Asset Protection Strategies Can Have Significant Tax Consequences

Asset protection requires expertise in many different areas of law.  One key area is litigation, since the ultimate test of any asset protection plan is how well it will hold up in court.  Asset protection attorneys must also have expertise in business entities (particularly limited liability companies); trusts; and estate planning (since asset protection planning should generally be integrated with your estate plan). 

Asset protection strategies can also have very significant tax consequences.  For example, moving assets in and out of business entities (or even between individuals) can potentially have both gift and income tax consequences.  Changing an S corporation into an LLC may result in a liquidation of the company for tax purposes.  Holding funds in offshore accounts will likely mean that you will need to file FBAR and FATCA reports.  And those are only a few of the many tax-related considerations that might have to be addressed with an asset protection plan.  So the law firm doing your asset protection planning should have expertise not only in litigation, business law, trusts and estates, but in tax matters as well.

Consider Converting an S Corporation to an LLC

Both corporations and LLCs provide asset protection in that the owner will generally not be responsible for debts of the entity.  But when it comes to protecting an owner’s personal assets from his or her personal creditors, an LLC generally offers better protection than a corporation.  A creditor who controls the stock of a corporation essentially controls the whole corporation.  A creditor attempting to gain control of an owner’s LLC interest has a much more difficult task. The creditor can generally obtain only a charging order against distributions from the LLC.

Given the advantages of an LLC for certain asset protection purposes, a number of our clients have recently been converting S corporations to limited liability companies.  There can be serious tax and other consequences to this kind of conversion so it should only be done with the assistance of a qualified professional. 

The conversion can be a liquidation for federal income tax purposes.  This may not be the case, however, if you elect to have the LLC taxed like an S corporation.  Again, there are a number of very technical tax implications that have to be addressed in connection with any such conversion.  But in a number of situations there will be clear advantages to converting an S Corporation to an LLC to provide better asset protection.  

Trust Protector Can Provide Added Flexibility For An Irrevocable Trust

A recent article in the New York Times by John F. Wasik provides an excellent discussion of trust protectors.  Many states now allow for trust protectors - - someone other than the trustee who essentially provides some checks and balances in a trust arrangement.

A trust protector is a bit like a watchdog.  He or she is not the trustee, but rather someone who keeps an eye on the trust (and the trustee) to be sure it is operating the way it was intended to.

A trust protector also might be able to make certain changes in an irrevocable trust arrangement in response to changes in the law.  Since asset protection statutes, tax laws, and trust laws are changing so rapidly these days, it is advisable to build as much flexibility as possible into an irrevocable trust.

A trust protector may be given the power to replace the trustee under certain circumstances, which obviously provides a very significant check on the power of the trustee. 

The role of a trust protector should be discussed with your asset protection attorney and/or your estate planning attorney whenever you set up an irrevocable trust.

Extent of Protection for Inherited IRAs Remains Uncertain

Clients frequently ask whether a so-called inherited IRA is exempt from their creditors.  An inherited IRA is one you receive from say the death of a parent, rather than one to which you contribute your own funds.  Unlike a traditional IRA, the inherited IRA must begin distributions to the current owner within a year of the original owner’s death.  And the current owner cannot add any more funds to it. 

How well inherited IRAs can be protected will soon be decided by the United States Supreme Court.  The Supreme Court said it would hear an appeal from the United States Court of Appeals for the Seventh Circuit - - which essentially gave creditors the ability to go after money in IRAs that are inherited by people who have not retired yet.

According to my review of the U.S. Supreme Court docket, the case of Clark v. Rameker, (Case No. 13-299) is currently set for argument on Monday, March 24, 2014.  At some point following that argument, the Supreme Court will hopefully provide specific guidance on how funds in inherited IRAs can (or cannot) be protected from creditors.  

Considering an Offshore Trust? Then Consider the Cook Islands

Many foreign jurisdictions provide opportunities for offshore trusts.  But if you are seriously considering such a trust, the Cook Islands deserve your attention.

Asset protection lawyers frequently debate the pros and cons, risks and possible rewards of offshore versus domestic asset protection trusts.  And there are lots of potential asset protection strategies that do not involve a trust at all.

But if you are one of the relatively limited number of people considering an offshore arrangement, you should consider the Cook Islands.  A recent lengthy article in the New York Time by Leslie Wayne provides lots of comments about Cook Islands trusts - - both positive and negative.  As the article points out, the Cook Islands are a global pioneer in offshore asset protection trusts.  Its laws are specifically designed to protect foreigners’ assets from legal claims in their home countries.  Some unscrupulous characters have used these trusts (which can give them a bad reputation); but so have individuals who are simply affluent and feel the need for asset protection. 

One conclusion seems clear.  If you are in that relatively limited category of people who are seriously considering an offshore trust, the Cook Islands is clearly a jurisdiction to consider for that trust.  

Are We Already Forgetting the Impact of the Recent Recession?

