Category: Article

Why the Our Trust is Better than an FLP or LLC

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Our Trust is better than a family limited partnership (“FLP”) or LLC for the following reasons:

Criteria FLP or LLC Our Trust
Confidentiality An ownership interest in an FLP or LLC must be disclosed on the financial statements and tax return of each family member who owns an interest.  This subjects the interest to scrutiny and attack in the event any family member is subject to a lawsuit, divorce, bankruptcy, or review by a government agency, including a review for eligibility for student loans or grants or other assistance. Our trust requires no disclosure by any family member on financial statements or tax returns.  Our trust is not discoverable through discovery of tax returns, or through a bankruptcy questionnaire.
Ownership  If you own something, then you can lose it in a lawsuit, divorce, bankruptcy, or a proceeding with a government agency.  Each family member who has ownership in an FLP or LLC, has an asset that could be jeopardized. Neither you nor any family member has any vested ownership interest in the trust.  Therefore, you have no asset that can be pursued or taken into account if you are sued, divorced, bankrupt, or subject to an examination by a government agency.
Flexibility After you have given ownership away to family members, their ability or willingness to return the ownership is limited by gift tax laws, fraudulent transfer laws, and changing attitudes, wants and needs.  If your child becomes estranged from you, or subject to a divorce or bankruptcy, there may be no way for you to take their ownership away. Our trust includes a power (called a “special power of appointment” or “re-write power”) which allows the terms, conditions,  and potential beneficiaries or distributees to be changed at any time.  If a family member is estranged from you or under financial attack, the special power of appointment can be used to remove the family member from the trust, and then reinstate them at a later date.
Case Law  Most states allow a creditor to foreclose and become the owner of an interest in an FLP or LLC.  Some states limit the remedy of a creditor to a charging order.  Some states allow a court to give a creditor a broad charging order that gives the creditor a right to an accounting or other directions and requirements against an FLP or LLC.  All states allow a minority interest holder to enforce minority rights and fiduciary duties to ensure that the assets are managed for the benefit of all stake holders.  Most charging orders result in a settlement payment to buy the creditor out at a reduced value.  Most people do not enjoy having to buy a creditor out of their FLP or LLC. Because no one has a vested interest in the trust, neither do their creditors.  For a listing of cases supporting the asset protection provided by our trust, see Law and Precedent Supporting the Trust.
Tax and Family Complexities You are required to file a partnership tax return for an FLP or LLC each year.  You are also required to give each family member who owns an interest in an FLP or LLC a k-1 which indicates the portion of income attributed to their interest.  This means that they cannot file their taxes until the partnership return is complete, and they may want to be reimbursed for their portion of the income each year.  It also means that family members and in-laws are entitled to information about the assets, activities and income of the partnership.  This can create significant tax complexities and family complexities.  Our trust results in NO extra tax returns.  Family members don’t even need to know about the existence of the trust, except to the extent you choose to tell them.

How to Attack an Asset Protection Trust and How to Defend Against Such an Attack

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If you read all the asset protection cases out there, you will find that there are really only three ways to attack a well crafted asset protection trust: (1) attempt to prove that the transfers to the trust were fraudulent transfers, (2) attack a self-settled asset protection trust by using the laws of a state or jurisdiction that doesn’t recognize self-settled trusts, or (3) attack the trust based on several related theories referred to as reverse veil piercing, alter-ego, constructive trust, or the sham transaction theory. For purposes of this article, the third category will be referred to as “veil piercing.”

Fraudulent Transfers

It is easy to completely avoid and prevent an attack based on a fraudulent transfer theory. You simply transfer your assets to your asset protection trust in advance of a problem, lawsuit, or bankruptcy. Note that the courts analyze fraudulent transfers based on if a prudent person in your situation might or could have foreseen liability given the circumstances. 

For example, in Albee v. Krasnoff,[1] Mr. Krasnoff was a fifty percent owner of an investment partnership with hundreds of investors. Mr. Krasnoff conveyed a home to an irrevocable trust for his wife. Five years later it was discovered that Mr. Krasnoff’s partner had embezzled money from the partnership. All the investors lost money and sued the partnership as well as Mr. Krasnoff and his partner. The investors argued that the transfer to the trust was fraudulent because it occurred after the investment had been made, but the court ruled that the transfer was not fraudulent because it was done for estate planning purposes and Mr. Krasnoff had no knowledge of the fraud or the potential claim when the transfer was made.

In another court case called, In the Matter of Damrow,[2] the court examined two separate transfers by the same person, and the court found that one of them constituted a fraudulent transfer, and the other did not. When the first transfer was made, in January of the year 2000, Mr. Damrow had guaranteed significant loans to several lenders, but he was not behind on payments. When the second transfer was made, in November of 2001, Mr. Damrow was behind on payments and several creditors had initiated collection activities. The court found that the second transfer was fraudulent because Mr. Damrow was insolvent when he made it, and the first transfer was not fraudulent because he was not insolvent when the first transfer was made.

If you make a transfer with actual intent to hinder, delay, or defraud a creditor, or if you make a transfer at a time and under circumstances that appear to be a fraudulent transfer, then a creditor can obtain a judgment against the trust regardless of how well the trust is designed and drafted. Countless court cases make it unmistakably clear that no asset protection trust, domestic or offshore, can be relied upon to protect assets if the transfers are made at a time and under circumstances that are likely to result in a fraudulent transfer.

Even if you do have a current lawsuit or judgment against you, you may be able to make a transfer to an asset protection trust that is not a fraudulent transfer if you retain sufficient assets in your name to satisfy the pending judgment. The test that is used to determine if a transfer is fraudulent is based on your specific facts and circumstances. If you have any question whether a transfer could be considered fraudulent, you should consult legal counsel regarding your specific situation.

