Dedon on Estate Planning

Asset Protection For Business Owners

See the attached article below published on December 2, 2009 in Virginia Business Magazine on asset protection for business owners.

Wednesday, December 2, 2009

Virginia Business

Asset protection for business owners in uncertain times

December 02, 2009 11:30 AM
John Dedon

 

Many business owners face a number of issues unrelated to revenue and expenses. One pressing concern is the threat to the business from liability claims. If you are selling a product or providing a service, the danger that you may be the target of a products liability or negligence claim is a reality of doing business. The business could be selling automobiles, landscaping, real estate development or property management, customers in a store. It does not matter because the concern is the same: if I am sued am I personally at risk, and is my business at risk?

Checklist of protection steps

Here is a checklist of basic safeguards all business owners should have in mind:

1. Do you have sufficient liability insurance in amount and in scope of coverage?

2. Are you aware of the various statutes of limitations that may protect you from various claims?

3. Do you operate as a corporation or LLC so that you are protected personally?  Thus, liability would be limited to the entity, not its shareholders, officers or directors.  This assumes you observe the corporate formalities so that a plaintiff could not “pierce the corporate veil.“

4. If the corporate veil was pierced, perhaps the stock is owned in a Trust or separate entity so that you are not personally liable as the shareholder.

5. If you operate as an S corporation or an LLC, do you pay out most or all of the earnings to the owners so that, if liability is limited to the entity, there are not significant assets at risk?

6. If there are various business activities (e.g., real estate holdings, real estate management, and real estate sales) do you maintain LLC’s or Corporation’s for each business to segregate liability?

7. If somehow personal liability attaches to the owners, officers, or directors, have you titled and positioned your personal assets so that the personal assets are protected? These personal steps could include tenants by the entirety, trusts, or entities that receive the protection of charging orders.  For more information on these personal steps, see below.

Personal liability protection

If you are a professional you may be subject to personal liability for negligence claims regardless of the entity you create.  Alternatively, any business owner who fails to take the necessary steps to ensure the corporation or LLC entity is respected can be liable if the plaintiff or creditor “pierces the corporate veil.”  In either of these events, you may be personally liable.  In the case of personal liability, what steps can you take to protect yourself short of a bankruptcy filing?

Here are some fundamental planning considerations:

1) Assuming you are married, are your assets titled “tenants by the entirety” with your spouse?  Many states, such as Virginia, protect assets from claims against only one spouse if the assets are jointly titled with the spouse.  One negative of titling assets “tenants by the entirety” is that it may not be desirable for estate planning purposes.

2) Have you irrevocably transferred assets to trusts with an independent trustee for beneficiaries, such as your children?  In this event, if a claim later arose after the transfer the assets in trust would be protected.  Some states, such as Delaware, offer additional asset protection if a Delaware irrevocable trust is created and managed by a Delaware Trustee.

3) Are you using LLCs or family limited partnerships with several members or partners so that, if you are sued, the remedy is a “charging order. “ A charging order precludes the creditor from attaching the assets or your ownership interest. 

Of course, if you transfer assets after a claim or judgment arises, none of these transfers would be protected if the plaintiff can prove a “fraudulent conveyance.”  A fraudulent conveyance refers to a transfer that renders you insolvent or that is done with the intent to delay, defraud or hinder creditors.  Therefore, the protective planning described above is best accomplished and mostly likely to succeed if done before any known or potential claims exist.  If the planning is part of a comprehensive estate plan it further enhances the likelihood of success.

John P. Dedon is a principal in the firm with the Trust, Estate & Tax Planning practice group of Odin, Feldman & Pittleman. Dedon blogs about estate planning issues for Virginians and U.S. citizens at dedonestateplanning.typepad.com

Are Foreign Accounts Worth It?