How much did the recent recession actually cost?  A fascinating article by Eduardo Porter in yesterday’s New York Times provides some startling information about the cost of the recession.  Three economists at the Federal Reserve Bank of Dallas have estimated that at a bare minimum, the crisis cost nearly $20,000 for each American.  Adding in some broader factors, the price tag could be as much as $120,000 for every man, woman and child in the United States; Mr. Porter notes that the loss was so staggering one would think the government and financial institutions were taking dramatic measures to be sure it never happened again.  Unfortunately, it is not clear that some problems are being adequately addressed. 

I find the situation with personal asset protection planning to be very similar.  When there is a crisis (some unexpected lawsuit, accident or economic problem), there is a sudden focus on asset protection.  If the crisis subsides, asset protection planning seems less urgent.

A catastrophic economic event like the last recession can certainly happen again.  Eduardo Porter’s article is another reminder to take advantage of laws that allow you to protect your assets - - and do so before there is some unexpected crisis. 

Basic Exemption Planning Should Come First

There are many asset protection alternatives.  These include offshore trusts, domestic asset protection trusts (called Ohio Legacy Trusts in Ohio), irrevocable life insurance trusts and limited liability companies.  But relatively simple exemption planning should always be the initial focus.  Exempt assets (those which applicable laws already make it difficult or impossible for creditors to reach) include funds in qualified retirement plans, IRA accounts (in most states) and some part of the equity in your primary residence.  Some states like Florida and Texas have a virtually unlimited homestead exemption.  Most other states exempt a portion of the equity in your residence.  For instance, Ohio recently raised its homestead exemption to $125,000 (which may effectively provide a $250,000 exemption for a married couple).  Maximizing the assets in these exempt categories can be a very cost effective and efficient means of asset protection.

Many individuals - - such as physicians and other professionals, business owners, high net-worth individuals and those at high risk for creditor claims - - will require more sophisticated planning.  But focusing on assets like those in qualified retirement accounts is always an important initial step. 

FBAR and FATCA Provide Separate Reporting Requirements for Offshore Accounts

FBAR and FATCA (which require reports by U.S. persons of interests in foreign accounts) overlap to a large extent.  But they impose separate reporting requirements.  Failure to comply (especially with regard to FBAR) can have very severe consequences. 

FBAR (a foreign bank account report) stems from a banking regulation under the Bank Secrecy Act.  It is specifically designed to inform the U.S. government of funds held by U.S. persons in foreign accounts.  Since the purpose of this report relates at least in part to the fight against terrorism, penalties for failure to file can be very severe. 

FATCA (the Foreign Account Tax Compliance Act) is a tax statute.  Pursuant to this federal law, the IRS requires that Form 8938 (Statement of Specified Foreign Financial Assets) be filed annually to report interests by U.S. persons in foreign accounts.  This reporting requirement clearly overlaps with the FBAR report.  But filing one of them does not excuse filing the other one when required.

Tax preparers are becoming increasingly familiar with these forms.  But if you have offshore accounts, you should confirm with your accountant or tax preparer that you are filing all reports that a U.S. person would be required to file to reflect ownership in those accounts.

Asset Protection Trust Should Have Provision Allowing Trustee to Change Situs

Earlier this year Ohio joined a number of other states that allow creation of a domestic asset protection trust.  In Ohio, it is called an Ohio Legacy Trust.

Ohio law (just like the law of every other state) can change at any time.  We currently anticipate no significant change in the new Ohio domestic asset protection trust statute in the near future.  And even if there was a change in Ohio law, it is possible that existing legacy trusts would be “grandfathered.”

But since there can be no assurance that Ohio law will always remain as favorable as it is right now, we include a provision in our Ohio legacy trust to cover a change in Ohio law or policy.  We provide that the trust can essentially be moved to another jurisdiction if necessary - - where hopefully there would be better protection at that time.  We aim to provide the trustee and/or the trust protector with maximum flexibility to protect trust assets.  

Ohio Legacy Trust Allows Settlors to Retain Many Powers

The Ohio Management Modernization Act, which became effective on March 27, 2013, now allows Ohioans to put assets in a trust (of which they are a beneficiary) and protect those assets from creditors.  This newly permitted trust is called an Ohio Legacy Trust. 

An Ohio Legacy Trust must be irrevocable and the settlor (the person setting up the trust) cannot be the trustee.  So the settlor has to surrender a certain degree of control over the assets placed in such a trust. 

The new Ohio statute, however, allows the settlor to retain various powers.  For example, the settlor can retain the power to veto distributions, remove and replace trustees, and essentially direct trust investments.  In setting up a legacy trust, you have to give up some control - - but certainly not complete control - - over the assets placed in the trust.

Ohio is now one of the most debtor-friendly jurisdictions in the country.  It offers various opportunities to protect your assets.  And you certainly do not have to surrender complete control of assets in order to protect them.