In summary, the best way to defend against a fraudulent transfer attack is to create and fund your asset protection trust at a time when you are not insolvent, the transfer does not render you insolvent, you have no judgments against you, you are not behind on payments, and you have no reason to believe that substantial liabilities or judgments are imminent. If you do so, the fraudulent transfer attack is avoided and you can move on to the next phase of the analysis.

Self-Settled Trusts

The common law rule in the United States has always been that if a settlor is also a beneficiary of a trust, the settlor’s creditors can reach the maximum amount which the trustee can pay to the settlor. (See Restatement (Second) of Trusts, Section 156 and Uniform Trust Code Section 505). Over the past thirty years, several domestic and offshore jurisdictions have passed statutory laws providing that the assets of a self-settled trust (a trust in which the settlor is also a beneficiary) are protected from creditors. Almost all offshore and domestic asset protection trusts are based on these new laws which provide asset protection for a self-settled trust.

If you create a self-settled asset protection trust in a supportive jurisdiction, a creditor could attack your trust by arguing that the law of a different jurisdiction applies. For example, if you create a Delaware asset protection trust, a creditor from New York may argue that New York law applies instead of Delaware law because the offense occurred in New York and the offended party is a resident of New York. Because the laws of the State of New York do not allow a debtor to protect assets in a self-settled trust, the New York courts could potentially allow a New York resident to obtain a judgment against the trust. Similarly, it is possible that a federal court (including a bankruptcy court) could refuse to recognize the laws of a jurisdiction that provides asset protection for a self-settled trust. Because domestic self-settled asset protection trusts have only been around for 13 years, there are no court cases on this issue at the present time. There are however, two federal bankruptcy cases where the bankruptcy court has refused to recognize the self-settled trust laws of a foreign jurisdiction because it is against the policy of the federal bankruptcy courts.[3]

In the Portnoy case cited above, Judge Brozman of the Federal Bankruptcy court said, “I think it probably goes without saying that it would offend our policies to permit a debtor to shield from creditors all of his assets because ownership is technically held in a self-settled trust.”[4]

In Dexia Credit Local v. Rogan,[5] Dexia sued Peter Rogan for fraud, conspiracy, and other torts and obtained a judgment against him for $124,000,000. Rogan had established a trust under Bahamian law which protects the assets of a self-settled trust from the creditors of the grantor. The Illinois court said that it would not honor the laws of a jurisdiction where doing so would violate the public policy of the State of Illinois.

You can avoid an attack based on a self-settled trust theory by simply not using a self-settled trust. If you create an irrevocable trust for your spouse and children and you are not included as a beneficiary, the risk of an attack based on a self-settled trust theory is completely eliminated.

There are other ways that you can potentially receive benefits from a trust without being included as a beneficiary. For example, you could receive a salary for managing companies owned by a trust. Or, the trust could provide distributions to your spouse, which your spouse could later transfer to you as a gift or allow you to enjoy as a collateral benefit of being married to a wealthy spouse. Another option is to grant your spouse or some other person a special power of appointment. This is a power to appoint the assets of a trust to anyone except for the person who holds the power (or their estate or their creditors). The special power of appointment could be used to provide benefits to you if necessary, even though you are not a beneficiary of the trust. Many statutes and cases support the fact that a special power of appointment does not create creditor rights.[6]

In summary, you can avoid an attack based on a self-settled trust theory by not using a self-settled trust. However, this creates other risks because it means that you are left out as a beneficiary. The best way to solve this problem is to include a special power of appointment in the trust, and design a system of trustees and trust protectors that ensures that no person has power to abuse the trust.

Veil Piercing

The only other way to attack an asset protection trust is to argue that the trust is not to be respected as a separate legal entity from the debtor. This attack is often referred to as reverse veil piercing, alter-ego, constructive trust, or the sham transaction theory. There are many court cases discussing and applying these theories to determine if a creditor can pierce an irrevocable trust.

For example, in Dean v. United States,[7] George and Catherine Mossie established an irrevocable trust for the benefit of their children for estate planning purposes. They transferred assets to the trust on December 4, 1990. At the time the transfer was made, they were not aware that their tax return from 1988 was being audited. Later the IRS, audited all their returns from 1987 to 1990 and assessed back taxes and penalties against the Mossies in the amount of $281,093.95. The IRS placed a federal tax lien on the assets of the trust by claiming that it was the alter-ego of the Mossies, and the trustees sued to have the lien removed.

It is interesting to note the following facts pertaining to the alter-ego analysis:

  1. Except for a brief period at the beginning of the trust when Catherine Mossie used her personal checking account to pay rental expenses for the trust property, all trust checks were signed by the trustees and not the Mossies.
  2. All deeds, transfer documents, tax returns, and promissory notes pertaining to the trust were signed by the trustees.
  3. All management decisions concerning the trust were made by the trustees.
  4. The trustees did allow Catherine Mossie to live in a home owned by the trust without rent.
  5. The trust owns a car which it makes available for the personal use of George and Catherine Mossie.
  6. The trust owns a vacation home which it has made available to Catherine without rent, once or twice.
  7. George and Catherine Mossie have received no money from the trust, except for reimbursement for nominal trust expenses paid by the Mossies.
  8. The trustees were two of the Mossie’s four daughters.