Clients often ask whether they should utilize offshore accounts for tax planning and asset protection. For asset protection, offshore accounts may work if both the taxpayer and the assets are offshore. However, U.S. Courts have held U.S. taxpayers in contempt of court, and put them in jail, if the taxpayer asserts in front of the judge that he cannot obtain the assets because they are in a foreign account. Thus, offshore accounts for asset protection in most situations is not a viable option.

Regarding tax matters, U.S. residents or citizens are taxed on all income and assets regardless of where the assets are held. Many individuals erroneously think by titling assets overseas they are avoiding income or estate tax. Often what these U.S. citizens were falsely relying on was merely the secrecy laws of foreign countries.

As you may have read in newspapers and the popular press, many countries are loosening their secrecy laws in the face of increased U.S. pressure. UBS and other banks are now cooperating with the IRS. The IRS has targeted offshore accounts as a major enforcement issue. The IRS has hired thousands of new agents and imposed greater reporting requirements.

Among these reporting requirements is a return taxpayers must file by June 30th for the 2008 year. (Report of Foreign Bank and Financial Accounts or "FBAR.") There are a number of other returns associated with foreign accounts. You may have also read about a voluntary disclosure program announced by the IRS for taxpayers who confess their wrongdoing. However, this voluntary disclosure program does not eliminate the requirement to pay taxes, interest and all penalties. What it does do is avoid criminal sanctions and may reduce penalties.

In sum, foreign accounts may present opportunities and advantages for certain U.S. taxpayers. However, considering the reporting requirements, the suspicion of fraudulent conveyance, and the cost involved, most clients should conduct their asset protection and tax planning within the U.S.

PROTECTING ASSETS

In this economy, creditor protection is an increasing concern for many individuals. In contrast to prior years, when perhaps real estate developers at times or professionals concerned about malpractice, had creditor protection concerns, today's environment and the economy has affected many more people.

Any creditor protection solution is only possible if there is no "fraudulent conveyance." A fraudulent conveyance is any transfer that renders the debtor insolvent or which is done with the intent to delay, hinder, or defraud a creditor. Assuming no fraudulent conveyance, certain assets may be protected depending on state law or bankruptcy protection. Common examples are the following:

1. Many states protect property that is titled with a spouse "tenants by the entirety." Thus if there is a judgment against one spouse, the property would be protected. An example would be a real estate developer who signed a loan. Upon default, if a creditor sought collection from the developer’s real property and accounts that were titled "tenants by the entirety," those assets would be protected as long as his wife did not sign on the note. If his wife then died and the judgment was outstanding, then the protection is lost.
2. ERISA accounts, such as 401(k) plans, enjoy unlimited protection. IRA's, which are not ERISA plans, enjoy limited protection in many states up to $1 million. The IRA protection of $1 million may depend on whether the debtor is in bankruptcy and the 2005 Bankruptcy Act applying. Although assets rolled over from an ERISA plan to an IRA are also protected, it is important to make sure you do not commingle the two different kinds of accounts.

There are a host of other asset protection solutions ranging from charging order protection afforded partnerships and limited liability companies, to domestic asset protection trusts created in states that have favorable protection laws such as Delaware or Alaska, to offshore planning in Countries with even more favorable laws. However, the bottom line is that, for U.S. residents with U.S. assets, proactive asset protection planning will only work if it predates any fraudulent conveyance problems.

Recent Private Split Dollar Ruling

In the February 9, 2009 Virginia Business Online Magazine, I wrote about the advantages of private split dollar life insurance for taxpayers seeking to provide estate tax free insurance protection for their families. The private split dollar planning advantages and the details of structuring a plan are described in the February 11 Post and, therefore, will not be repeated here.

What is worthy of note, however, is that in March the IRS approved the desired tax results for taxpayers who entered into a private split dollar arrangement. The insureds were a married couple who purchased a survivorship policy and titled it in an Irrevocable Trust to remove it from their taxable estates. See Private Letter Ruling (200910002). Although a Private Letter Ruling is not legal precedent, it does indicate the IRS’ position on similar transactions. Of particular note, the IRS agreed with the taxpayers regarding the following:

• The transaction qualified as "non-equity split dollar" under Treas. Reg. Section 1.61-22, and the taxpayers, the grantors of the Trust, were the "owners" for split dollar purposes.

