Something that often gets entangled with estate planning is asset protection. Investopedia defines asset protection this way: Asset protection helps insulate assets in a legal manner – without engaging in the illegal practices of concealment (hiding of the assets), contempt, fraudulent transfer (as defined in the 1984 Uniform Fraudulent Transfer Act), tax evasion, or bankruptcy fraud.
Asset protection can be put into place for three different reasons.
To protect the assets from creditors.
To have the assets pass outside of a taxable estate.
To preserve wealth.
One thing that you might want to keep in mind when doing asset protection is that it’s beneficial to all involved to work with an attorney, who will bring legal knowledge to the table while you provide the tax expertise.
Most people have already done some basic forms of asset protection. They have liability insurance, auto insurance, or may have formed a corporation or LLC. Asset protection should not be a substitute for liability and professional insurance, but rather to supplement insurance. It is a myth that asset protection plans invariably scare away plaintiffs.
Additionally, an asset protection plan doesn’t pay legal fees to defend against a lawsuit. Insurance also supplements asset protection planning because it can help a debtor survive a fraudulent transfer claim. If a client gets sued, he or she should let the insurance company pay to defend the claim – and pay to settle it.
Forming a Corporation or LLC
Most businesses will form corporations or LLCs to protect business assets. This is a situation where you need to step in and explain tax planning to the attorney.
I once met a potential client who had spent $20,000 on asset protection right before he met me. The attorney set up five partnership LLCs. He then took the assets from the client’s S corporations and put them into the partnership, setting off a taxable event. Not to mention the client was in the 39.6 percent tax bracket. On top of that, he had to pay self-employment tax. Interestingly enough, the client’s CPA signed off on this entity structuring. The client owned a technology company whose goal was to either be bought out or go public in five years.
I explained to the client that he really wanted to be a C corporation. The highest tax bracket the corporation would pay tax at would be 35 percent. The transfer of assets from the S corporations to the C corporations would be treated as a tax-free Section 301 transfer. If the corporation’s stock was sold after five years, then the sale would be tax-free.
Irrevocable Trusts vs. Revocable Trusts
When it comes to trusts and asset protection, it is important to know the difference between an irrevocable trust and a revocable trust. A revocable trust can, by its terms, be changed or terminated at any time. Due to these terms, the grantor maintains ownership of his assets. Therefore, a creditor could force the owner of a revocable living trust to terminate the trust and surrender the assets.
Once a grantor establishes an irrevocable trust, he or she no longer legally owns the assets he or she used to fund it and can no longer control how those assets are distributed. By creating an irrevocable trust, the grantor surrenders the ability to later modify the trust instrument.
Note that irrevocable trusts are taxable entities. The corpus (what is contributed to the trust) isn’t taxable. However, the corpus is usually invested or grows in value. The income that the corpus earns is taxable to the beneficiaries.
Family Limited Partnerships
Another way to protect assets is to put the asset into a family limited partnership (FLP). A limited partnership is made up of a general partner (usually a shell corporation), who is responsible for the limited partnership, and limited partners, who have no say in the workings of the limited partnership. The taxable effect of the FLP is that the limited partners have passive income or losses.
In a typical situation, the senior family members (i.e., the parents) transfer assets to the FLP in exchange for partnership interests, or units, which under the terms of the partnership agreement carry with them certain rights. This initial capitalization of the partnership is generally a tax-free event. Partnership interests are then gifted or sold by the parents to junior family members (children) or to trusts established for the children’s benefit.
Here are several benefits of an FLP:
1. Shift income from higher bracket. FLPs can be used as income-shifting devices. Older-generation taxpayers can shift income from their higher bracket to lower-bracket children and grandchildren, although much of the unearned income of children under age 19 (or under age 24 if a full-time student) is taxed at the parents’ rate.
2. Avoid corporate double taxation without having to comply with more restrictive S corporation rules. When a business is owned through a partnership, partnership rules may also provide the ability to advantageously terminate an owner’s interest through the structuring of liquidation payments under Code Section 736. The ability to make such payments would not be present if the business was incorporated.
3. Allow for the step-up of basis in partnership assets upon the death of a partner and more flexibility than other entities with regard to distributions and tax allocations. A partnership is allowed to make an election under Section 754 to adjust the inside basis of partnership assets when the transfer of a partnership interest results from the death of a partner. This election allows the successor-in-interest to avoid income tax on his or her share of the appreciation of the partnership asset.
4. Divert appreciation of assets from the estates of older family members. Most partnership interests, particularly noncontrolling limited partnership interests, have a value that is less than the proportionate share of the liquidation value of the underlying business or assets. When transferred, their value is often based on the estimated distributable cash flow and other rights and powers that inure to these interests. This value is often significantly less than the liquidation value of the partners’ prorata share of partnership assets. To the extent this discount is reflected in the transfer tax value of the gift, value can be removed from a senior generation family member’s estate on a tax-advantaged basis.
5. Maintaining some degree of control over assets. A senior generation family member can use an FLP to make gifts while maintaining some control over the underlying assets. However, because of possible application of Section 2036(a)(2) to FLPs (disregarding any discounts associated with FLP ownership interests because of retained interests), conservative planners may want to discourage the taxpayer from retaining a general partnership interest (and thereby having control over distributions and liquidations). Control over investment decisions may be retained by structuring a partnership with co-general partners.
6. Facilitating gifting programs. Gifting FLP interests is a convenient way to take advantage of the federal gift tax annual exclusion, as well as the generation-skipping transfer tax exemption. A married couple may jointly give $28,000 to each donee. A donor may make these transfers outright to family members or transfer into one or more appropriately designed trusts for their benefit. In addition, gifting of certain assets, such as real estate, is more easily facilitated by executing an assignment document to transfer partnership interests, as opposed to changing title to the underlying property.
7. Avoiding local probate. When real estate is involved, the owner’s estate would be required to probate the property in the state where the real estate is located, even if this differs from the state of domicile. If the property is owned through a partnership, the decedent would not own a direct interest in real property, but would own an interest in a partnership, which is intangible personal property and would be probated with other property in the jurisdiction of his or her domicile. This ownership structure will simplify the probate process and minimize related costs.
8. Creditor protection. A limited partner cannot generally reach the assets of the partnership or compel distributions. The opportunities for a creditor of a partner to benefit from his or her partnership interest are far less than where there is direct access to the underlying property. Buy/sell arrangements also can be used to discourage third-party creditors of partners.
9. Maintaining family control. An FLP with appropriate buy/sell provisions can be used to keep control of assets or a business within a family.
A limited partnership, and more specifically an FLP, is not designed to run going concerns. They are simply designed to hold and protect assets. Some assets that are commonly transferred to an FLP would be real estate, patents, trademarks, and other intangible assets. If the family has a family business, they can form an LLC or corporation and pass the wealth to the next generation in another way.
Asset protection boils down to protecting assets from creditors. When engaged with asset protection, you should involve an attorney and give tax advice. Any entity that is formed will have a taxable effect. Our job in asset protection is to have a working knowledge of the different ways to protect assets and to work with those protections to mitigate income tax.
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