The court recited the general rule for applying the alter-ego doctrine which is that a separate entity will be respected unless it was so dominated that it had “no separate mind, will or existence of its own.” The court found that the Mossies had established the trust for legitimate estate planning purposes and that the legal control of the trust assets had shifted to the trustees. It is true that the trustees had allowed the Mossies to receive some collateral benefits from the trust but the court said that is how families do function and should function and small deviations from the trust are not enough to invalidate the whole trust. In the end, the court ordered the IRS to return the trust property to the trustees and release the tax liens against the trust property.

Another example is the case called, In re Vebeliunas.[8] In the Vebeliunas case, a wife established an irrevocable trust for her husband (the “debtor”), naming herself as the sole trustee. The court found that the creditor was not able to pierce the veil of the trust, despite the following facts: (1) the debtor was indicted for fraud, (2) the debtor filed for bankruptcy to obtain relief from his creditors, (3) the bankruptcy court sought to have the debtor declared the alter ego of the trust and to have the trust assets treated as part of debtor’s bankruptcy estate, (4) the debtor’s family received and retained rent proceeds from trust, (5) the debtor and his family lived on property owned by the trust without paying rent to the trust; (6) the debtor granted easements on property owned by the trust, (7) the debtor and his wife deducted from their personal tax returns real estate taxes and interest expenses relating to the trust, (8) the debtor granted mortgages on property owned by the trust, (9) the debtor pledged the trust property in order to obtain bail in his criminal case; and (10) the debtor represented to several banks that his revocable trust owned the property which was actually owned by the irrevocable trust. Although the debtor probably pushed the limits of dominion and control over the trust in this case, this case illustrates the fact that a court will generally uphold an irrevocable trust as a separate and distinct legal entity unless the debtor exerts so much dominion over the trust that it has no separate identity.

Similarly, in Miller v. Kresser,[9] a mother created a trust for her son and named another son as the trustee. The beneficiary son was sued for over $1,000,000. The trial court found that the beneficiary son exerted significant control over the trust by taking money out without the trustee’s knowledge, dominating investment decisions, and keeping possession of the trust checkbook. The Florida 4th District Court of Appeals upheld the creditor protection provided by the trust even though “the facts in this case are perhaps the most egregious example of a trustee abdicating his responsibilities . . . the law requires that the focus must be on the terms of the trust . . . and the trust did not give the beneficiary any authority whatsoever to manage or distribute trust property.”

We think these cases demonstrate the fact that a court will generally uphold the separate existence of a trust, just as they generally uphold the separate existence of a corporation, unless the facts are so egregious as to indicate a total disregard of the legal entity so that it becomes the alter-ego of the debtor.

The solution to avoiding these attacks is really quite simple: (1) the trustee should demonstrate control over the trust and abide by the terms of the trust instrument, (2) the presence of an independent trustee is not required, but it goes a long way to show that the trust is a separate legal entity from the grantor or the beneficiaries, (3) the grantor and beneficiaries should not exert so much control or dominion so that they appear to be the owners of the trust assets, (4) the benefits of the trust should be reserved for the beneficiaries, and (5) transactions with the trust should be on the same terms as would be expected between unrelated parties.

Another way to defend against the veil piercing type of attack is to locate the trust in a state with greater asset protection laws. Currently, the best states are Nevada, Alaska, and South Dakota. A person in any state can create a trust in one of these locations by appointing a trustee in the state where they want the trust to be located. Consider the language of these Nevada Statutes which are designed to protect against a veil piercing attack:

NRS 163.4177 Factors which must not be considered exercising improper dominion or control over trust. If a party asserts that a beneficiary or settlor is exercising improper dominion or control over a trust, the following factors, alone or in combination, must not be considered exercising improper dominion or control over a trust:

  1. A beneficiary is serving as a trustee.
  2. The settlor or beneficiary holds unrestricted power to remove or replace a trustee.
  3. The settlor or beneficiary is a trust administrator, general partner of a partnership, manager of a limited-liability company, officer of a corporation or any other manager of any other type of entity and all or part of the trust property consists of an interest in the entity.
  4. The trustee is a person related by blood, adoption or marriage to the settlor or beneficiary.
  5. The trustee is the settlor or beneficiary’s agent, accountant, attorney, financial adviser or friend.
  6. The trustee is a business associate of the settlor or beneficiary.

NRS 163.418 Clear and convincing evidence required to find settlor to be alter ego of trustee of irrevocable trust; certain factors insufficient for finding that settlor controls or is alter ego of trustee of irrevocable trust. Absent clear and convincing evidence, a settlor of an irrevocable trust shall not be deemed to be the alter ego of a trustee of an irrevocable trust. If a party asserts that a settlor of an irrevocable trust is the alter ego of a trustee of the trust, the following factors, alone or in combination, are not sufficient evidence for a court to find that the settlor controls or is the alter ego of a trustee:

  1. The settlor has signed checks, made disbursements or executed other documents related to the trust as the trustee and the settlor is not a trustee, if the settlor has done so in isolated incidents.
  2. The settlor has made requests for distributions on behalf of a beneficiary.
  3. The settlor has made requests for the trustee to hold, purchase or sell any trust property.
  4. The settlor has engaged in any one of the activities, alone or in combination, listed in NRS 163.4177.

Conclusion

In our experience, most properly designed asset protection trusts are never discovered in the first place. If you are sued or subject to some kind of unexpected liability, the creditor will ask for your personal financial statements. Because you have no ownership in the trust or its assets, they should not be included on your personal financial statements. If your trust is funded more than two years before you file bankruptcy, the trust is usually not discovered through a typical bankruptcy proceeding.