• As the policy owners for split dollar purposes, the gift tax charged to the grantors is the economic benefit that the Trust receives, i.e., generally the cost of the term insurance under Notice 2002-8, 2002-1 CB 398. This amount is significantly less than the premium payment.

• For estate planning purposes, however, the Irrevocable Trust is the owner of the policy. Thus, the insurance death benefit is removed from the taxpayers’ estates. Obviously this is the desired result whenever a second to die policy is used to pay estate tax at the second death.

• In non-equity split dollar, there is a receivable due to the insureds’ estate at the termination of the agreement, which is included for estate purposes.

Private split dollar is a planning alternative to be considered by taxpayers to provide insurance protection for their families in a gift tax efficient manner.

Bad Times Make Good Gifting Opportunities

In my October 13 Post, I discussed how this is an opportune time to make gifts to family members because of reduced stock values. The same could also be said for real estate and perhaps closely held businesses.

Recent articles from two leading newspapers follow these same lines. In an October 18th Wall Street Journal article, captioned "Why Now Is the Time to Help Your Heirs," the Journal mentions several techniques to make generational transfers, including GRATs (which I have written about in the past), gift and sales to Intentionally Defective Trusts, and family loans. These go hand in hand with the Family Partnership concept that I wrote about last week. In the charitable arena, the Journal also mentioned Charitable Lead Annuity Trusts.

The second article was an October 16th New York Times piece by Warren Buffett in which he urged investors to continue to buy American stocks and take advantage of buying opportunities. As Buffett says, "be fearful when others are greedy, and be greedy when others are fearful." As Buffett's October 16th article states: yes the financial world is a mess, but it also presents opportunities in the long term for generational transfers.

Looking For The Silver Lining In Economic Clouds: Family Partnerships and Marketable Securities

As bad as our balance sheets appear in these dire times, if we strain we can try to find the silver lining. A possible silver lining is for parents and grandparents who are considering generational transfers to reduce their taxable estates. They can take advantage of hard economic times by removing marketable securities from their taxable estates. The combination of low stock values, and market and minority discounts resulting from using family limited partnerships (FLP), can result in substantial estate tax savings.

Granted, many taxpayers who previously considered gifts to reduce their taxable estates are no longer concerned or at least do not view it as a priority. On the other hand, the depressed stock market presents a unique opportunity to make current gifts and save significant gift and estate taxes. Therefore, if the estate is still substantial, now is the time to gift marketable securities.

I have previously written about GRATs. Another tried and true transfer tool with a long history is the FLP. In an FLP, the senior generation typically contributes the bulk of the assets and retains control as the general partners. (The general partnership interests are analogous to voting stock of a corporation.) They gift limited partnership interests to children and grandchildren. These limited partnership interests, which represent equity in the FLP, do not have any voting rights. The absence of voting rights and control often result in discounted asset values for estate and gift purposes.

Taxpayers and the IRS have had many battles regarding whether FLP’s can be used to reduce estate taxes, either by lifetime gifts or upon death. Broadly stated, taxpayers assert FLP restrictions prohibiting limited partners from freely selling or controlling the FLP assets significantly depress the value of the limited partnership interests, and hence the partnership assets. These "market and minority" discounts typically reduce the partnership asset values anywhere between 20% and 50%, depending on the type of asset, income generated from the asset, and other factors. The IRS’ positions are varied: they include 1) there is no business purpose for the FLP, rather it is only a device to artificially reduce gift and estate taxes; 2) purported transfers were illusory because the transferors retained indirect control; 3) the formalities were not observed, such as FLP bank accounts were not opened, capital accounts, schedules, and tax returns were not prepared; 4) pro rata distributions to the partners were not made; 5) the discounts were too high, and on and on.

