Selection of Entities to Hold Assets or Do Business 

Limited Liability Companies, Corporations, Partnerships, Business Trusts, Retirement Plans, and Domestic and Foreign Spendthrift Trusts
 

INTRODUCTION 

The following article discusses typical uses of various business entities to achieve asset protection objectives. It is important to note that a fundamental issue when considering the use of a formal entity to operate a trade or business focuses in part on the degree of asset protection the entity will afford. The most typical used of these types of formal entities are Limited Liability Companies, Limited Partnerships and Corporations (C or S). 

An investor will be reluctant to invest in a trade or business if the creditors of that business can reach directly to the personal net worth of the investor. In addition, entrepreneurs first starting out in business may be reluctant to place their entire savings in jeopardy if the business fails. 

Therefore, the following analysis may reveal essential information about each form of entity you may be considering. Each form of entity provides its own unique form of asset protection as well as operational and tax benefits and obstacles. The ability to render advice to assist in the selection of the best possible entity for one's trade or business is not a simple task. Many professionals disagree on whether or not a C corporation or an S corporation is advisable in a given situation. 

Now with the recent enactment in most states of statutes authorizing the use of the Limited Liability Company or the Limited Liability Partnership, and the overriding concerns of individuals over the litigious nature of our society, generating a greater interest in anonymity, the revival of the common law Business Trust, also known as a Massachusetts Trust or statutory trust foreign trusts, domestic spendthrift trusts and creative uses of qualified retirement trusts, the choices available are far greater and so will be the disagreement among professionals. Another dilemma is the fact that many professionals do not yet understand the benefits or obstacles of these new and old entities that are now in vogue. 

My objective has been to "chart" for each client, the benefits and obstacles available from each entity, in an effort to understand each client's specific concerns and unique objectives. Important questions that must now be asked of clients include whether they want the business entity they operate to gain in value, or whether they would prefer that their own personal net worth, or the net worth of family members, be the primary beneficiary of a profitable trade or business. 

I firmly believe that in most cases the analysis and analytical skills of your attorney and tax advisor are far more important than then perceived technical drafting skills. The selection of an entity should integrate with the client's concerns and objectives for asset protection and preservation planning, marital property planning, estate planning, tax planning and must also take into account the need to operate and maintain a trade or business and deal with the general public, shareholders, investors, banks and employees. 

CORPORATIONS

In California, as in most states, a corporation form of doing business and the corporate veil generally affords a great deal of protection for shareholders, when corporate formalities are observed. As a general rule it is only when it is determined that a corporation is being used to perpetrate a fraud, circumvent a statute or accomplish some other wrongful or inequitable purpose when a court can disregard the corporate entity. 

The limited liability of shareholders also extends to professional law corporations. The leading California case Canal-Randolph Anaheim, Inc. v. Wikoski, 103 Cal. App. 3d 282 (1980) holds that California law corporations are entitled to all rights of regular corporations to protect its shareholders from "piercing of the corporate veil", "alter ego theories" and disregard of the corporate entity". 

A corporation has three categories of principals who make up its organizational structure, shareholders, directors and officers. The most protected principals of the corporate form are the shareholders or investors, who own the corporation. The shareholders elect directors who are responsible for the operations of the corporation. 

Directors have a fiduciary relationship to their shareholders, and therefore have liability to their shareholders for acts of undisclosed self-dealing, gross negligence and intentional wrongful conduct. In addition directors may have liability to the general public for acts of gross negligence and intentional wrongful conduct and in some cases may have liability local, state and federal authorities for failure to pay taxes that are collected by the corporation for payment to these agencies. The directors appoint or elect officers to run the day to day operations of the corporation. 

Officers are agents and employees of the corporation. As employees, their liability to the corporation is generally limited to cases of intentional fraud or theft. They may also incur liability to third parties, including the government, when they participate in fraudulent and wrongful acts, or fail to remit taxes that the corporation collects for payment to government agencies. It is the officers who run the day to day business of the corporation, pursuant to the dictates of the directors. The officers hire employees and transact the corporation's business. 

In California, the same person can be the shareholder, the director and the officer of the corporation, solely or among others. Liability generally cannot be imposed upon these corporation principals unless they have acted contrary to public policy and/or perpetrated some form of gross negligence or fraud. In the case of the savings and loan crisis, the federal government as the primary insurer of failed savings and loans, brought legal actions against directors and officers of failed savings and loans for their gross negligence in failing to protect the public interest and public monies entrusted to them. 