Although an asset protection trust is not discovered in the majority of cases, one should never rely solely on secrecy to defend against every attack. A sophisticated creditor can always get you under oath and ask enough of the right questions to discover the trust. If that happens to you, you should always answer honestly and with confidence that your trust was established for appropriate purposes and that it will hold up on its own merits. The best asset protection trust has the following characteristics: (1) it is funded in advance of a problem, (2) it is created for legitimate estate planning purposes, (3) it is an irrevocable trust that does not include the grantor as a beneficiary, (4) it includes an independent professional trustee in the State of Nevada (although it is possible to use a family member or friend in your home state as long as the parties respect the trust as a separate legal entity), and (5) it includes a special power of appointment which provides flexibility to the trust despite the fact that the trust is irrevocable.

[1] 566 SE 2d 455 (Ga.Ct. Appeals 2002).

[2] Case No. BK02-43392 (Bankr.Neb. 3/13/2007) (Bankr.Neb., 2007).

[3] See In re Portnoy, 201 B.R. 698, and In re Brooks, 217 B.R. 98.

[4] In re Portnoy at 700.

[5] 624 F. Supp. 2d 970 (N.D. Illinois 2009).

[6] See US Bankruptcy Code Section 541(b)(1), California Probate Code Section 681, Delaware Code Section 3536, In Estate of German, 7 Cl. Ct. 641 (1985) (85-1 USTC Par 13,610 (CCH), In re Hicks, 22 B.R. 243 (Bankr. N.D.Ga.1982), In re Knight, 164 B.R. 372 (Bankr.S.D.Fla.1994), RESTATEMENT OF THE LAW (SECOND) PROPERTY, Section 13.6.

[7] 987 F. Supp. 1160 (December 4, 1997).

[8] 332 f. 3D 85 (Ct. Appeals 2nd Cir. 2003).

[9] 2010 Fla. App Lexis 6152.

Asset Protection – Stories from the Trenches

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We talk a lot of theory about asset protection, and everyone seems to have their own opinion about what works and what doesn’t.  These are some real-life experiences that have shaped my perspective:

1.  I worked for a law firm that set up a lot of family partnerships.  One client put a substantial amount of assets in his family partnership and made annual gifts to his children.  One child had financial problems and went bankrupt.  Because the child’s interest in the family partnership was included on her tax returns and among her assets, she had to include it as an asset on her bankruptcy questionnaire.  The bankruptcy trustee demanded an accounting from the partnership and a liquidation of the partnership interest for the benefit of the child’s creditors.  We insisted that the bankruptcy trustee was limited to a charging order, and the court agreed.  The bankruptcy trustee continued to monitor the dealings of the partnership and question the actions of the general partners to ensure that they were fulfilling their fiduciary duties to the partners and not simply using the partnership for their own benefit.  The client eventually negotiated a settlement and agreed to buy the child’s interest from the bankrutpcy trustee for a fourth of its real value.  Even though the client was able to buy the child’s share for pennies on the dollar, the client said, “I lost tens of thousands of dollars to my child’s bankruptcy, and you call that asset protection!”

2.  My friend from law school works for a law firm that is well known for promoting Cook Island Trusts.  He tells how one client formed a Cook Islands Trust and transferred millions of dollars to the trust.  Later, the client went bankrupt and failed to include the trust assets on his bankruptcy questionnaire.  The Bankruptcy Court reviewed the client’s tax returns and easily discovered the offshore trust. The Bankruptcy Court said this was bankruptcy fraud & ordered the client to turn over the assets of the trust.  The client claimed that he had no power to turn over the trust assets.  The Court did not believe the client and said that if the client disobeyed its order, the Court would send the client to jail for contempt of court and impose a fine of $10,000 per day until the money was turned over.  The client found a way to retrieve the money and threatened to sue the law firm for malpractice.  The lawyers were also accused of conspiracy to commit fraud.

3.  My client put $4,000,000 in a special power of appointment trust (“541 Trust®”) in 2004. In 2007, he entered into a business deal with a wealthy investor.  The client and the investor agreed to share the risks and the profits.  The deal went bad and they both lost all of the money that they had invested.  The investor sued my client for millions of dollars.  My client went to the pretrial conference and explained that he had no assets, and that if he lost the case, he would simply go bankrupt. The investor hired a private investigator who did an asset search and a review of his tax returns and found nothing. The case was dropped without going to trial and the assets continue under the protection of the 541 Trust®.  My client feels that he acted honestly because he funded the trust well in advance of the deal, the investor went into the deal with an accurate understanding of the risks involved, and my client had every right to set aside assets for the security of his family before entering into that deal.

4.  Another client set up a 541 Trust® in 2003. He was recently sued and he had to give an asset statement under penalties of perjury. He also had to give tax returns for the past 3 years and sign an affidavit that he had not made any transfers in the past 3 years.  The client answered everything honestly and the 541 Trust® and its assets were never discovered.

In the two cases described above, an offshore trust would have been easily discovered in a review of the client’s tax returns.  The offshore trust still may have worked, but it would have been frightening to explain and defend the offshore trust to the judge.

In my experience, the safest course is to do asset protection planning well in advance of a problem, do it in way that avoids any discovery, do it in a way that avoids tax problems or issues of any kind, do it in a way that can be easily amended, and do it in a way that is acceptable and defendable even if it is discovered.  That is why I think the 541 Trust® is the best asset protection solution.

Squeeze, Freeze and Burn

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RUNNING THE NUMBERS

ON A SALE TO A DEFECTIVE GRANTOR TRUST

by Lee S. McCullough, III

 

 

A sale to a defective grantor trust is often the best tool available for reducing or eliminating estate taxes in a large estate.  The federal estate tax is in a state of flux and uncertainty, but the assumptions included below reflect my best guess as to what the law will be.  For purposes of this article, I have assumed an exemption of $3,500,000, an estate tax rate of 45%, and an interest rate of 3%.  I have omitted any gifting for simplification purposes.