Notwithstanding these IRS assaults, FLP’s are still a valid planning tool if created properly and implemented appropriately. A recent case, Holman v. Commissioner, 130 T.C. No. 12 (May 27, 2008), supports FLP’s to reduce gift taxes even if the FLP consists only of marketable securities. In Holman, the taxpayer contributed solely Dell Computer stock. The Tax Court rejected the 49.25% discount claimed by the Holman’s for the gift of limited partnership interests to their children. However, the Tax Court did allow discounts exceeding 20%, simply because the Holman’s used an FLP to gift limited partnership interests rather than gift the Dell stock directly. The Tax Court rejected the IRS’ position that the transfers were indirect transfers of the Dell stock and the FLP should be disregarded. The Court also disagreed with the IRS position that Internal Revenue Code Section 2703 trumps the FLP agreement and treats limited partnership interests as freely transferable, thereby eliminating any market and minority discounts.

What does Holman mean to taxpayers seeking to reduce gift and estate tax? Consider this example:

Mr. and Mrs. Taxpayer have marketable securities that were worth $12 million in 2006. In 2008, their portfolio fell 25% to $9 million. They want to gift roughly 1/3 of the $9 million portfolio to their children. They first create an FLP, next they contribute the marketable securities to the FLP, and then they gift FLP limited partnership interests to their children. They obtain an appraisal which discounts the limited partnership interests by 31%, so that the FLP assets are worth $6,210,000. They gift 30% of their FLP limited partnership interest to their children, which is worth only $1,863,000 for tax purposes. The underlying asset value, however, is $2.7 million. If the assets bounce back to $12 million, they have removed $3.6 million from their estates. By taking advantage of the FLP and discounts, the estate tax savings based on a $9 million valuation is almost $400,000 (tax savings on a transfer of $1,863,000 instead of $2.7 million). If the portfolio bounces back to $12 million, the estate tax savings are approximately $800,000 (tax savings on a transfer of $1,863,000 instead of $3.6 million). These savings do not take into account the future appreciation also removed from the estate.

In sum, FLP’s satisfy a number of advantages. They can provide asset protection for assets inside the FLP; they can maintain assets for future generations by providing a management structure; and as discussed above, FLP’s provide significant estate tax savings for individuals seeking estate tax relief without losing complete control over the assets.

Creditor Protection and IRAs

As individuals continually find new ways to save for retirement, it is important to examine their level of vulnerability to creditors’ claims. Individual retirement accounts ("IRAs") are helpful tools which allow a person to set aside money for retirement while also providing potential tax advantages. Unlike ERISA qualified retirement plans (e.g., 401(k), 403(b)), which enjoy unrestrained creditor protection, IRAs are afforded creditor protection on a more limited basis depending on their categorization and the relevant law being applied.

The Employment Retirement Income Security Act of 1974 was passed in an effort to remedy a host of problems associated with employee benefit plans. By creating minimum standards, ERISA sought to ensure the "equitable character of such plans and their financial soundness." 29 U.S.C. § 1001 (2006). Through its legislative provisions, an individual’s interest in an ERISA qualified retirement plan is protected from creditors. see Patterson v. Shumate, 504 U.S. 112 (1992). Furthermore, federal bankruptcy law offers unlimited creditor protection for ERISA plans and all non-ERISA plans which are exempt from taxation.

Whether creditor protection is available to an IRA depends on the state and its applicable laws. Though every state possesses its own bankruptcy exemptions, Virginia is an opt-out jurisdiction; this means that Federal Bankruptcy exemptions are applied to retirement plans. Va. Code §34-34 (2007). In recent years, the security provided to IRAs has expanded due to newly enacted federal legislation.

The Bankruptcy Abuse Prevention and Consumer Protection Act was signed by the President in 2005. While the law was largely enacted to make it more difficult for debtors to discharge debt, certain provisions provide more expansive creditor protection. Section 224 of the BAPCPA allows protection to IRAs which would not have otherwise been provided to them under federal or state law. Though increased protection is given under the BAPCPA, limitations are imposed.