As noted above, shareholders are generally insulated from the actions of the corporation, as they are not involved in the day to day operations of the business. Therefore, unless it can be established that the corporation was not properly operated as a corporation, pursuant to objective established formalities, the shareholders, in that capacity will generally avoid any liabilities created by the corporation, unless they have personally guaranteed the same. 

Notwithstanding the ability of shareholders, directors and officers to avoid personal liability for most of the obligations incurred by the corporation, the corporation and its assets will generally remain vulnerable to its own creditors. Therefore, a significant planning tool that is desirable is one that can protect the assets of a corporation from the claims of creditors. This objective can be achieved by segregating the divisions and operations of the corporation from each other, by use of subsidiaries, or brother-sister entities, so that the corporation itself is a shareholder of other higher risk operating entities. 

A corporation that generally limits its activities to passive investment in other operating entities, is generally referred to as a holding company.

The protections afforded to the corporate form of doing business are generally the best protections afforded to any entity doing business. The various limited liability entities available by law, attempt to emulate the limited liability nature of the corporate form. The fundamental difference between the these various entities has to do with their tax ramifications under the Internal Revenue Code. Since we are working with tax sensitive entities, any form of organizational structure has a "tax" side and tax consequence. 

The corporation is a "taxpayer". This means that the corporation pays federal and in most states, state income taxes on its net profits. Depending upon the type of business that is being operated, the taxes imposed upon a corporation may be less than those imposed upon individuals. When a corporation distributes its earnings and profits in the form of dividends to its shareholders, the shareholders experience a second tax on previously taxed corporation profits, commonly referred to as the "double tax." Other forms of limited liability entities attempt to avoid "double taxation" and caused by taxation at the entity level, and instead pass the tax liability through to the shareholders, owners, partners or investors. These are called "pass-through" tax entities. 

Even though a traditional corporation form of organization has the potential to cause "double taxation", there a good number of organizational and tax benefits to the traditional corporate form that need to be evaluated before it is rejected in favor of a "pass-through" entity. For example the traditional corporate form is generally a simpler entity to administer. This may mean less complications and reduced legal fees in connection with organizational matters, such as the additional of new shareholders and entering into traditional and creative financing arrangements, both bank and private. The corporation is the best form of entity when a start-up business needs to retain working capital generated from initial profits because the first $100,000 of annual corporate income is taxable at federal tax rates that may be less than the federal tax rates that would be imposed upon the shareholders. (Pass through pass the taxable income to the owners, whereby the taxes will be at the owners income tax rates.) Under very favorable rules, Corporations can accumulate operating losses and either carry them backwards or forwards, to achieve a beneficial tax result. In addition, the benefits of pass-through status can in many cases be emulated by the establishment of a factual basis and legal authority to declare higher salaries and bonuses for key shareholder-employees when corporate earnings increase. The corporate form also offers a better form of qualified retirement plan for shareholder-employees, and more alternatives when offering employee stock plans. Most importantly, the corporate form may be the best form if the entity has plans on "going public" through an initial public offering, or "IPO". Qualified legal counsel should be able to help their clients prioritized both the long term and short term business objectives that must be evaluated with respect to each of the forms of entities that are available. 

As noted above, if a corporation can meet the narrow prerequisites of an S corporation, the shareholders of the corporation can elect S status and convert the traditional corporation into a "pass-through" entity, that will pass some of corporation's taxable income directly to the shareholders, avoiding tax at the corporation level. However, the Internal Revenue Code imposes other forms of restrictions and obstacles to achieve "pass-through" tax status. As a result, when evaluating whether other forms of doing business may be beneficial, you have to evaluate the impact of the restrictions and obstacles on the overall business and the impact of these restrictions and obstacles on the ability of the business to succeed and be profitable. One of these restrictions and obstacles has affected the viability of the limited partnership. The Internal Revenue Code requires that in order for a limited partnership to be taxable as a "pass-through" entity, its general partner must have "unlimited" liability to creditors of the limited partnership. 

Tax planners have been attempting to circumvent the restrictions and obstacles by forming limited partnerships that are operated by corporation general partners. Limited Liability Companies have been granted a reprieve from this "unlimited" liability requirement and other restrictions and obstacles, and are therefore becoming more popular than limited partnerships. 