 

Consider the following example:

 

Background Information

 

John owns a business worth $15,000,000 and it produces $1,000,000 per year in income to John.  He and his wife also own cash, real estate and personal assets worth $5,000,000 and a term life insurance worth $3,000,000.

 

 

Assets Included in Taxable Estate

Business                          $15,000,000

Cash & Real Estate         $  5,000,000

Life Insurance                 $  3,000,000

Total Taxable Estate       $23,000,000

Estimated Tax                 $ 7,200,000

 

  

Assets Outside of Taxable Estate

$0

 

Step 1: John uses accepted discounting methods and sells his business and life insurance to one or more defective grantor trusts for his wife and children, in exchange for a promissory note equal to $9,000,000.  Because it is a sale from a grantor to a defective grantor trust, the sale is does not trigger income taxes or capital gains.

 

 

Assets Included in Taxable Estate

Note Receivable             $   9,000,000

Cash & Real Estate        $  5,000,000

Total Taxable Estate       $14,000,000

Estimated Tax                $  3,150,000

 

  

Assets Outside of Taxable Estate

Note Payable                   $   9,000,000

Business                           $ 15,000,000

Life Insurance                   $   3,000,000

 

At the conclusion of Step 1, John has already reduced his taxable estate by $9,000,000!

 

Step 2: Each year, the business will pay the dividends of $1,000,000 to the trust.  The trust will then pay the $1,000,000 to John as a payment on the note.  The payment is part principal and part interest.  Because it is a payment from a defective grantor trust to a grantor, the interest is not taxable to John.  Because the trust is a defective grantor trust, John is personally liable for the income taxes earned by the business even though it is owned by the trust.  John pays income taxes of $400,000 and he spends the rest of his income.  The note will be paid off in less than 11 years.  If the assets appreciate by 50% during that time, the numbers will look like this:

 

 

Assets Included in Taxable Estate

 

Cash & Real Estate         $  7,500,000

Total Taxable Estate       $  7,500,000

Estimated Tax                 $     255,000

 

  

Assets Outside of Taxable Estate

 

Business                           $22,500,000

Life Insurance                  $   3,000,000

 

Step 3: Because the trust is a defective grantor trust, John is personally responsible for the income taxes.  If he pays the income taxes from his own money, and allows the money in the trust to grow without income taxes, this is the equivalent of a tax-free gift to the trust each year.  John’s estate will be reduced by $400,000 per year as long as he chooses to pay the income taxes for the trust.  Within two years, his estate will be reduced to an amount that is below his exemption and he will have reduced his estate tax obligation to zero.

 

 

Assets Included in Taxable Estate

 

Cash & Real Estate         $  6,700,000

Total Taxable Estate       $  6,700,000

Estimated Tax                 $                0

 

  

Assets Outside of Taxable Estate

 

Business                           $22,500,000

Life Insurance                  $   3,000,000

 

The total tax savings can be summarized as follows:

 

Value of estate with no sale to defective grantor trust:                                 $32,200,000

Estimated estate tax with no sale to defective grantor trust:                         $11,340,000

Estimated estate tax savings from sale to defective grantor trust:                 $11,340,000

 

The total tax savings can be broken down into three categories:

 

Savings from valuation discounts:                                                                         $  2,700,000

Savings from freezing estate against future appreciation:                              $  4,725,000

Savings from using income taxes & spending to reduce the estate:               $  3,915,000

 

Now consider the same analysis with a larger estate:

 

Background Information

 

Allison owns a business worth $50,000,000 and it produces $8,000,000 per year in income.  Allison is single.  Her living expenses are $1,000,000 per year and her income taxes are $3,000,000 per year.  She owns cash, real estate and personal assets worth $15,000,000.

 

 

Assets Included in Taxable Estate

Business                          $50,000,000

Cash & Real Estate         $15,000,000

Total Taxable Estate       $65,000,000

Estimated Tax                 $27,675,000

 

  

Assets Outside of Taxable Estate

$0

 

Step 1: Allison uses accepted discounting methods and sells her business to defective grantor trusts for her children, in exchange for a promissory note equal to $30,000,000.  Because it is a sale from a grantor to a defective grantor trust, the sale does not trigger income taxes or capital gains.

 

 

Assets Included in Taxable Estate

Note Receivable             $  30,000,000

Cash & Real Estate         $ 15,000,000

Total Taxable Estate       $ 45,000,000

Estimated Tax                 $ 18,675,000

 

  

Assets Outside of Taxable Estate

Note Payable                    $ 30,000,000

Business                           $ 50,000,000

 

 

At the conclusion of Step 1, Allison has already reduced her taxable estate by $20,000,000 and her estimated tax by $9,000,000!

 

Step 2: Each year, the business will pay dividends of $4,000,000 to the trust.  The trust will then pay the $4,000,000 to Allison as a payment on the note.  The payment is part principal and part interest.  Because it is a payment from a defective grantor trust to a grantor, the interest is not taxable to Allison.  Because the trust is a defective grantor trust, Allison is personally liable for the income taxes earned by the business even though it is owned by the trust.  Allison pays income taxes of $3,000,000 and she spends the rest of her income.  The note will be paid off in less than 10 years.  If the assets appreciate by 50% during that time, the numbers will look like this:

 

 

Assets Included in Taxable Estate

 

Cash & Real Estate         $ 22,500,000

Total Taxable Estate       $ 22,500,000

Estimated Tax                 $   8,550,000

 

  

Assets Outside of Taxable Estate

 

Business                           $75,000,000

 

 

 

Step 3: Because the trust is a defective grantor trust, Allison is personally responsible for the income taxes.  If she pays the income taxes from her own money, her estate will be reduced by $3,000,000 per year and the income that is accumulating in the trust will increase by $3,000,000 per year.  She will have reduced her taxable estate to the exemption amount and her estate tax obligation will have been reduced to zero.

