planning No Comments


In a recent article (click here), the Wall Street Journal tells how to leave your Roth IRA to kids and grandkids.  Featured in the article is what we call a “retirement benefits trust,” which offers asset protection and other benefits provided by traditional trusts.

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