It has to be noted that creditors of a shareholder, investor or partner, are generally always able to reach the shares owned by that shareholder, investor and partner. As a result, these third party creditors may have the ability to assert the rights and privileges associated with those corporation shares as against the corporation. Depending upon the state of incorporation and the number of shares levied upon, these rights could include a forced liquidation or sale of the business of the corporation. As a result, there are a variety of specialized agreements, that include shareholder buy-sell agreements, share vesting agreements, phantom stock plans, retirement plans, stock option agreements, employment agreements, etc. that modify the rights and privileges of a shareholder, by contract or by creating different classes of shares, which can mitigate these risks caused by levy upon the shares of a shareholder. 

Therefore, when a corporation is considering issuing shares to an employee, it must also take into account the risk that the employee could lose his or her shares in a divorce, to a creditor, or to an unwelcomed heir in the event of a death. 

LIMITED PARTNERSHIPS, LIMITED LIABILITY COMPANIES and S CORPORATIONS

The California Corporations Code specifically and explicitly states that the limited partners of Limited Partnerships and members of Limited Liability Companies are not subject to the claims of creditors of the Limited Partnership or Limited Liability Company. Limited Partnerships are a statutory form of doing business, that has been authorized in all states, that allows the use of a "pass-through" tax entity, such as a partnership, to operate, without creating liability among limited partners, for claims made against the entity. The tax benefits of a "pass-through" entity which can avoid the code and regulatory restrictions inherent in a corporation form, is the greatest incentive for using a Limited Partnership. 

The Limited Partnership generally has only two principals essential to its organization. A general partner, who as mentioned above, is required by the Internal Revenue Code to have "unlimited liability", and a limited partner, who is entitled to the same protections as a shareholder of a corporation, provided that the limited partner is not involved in the day to day operations of the partnership, or any prohibited management function. 

In addition, the Limited Partnership form of doing business will generally vest most, if not all, of management authority in the General Partner. As a result, if a limited partner loses his partnership interest in a divorce, to a creditor, or to an unwelcomed heir in the event of a death, the rights of that third party vis-a-vis the Limited Partnership can be limited. Some states do authorize "charging orders" against a partnership, which can require the General Partner to remit to the holder of a limited partner's interest financial benefits accrued from the limited partner interest. Therefore, if this is a concern, the need to evaluate the state of formation and/or the use of a Limited Partnership vehicle should be reassessed. 

As noted above, the most significant objections to the Limited Partnership form, is that someone has to act as the General Partner, and that person or entity has by law, unlimited liability to the claimants and creditors of the Limited Partnership. In addition, limited partners are by statute prohibited from participating in the management of the Limited Partnership. 

As noted above, planners have been attempting to use a corporate general partner, however, under the Internal Revenue Code, in order for the corporate general partner to demonstrate the characteristic of "unlimited liability", the corporation general partner must be able to show a significant financial net worth in excess of the general partner's interest in the Limited Partnership. 

Limited Liability Companies (or LLCs) have now been approved in most states. These entities by statute are intended to provide the same form of protection to their members, as the corporation is intended to provide to its shareholders, however they can operate similar to a general partnership. LLCs are in many cases replacing the Limited Partnership and S Corporations. 

The LLC only requires the use of one type of principal in its organizational structure, more than one member/partner. There is no restriction on the managerial activities of the member/partner, as in the case of limited partners and shareholders. In comparison to the Limited Partnership, the LLC is similarly taxable, and in fact utilizes an operating agreement that is very similar in many ways to a limited partnership agreement. However, the LLC is designed to protect the limited liability status of its member/partners, regardless of the nature and scope of participation in the management of the entity. Any one or more of the owners, called members, can transact business more like "general partners", however none of them are required to have personal liability for the legal and authorized acts of the LLC. The Internal Revenue Code still imposes some restrictions on the organizational structure of the LLC, as a condition to its "pass-through" status, which may make it undesirable. However, the LLC eliminates most of the overriding concerns faced by the Limited Partnership and its need to have a general partner with unlimited liability exposure. 