 

 

Assets Included in Taxable Estate

 

Cash & Real Estate         $ 3,500,000

Total Taxable Estate       $ 3,500,000

Estimated Tax                 $               0

 

  

Assets Outside of Taxable Estate

 

Business                           $96,000,000

 

 

 

The total tax savings can be summarized as follows:

 

Value of estate with no sale to defective grantor trust:                                 $99,500,000

Estimated estate tax with no sale to defective grantor trust:                   $43,200,000

Estimated estate tax savings from sale to defective grantor trust:           $43,200,000

 

The total tax savings can be broken down into three categories:

 

Savings from valuation discounts:                                                                   $  9,000,000

Savings from freezing estate against future appreciation:                        $ 11,250,000

Savings from using income taxes & spending to reduce estate:              $ 22,950,000

 

 

Richard Oshins, a well known estate tax attorney from Nevada, has called these three benefits the squeeze, freeze and burn.  The valuation discount is called the “squeeze.  The sale to the defective grantor trust is called the “freeze”.  Using income taxes and spending to reduce the taxable estate and let the non-taxable asset grow tax free is called the “burn.”  By effectively implementing a squeeze, freeze and burn strategy, you can substantially reduce or completely eliminate the federal estate tax on almost any estate.

IRREVOCABLE TRUSTS

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What is an irrevocable trust? 

As you may guess, it is a trust that cannot be “revoked” or drastically changed. When you give property and assets to a revocable trust to manage and distribute according to rules you helped create, you keep the power to change, remove, sell, and use property and assets in the same way you do now. With an irrevocable trust, you lose the option to ‘take-back’ the assets.

Inflexibility with an irrevocable trust is not a commonly sought-out quality in an irrevocable trust. The most influential reasons for using an irrevocable trust in your estate plan arise when property in a trust is considered “yours” or “not yours.” There are some important times where an irrevocable trust can make sure that money is not considered “yours.”

Asset Protection

Asset protection is an important goal for many prospective clients. Asset protection helps provide peace of mind in knowing that potential future events (like divorce, business troubles, or lawsuits) won’t risk financial security. Using an irrevocable trust helps keep the property you put in trust from being treated as “yours” if one of these events occurs and creditors try to reach the property you intend to protect.

Estate and Gift Tax

It’s important to note that, for many people, gift tax won’t be an issue and the estate tax will affect even fewer. They’re still worth considering, though. A brief explanation: the current estate tax paid out of your estate after death has an exemption of $11,580,000 for a couple in 2020, meaning that very few people will have to actually pay any taxes on money exceeding the exemption amount. Gift tax returns, by contrast, are filed annually when you give large gifts. They add up over your lifetime to reduce that $11.5 million exemption upon death. In 2020, a gift tax return has to be filed if one person gives one other person more than $15,000 in a single year (spouses can gift twice that, and couples can receive twice that). 

Gift Tax: Money in an irrevocable trust can create gift tax liability, so irrevocable trusts can be a useful tool to avoid gift taxes. While trusts have their own tax and accounting responsibilities, putting property in an irrevocable trust is part of making sure that the IRS does not require you to file a gift tax return.

Estate Tax: If your estate is large enough to run up against the $11,580,000 exemption, making your trust irrevocable is part of keeping the IRS from considering that property as part of your taxable estate at death.

Conclusion

While a revocable trust provides flexibility, there are protections it cannot provide that ARE available in a properly drafted irrevocable trust. Irrevocable trusts can protect property from creditors, estate and gift tax, and [income tax?]. McCullough is experienced in drafting various specialized irrevocable trusts to provide for each client’s needs. 

Advantages of a Life Cycle Buy Sell Agreement

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The Life Cycle Buy Sell Agreement

The Life Cycle Buy Sell is a relatively new method for structuring a Buy Sell Agreement. Under traditional methods, owners must choose between company owned life insurance or cross-owned life insurance. Both of these methods have their advantages and disadvantages. The Life Cycle Buy Sell attempts to provide the advantages of both of these methods.

Description Company Owned

Life Insurance

 Cross-Owned Life Insurance Life Cycle Buy Sell
Step-Up in Tax Basis for Surviving Owners No Yes Yes
Only One Policy Needed Per Owner Yes No Yes
Custom Allocation of Costs and Benefits No No Yes
Tax-Free Access to One’s Own Cash Values* No No Yes
Cash Values Protected from Company Creditors No Yes Yes
Cash Values Protected from Individual Creditors Yes No Yes
Retiring Owners Can Take Policy Without Triggering Transfer-For-Value Tax No No Yes
Avoid C-Corp. AMT Taxes on Death Benefit No Yes Yes

* Distributions are Tax-Free to Extent of Premiums Paid, then Tax-Free Policy Loans

– This page presents summary information and should not be taken as legal advice for any particular situation.  Clients should seek legal counsel pertaining to their individual situation.

 

by Lee S. McCullough, III

Not all Trusts are Created Equal

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NOT ALL TRUSTS ARE CREATED EQUAL
by Lee S. McCullough, III

Why pay for a specialized estate plan when you could get one for less from an internet service or a general practice attorney?  If I pay for a first class estate plan, what added value do I receive?

1.    Good advice based on your specific circumstances.  That sounds simple, but good advice can save you more money, time and hassles than any document or financial product.