Creditor protection for IRAs is only provided in bankruptcy; therefore, the BAPCPA does not apply when a judgment is rendered in another court where state law applies. ERISA is not similarly restricted in that it applies to judgments other than bankruptcy, regardless of applicable state laws. Additionally, the type of IRA created will determine the protection it is given. Section 224(e) creates a $1 million inflation adjusted cap on the value of a debtor’s interest which may be claimed as exempt from his bankruptcy estate. This cap is instituted when dealing with Roth IRAs or traditional IRAs. In contrast, eligible rollover accounts (such as a 401(k), a 403(b), or a profit sharing plan) have unlimited exemption and are therefore not subject to a similar cap. Due to the different treatment afforded to varying IRAs, all roll over assets should be kept in a separate IRA from contributory assets.

While IRAs do not enjoy the extensive creditor protection afforded to ERISA qualified plans, they do provide a level of creditor security. When assessing the degree of creditor protection afforded, both the specific type of IRA and the relevant jurisdiction should be examined.

Converting Partnerships to Limited Liability Companies

Limited Liability Companies ("LLC"), rather than limited partnerships, have become the planning tool of choice for owners of real estate seeking to protect themselves from liability. What if you have an existing partnership and you want to convert to an LLC? The discussion below applies to all partnerships, general or limited.

As background, generally a member of an LLC is not personally liable for damages arising from activity inside the LLC. On the other hand, a general partner of a limited partnership is personally liable for damages arising from activity inside the partnership. Take this example:

Estate Planning for Business Owners

Protecting and preserving assets is complicated for individuals planning their estate. Assets can be depleted by income taxes and potential lawsuits during lifetime and by probate costs and estate taxes upon death. A comprehensive estate plan should address all of these threats. For business owners, creating and implementing an estate plan is even more important and perhaps more complicated. However, the good news is that there are ample tools available to address the problems and provide solutions. Further, each business owner can take comfort in knowing they are not the first one to have successfully protected his family and his assets.

Everyone is concerned about basic estate planning issues. These issues include avoiding probate, eliminating or reducing estate taxes, ensuring that the assets passing to children are protected from the children’s creditors and from their failed marriages, and making sure that the people or institutions named as Executors and Trustees manage the assets properly. If there are minor children, Guardians need to be appointed to care for the children. Business owners have these same concerns, but face ever greater challenges.

Intent Test

A prior post (June 9, 2008) dealt with fraudulent conveyances and their ability to expand potential remedies available to creditors beyond those present under the asset protection arrangement being used by a debtor. When determining whether a transfer is a fraudulent conveyance one of two tests, an intent test or an insolvency test, may be used for the relevant analysis. This post will be dedicated to exploring the intricacies of the intent test.

A debtor has committed a fraudulent conveyance under the intent test when he has transferred property with the intent to hinder, delay, or defraud his creditors. If the intent test is satisfied then the transfer constitutes actual fraud. Intent can be difficult to prove; therefore, courts permit circumstantial evidence, also referred to as "badges of fraud", to assist the creditor in his showing (see prior post for examples of "badges of fraud"). While numerous "badges of fraud" exist to support a creditor’s claim, a transfer from a debtor to an "insider" is highly probative that a fraudulent conveyance has occurred. The term "insider" is defined under both the Bankruptcy Code, Section 101(31), and the UFTA, Section 1(7), and includes relatives of the debtor, partnerships in which the debtor is a general partner, general partners of the debtor (as long as the debtor is also a general partner under the UFTA), and a corporation where the debtor is a director, officer, or person who is in control. When an adequate number of "badges of fraud" are present, then a presumption of actual fraud may be inferred. While the debtor may rebut the creditor’s assertions, the burden always remains with the creditor to prove intent.