The S Corporation, as discussed above, is a regular corporation, but by reason of provisions in the Internal Revenue Code, and applicable state tax laws, can be taxed as a "pass-through" entity on income earned from normal operations. When compared to the LLC, the S Corporation has numerous obstacles that may restrict its usability. The S Corporation restricts the number of shareholders, prohibits more than one class of stock or shareholder, and prohibits foreign ownership of stock. None of these restrictions exist in the LLC or the Limited Partnership. A further dilemma of the S Corporation is that while it taxes income similar to a partnership form of business, it taxes many capital transactions, mergers and acquisitions, stock redemptions, etc., as a regular C Corporation, which in many cases can create the dreaded double tax. 

BUSINESS TRUSTS

The Massachusetts Business Trust is the most well known of these forms of entities, that has statutory approval in a limited number of states, and "common law" approval and statutory recognition in most other states. The entity also known as a Business Trust, or a "statutory trust" is a trust, but can operate a "for profit" business, which is distinguishable from most trusts, which primarily act as a means to preserve and protect assets for its beneficiaries. For this reason the Business Trust operates similar to a closely held corporation, a LLC or Limited Partnership. 

The Business Trust, similar to any other type of trust, requires three principals as part of its organizational structure. First is the Trustor or Settlor, the person who declares or forms the trust and trust documentation. Second is the Trustee, the individual(s) or entity who is appointed to administer the trust, and third is the Beneficiary, the beneficial owner of the trust property. The Trustor has little involvement in the affairs of the trust after it is formed, unless it is a revocable or modifiable instrument, or by its terms, authorizes the Trustor to act.

The Trustees are most similar to directors of a corporation and the have similar liability to Beneficiaries and third parties. In addition, in many cases the state government wherein the trust has been formed, has a supervisory function, and has authority to bring actions against Trustees who violate the terms of the trust instrument, or their duties to the trust. 

The Beneficiary is generally protected from all trust liabilities, and if spendthrift provisions are included in the trust instrument, it is possible that creditors of the Beneficiary can be prevented from reaching the beneficial interests of the Beneficiary. If however the same person is the sole Beneficiary and the Trustee, the veil of the trust can be penetrated, rendering that person liable to creditors of the trust and enabling creditors of the Beneficiary to reach the trust assets. 

The Business Trust, in jurisdictions that do not yet have "statutory" forms, such as California, generally retains that greatest amount of secrecy over its business, financial dealings and beneficiaries, because it takes advantage of all of the benefits inherent in trusts laws, that preserve secrecy. The Business Trust can be structured to be taxable as a general partnership, or as a corporation. 

The Business Trust can provide a variety of aspects of asset protection. As noted above, trusts can incorporate "spendthrift" provisions and thereby shield the trust beneficiaries beneficial interest in the trust from any risk of levy by their creditors the beneficiaries. The trustees can appoint officers as agents to transact the business of the Business Trust, and therefore act without liability for claims made against their employer. In addition, creditors of the trustees or the agents of the Business Trust generally cannot make claims against the Business Trust assets unless an identifiable ownership interest in the debtors is ascertainable, which is generally non-existent, as these individuals are merely fiduciaries and employees of the Business Trust. 

PUBLIC AND PRIVATE RETIREMENT PLANS

California Code of Civil Procedure ("CCP") Sections 704.110 and 704.115 generally exempt from levy and execution sums retained for the benefit of an employee in a public or private "retirement plan". 

The definition of a private "retirement plan" is very broad and includes "all amounts held, controlled, or in the process of distribution by a private retirement plan, for the payment of benefits as an annuity, pension, retirement allowance, disability payment, or death benefit..." CCP 704.115(b). 

In addition, CCP 704.115(d) exempts these same amounts after they are paid to the beneficiary. It is assumed that this protection applies provided that the benefits are not co-mingled. 

However the CCP distinguishes "self-employed" retirement plans from corporate plans, vesting greater protection in the corporate plans. The corporate plans appear to have absolute protection over all monies, however the self-employed plan limits the projections only to the extent that it is necessary to provide for support of the judgment debtor, spouse and dependents, when that judgment debtor retires, after taking into account all resources that are likely to be available to the judgment debtor. CCP 704.115(f). 

Even where a corporate plan is under the absolute control of the judgment debtor, the court in In Re Cheng (1991, CA9 CAL) 943 F2d 1114 held that the judgment debtor was entitled to the full exemption of a "private retirement plan" rather than the partial exemption as a "self-employed retirement plan". 

The foregoing is however subject to spousal support obligations of the judgment debtor. 

The broad definition of a private retirement plan allows a great deal of protection and planning to be accomplished in the areas both qualified and non-qualified deferred compensation. 