2.    Asset protection.  Most trusts provide zero asset protection.  If you never get sued or go bankrupt, this doesn’t matter to you.  If you do get sued or go bankrupt, a good estate plan may be the best investment you ever make.

3.    Estate tax savings.  In many cases, a good estate planning attorney can help you completely avoid estate taxes.  A really good trust can do a better job of avoiding estate taxes than a cheaper trust.

4.    Fairness.  Most trusts include one of two basic distribution plans: a common trust, or separate trusts. Both of these can produce an unfair division among your children.  For example, in a typical common trust, all assets are held in a common pool until the youngest child reaches the age of 21.  The problem with this is that the oldest children have their education paid for from the common fund while the youngest must pay for his education from his own share of the inheritance.  Separate trusts also create inequalities if one child must use his separate share to pay for his upbringing, while the oldest children get their share after all those expenses are paid.  A well designed trust will include a hybrid of these two options that gives you the best of both options.

5.    Maintaining Harmony in the Family.  Avoiding fights, hard feelings, or litigation within your own family may be the most important benefit of a good estate plan.  A good attorney can do a lot to help you to minimize the risk of family fights over your estate plan.

6.    Asset Protection for Heirs.  A good trust can protect the inheritance you leave for your spouse or children from lawsuits, bankruptcy or divorce.  Most trusts do not address these issues and do not provide this kind of protection.

7.    Quality is in the Details.  A good attorney will tailor a trust to your wants and needs and cover many critical details that you would never think of including protecting assets from a second marriage, providing for a change of control in the event of incapacity, providing flexibility through powers of appointment, and many many more.

8.    Service.  Included with the cost of your estate plan, I provide unlimited service in helping you title all of your assets appropriately.  In addition, I never bill you for brief phone calls or questions about your estate plan in the future.

Ethical and Effective Asset Protection Planning

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By Lee S. McCullough, III

When is it Ethically Appropriate to do Asset Protection Planning?

The law allows business owners to create corporations and other forms of business entities is to separate the personal assets of the owners from the liabilities of the business.  This type of planning is done every day, and most everyone would agree that there is nothing unethical about creating a corporation for this purpose.  Other situations where asset protection planning may be appropriate include the following:

  1. You want to separate the assets and liabilities of one business or property from the assets and liabilities of other businesses or properties.
  2. You come into some money and you want to set aside a rainy day fund to provide financial security for you and your family.
  3. Your are contemplating a new marriage or business partnership and you want to keep certain assets separate and protected from the new venture.
  4. You are asked to sign a personal guarantee, or take on joint and several liability with partners, and you want to limit the amount of assets you put at risk.
  5. You are willing to pledge sufficient assets to provide security for a new loan, but you don’t want to jeopardize more assets than are required by a lender.
  6. You want to discourage frivolous lawsuits, time consuming litigation, and expensive settlement payments by removing the incentive that comes with having “deep pockets.”

 

On the other hand, there are many situations where asset protection planning could be considered unethical or illegal.  Asset protection planning may be inappropriate in the following situations:

  1. Your business is going downhill and you desire to abscond with the remaining funds, default on your creditors, and file for bankruptcy.
  2. You want to give all your assets to your children, qualify for government assistance, and live off the government for the rest of your life.
  3. You have a desire to avoid your obligations, protect what you have, and shift your losses to your partners, lenders or others.
  4. You feel it is your constitutional right to refuse to pay taxes and to hide your income and assets from the government.
  5. You are contemplating divorce and you want to place some of the marital assets beyond the reach of your spouse.
  6. You have run a successful ponzi scheme and you can see that your time is running out.

 

It is interesting to note that when asset protection planning is done in an ethical and legal manner, it is generally very effective.  Also, when asset protection planning is done in an unethical or illegal manner, judges often find ways to ensure that the planning is not effective in protecting assets.  Consider the following recent cases that demonstrate these principals:

 

Lakeside Lumber Products, Inc v. Renee Evans, Dan R. Evans, et al., 2005 UT App 87 (Utah App. 02/25/2005).

In 1989, Dan and Renee Evans created a trust agreement that included a separate trust for Renee Evans and conveyed their home to this trust.  The trust agreement specifically provided that any property in that separate trust was the exclusive property of Renee Evans and that Dan

R. Evans waived all interests therein.

In 1996, Dan Evans personally guaranteed the debts of his company, E.S. Systems. In 1998, E.S. Systems filed for bankruptcy and a creditor, Lakeside Lumber Products, obtained a judgement against Dan Evans.  In 1999, Dan Evans filed for bankruptcy.

Lakeside Lumber Products filed a complaint against Dan and Renee Evans seeking to obtain an interest in the couple’s home.  The district court granted summary judgement to the Evans concluding that the transfer to the trust was not a fraudulent transfer and that there was no wrongful conduct on the part of the Evans in creating and funding the trust.  The appellate court affirmed this decision.

The creditors of Dan Evans were not able to reach the home titled in his wife’s trust for the following reasons:

  1. The transfer to the trust was done long before the debt was incurred, and long before a default or bankruptcy was anticipated.
  2. The transfer to the trust was motivated by appropriate reasons, including traditional estate planning motivations.
  3. A couple has a right to divide properties between themselves and to separate the assets of one spouse from the potential future liabilities of the other spouse.
  4. Renee Evans has a right to own property independent of her husband or any other person.
  5. The creditor had the opportunity to obtain appropriate security when it entered into business dealings with E.S. Systems and Dan R. Evans.
  6. Dan Evans did not hide assets, conceal information, or fail to use his personal assets to meet his obligations.

 

Because the court concluded that the Evans actions did not constitute “wrongful conduct,” the court upheld the asset protection planning done by Dan and Renee Evans.

 

In re Lawrence (S.D. Fla. December 12, 2006); In re Lawrence, 279 F.3d 1294 (11th Cir. 2002).

Stephan Jay Lawrence was a highly successful big stakes options trader.  When the stock market crashed in 1987, he found himself with more debt than assets.  He transferred $7,000,000 to an offshore trust two months before an arbitration settled his liabilities at $20,400,000.  A bankruptcy court found that the assets of the trust should be included in his bankruptcy estate.

The court ordered Mr. Lawrence to retrieve the assets from the offshore trust and Mr. Lawrence refused to do so, claiming that he had no control over the trust.  Mr. Lawrence was sentenced to jail for contempt of court on October 5, 1999 and remained in jail for six years because he continued to refuse to turn over the assets.  The court refused to give Mr. Lawrence a discharge in bankruptcy and the court continues to pursue collection from Mr. Lawrence.

Because the court determined that Mr. Lawrence had made a fraudulent transfer, and because the court determined that he “lied through his teeth” about his motivation for the transfer and his ability to retrieve the assets, the court found a way to make life very difficult for Mr. Lawrence.

 

Herring v. Keasler, 150 NC App 598 (01-1000) 06/04/2002.

Mr. Herring owed some money to a bank on a defaulted loan.  In 1996, the bank obtained a judgment in the local court but the bank did not pursue collection activities.  In 1999, Mr. Herring and some other unrelated parties formed several limited liability companies (LLCs) for the purpose of investing in real estate.  Mr. Herring transferred property to the LLCs in exchange for an interest in the LLCs.

In 2000, the bank assigned its claim to Mr. Keasler who attempted to collect on the judgement against Mr. Herring by foreclosing on his membership interests, selling them, and having the proceeds applied towards the satisfaction of the judgment.  The trial court denied the plaintiff’s request for the seizure or sale of Mr. Herring’s membership interests in the LLCs, but it granted the plaintiff’s motion for a charging order. The charging order provided that the LLCs must deliver to the plaintiff any distributions that Mr. Herring would be entitled to receive on account of his membership interests in the LLCs; but the plaintiff would not obtain any rights in the LLCs.

The attorney for the plaintiff had this to say, “The real problem with this decision is that it enables defendants to hide their assets from judgment creditors basically forever…. The decision takes assets that are potentially subject to execution and turns them into something you cannot get to. If you’re a member and manager of an LLC, you never have to give yourself a distribution or you don’t have to do it until the judgment runs out. [The defendant] owns at least seven or eight LLCs that were formed years after the judgment with his assets and I can’t get to them. If they were shares in a corporation, we could sell them.”

Presumably, the plaintiff was unable to get to the assets in the LLC for the following reasons:

  1. Mr. Herring received interests in the LLCs that were proportionate to the assets that he transferred.
  2. It appeared that Mr. Herring had good business reasons for making the transfers, in addition to protecting the assets from a creditor.
  3. The LLCs had other unrelated partners.  If Mr. Herring had owned 100% of the LLCs, the creditor may have been able to liquidate the LLCs.
  4. The LLCs were filed in a state whose laws did not allow foreclosure of an LLC interest.
  5. The operating agreements of the LLC must have included proper limitations and wording in order to keep the creditor from liquidating the interests in the LLC.

 

 

SEC v. Bilzerian, 131 F. Supp. 2d 10 (D.C. 2001).

In 1989, Paul Bilzerian was convicted of securities violations and sentenced to four years in prison. He filed for bankruptcy but it was determined that he owed $130,650,328 in a non-dischargeable debt.  Sometime between 1994 and 1999, Mr. Bilzerian transferred substantial assets to a complex structure involving partnerships and offshore trusts.  The court found that the transfer was made to purposefully insulate his assets from the reach of his creditors and ordered Mr. Bilzerian to turn over the assets that had been transferred.  When he refused to turn over the assets, the court sent him to jail until he complied.  After spending over a year in jail, he settled his claims with the government by paying over a substantial portion of his assets.

On February 5, 2002, the St. Petersburg Times reported, “After nearly a year in prison ­including some memorable days sharing a cell with a bullet-scarred buy named ‘Queenie’- Paul Bilzerian is back inside his family’s $5.7 million Tampa mansion.  The former corporate raider was freed from a maximum security lockup in Miami on January 16 after his wife, Terri Steffen, agreed to hand over millions of dollars in stock and other property to the federal Securities and Exchange Commission.”  Bilzerian said that his most recent stint in prison was “horrifying,” and “People just don’t understand how awful those places are.”

 

What are the Keys to Ethical and Effective Asset Protection Planning?

In determining whether asset protection planning is ethically appropriate, and whether it will be effective, there seem to be three critical factors that make or break an asset protection plan. The first factor is the timing.  The more time between the date when the plan is put in place and the date when the liability is incurred or the judgement is executed, the better.  The second critical factor is the purposes for the planning.  If your only purpose in doing a transaction is asset protection, it is not nearly as effective as if you have business purposes, estate planning purposes, or other valid purposes in addition to asset protection.  A third factor is proper documentation and operation of the entities involved in the plan.  In other words, if you don’t have the correct documentation and if you don’t operate things correctly, your asset protection plan will look more like a sham than a valid and enforceable business arrangement.

 

Lee S. McCullough, III, operates a private law practice in Provo, Utah, exclusively focusing on estate planning and asset protection. Lee is an adjunct professor, teaching estate planning at the J. Reuben Clark Law School at Brigham Young University.