Non-qualified deferred compensation generally involves the acquisition of large whole life insurance policies for the corporate executive, which stand up on their own for having good investment and tax savings benefits. In addition, non-qualified deferred compensation plans can also be funded with "employer securities" or as phantom stock plans. 

A fundamental difference between the non-qualified and qualified retirement plans is that the Internal Revenue Code requires the non-qualified plan assets to be subject to the claims of the creditors of the plan sponsor. Whereas the qualified plan, such as the typical profit sharing, 401(k), or pension plan that contains non-discrimination and minimum funding standards, contains its own "spendthrift" provisions that protect the plan assets from both those claims by the plan sponsor creditors and those claims by the employee/beneficiary creditors. 

The Internal Revenue Code distinctions between the qualified and non-qualified plans are rooted in the law on constructive receipt. Query however the impact of CCP 704.115 on such plans. There is still a great deal of planning to attempt to avoid vulnerability of these plan assets, while in the hands of the plan sponsor, and still not create constructive receipt to the employee/beneficiary. 

In any event, it appears that the use of both the qualified and non-qualified plans will provide a significant safe-haven to protect substantial wealth in a safe and prosperous investment environment. 

There may be vulnerability in the case of domestic non-qualified plans to the extent that the sponsor employer has liability to the creditor. However, this is where corporate layering may be important and the use of the corporate veil to protect brother-sister corporations and parent corporations from the actions of their subsidiaries. It would appear that the personal liabilities of a shareholder should not constitute valid claims against the corporation even under the IRC rules, in that these are not the kind of plan sponsor claims that must be vulnerable to creditors to avoid constructive receipt. 

Qualified plans however are generally taxed as "ordinary" income to the beneficiaries upon receipt. Other tax issues are created, however, it is better to have to pay some taxes than to lose the entire corpus to creditors. 

The laws of other states can be similar, more protective of these retirement monies, or less protective. Some states will exempt from the reach of creditors any monies held in an annuity purchased from an insurance company, which could be established at any time prior to attachment of the funds by the creditor. An acceptable form of planning to some clients is to consider relocating to another jurisdiction that can provide statutory protection and a life style that is more harmonious with their unique situation. 

FOREIGN TRUSTS

The purpose of using foreign trust, is to remove assets out of the jurisdiction of creditors who are anxious to levy. As each of our 50 states are sovereign and have their own laws that benefit the people of its jurisdiction, each government has their own laws to protect both their own people and forms of commerce that benefit those jurisdictions. 

The holding of assets in an offshore trust is a sophisticated device whose first impact is to raise serious question by a potential plaintiff and his counsel as to "is it worth it?" "Can we find anything?" The Federal Bankruptcy laws, and the laws of California and most states require that you must divulge, under penalty of perjury, in a court supervised examination, any assets that a you own, or directly or indirectly control, that a creditor can claim he is legally entitled to levy upon. 

If transfers were made that were in violation of the above described laws prohibiting Fraudulent Conveyances, Preferences, or Transfers in Defraud of Creditors, the recipient or other U.S. holder of those assets, and in many cases the foreign trustee of those assets can be required to divulge the whereabouts of those assets. 

As a result, unless the assets have been properly transferred under contracts and/or agreements that were "arms-length" and "fair", the benefits of using a foreign trust may be limited to the "hassle" value to deter your creditor from wanting to expend his or her resources to levy upon the property. 

However, the use of a foreign trust can prove invaluable if (1) the trust was properly formed in a jurisdiction favorable to protecting its corpus; (2) the debtor cannot be found to have any form of direct or indirect ownership or control over the trust assets; and (3) the transfers to the trust were effected in transactions that do not run afoul of the fraudulent conveyance statutes. 

Here again, a good deal of pre-planning and understanding of all aspects of the debtor's individual situation have to be examined to ascertain the legitimacy and ability to avoid the pitfalls that can be associated with off-shore transfers. In many cases the use of off-shore trusts will provide a means of double protection, after you have implemented a reasonable certain form of domestic based asset protection. The lawful transferee of assets can then choose to hold assets off-shore, to deter and avoid the threat that a local creditor may attempt to penetrate their own holdings. 

A primary benefit to a foreign trust is that the foreign trustee is generally not subject to the jurisdiction of American courts. Furthermore, if the foreign trusts have been established in advance of the existence of any creditors, as part of an estate plan that shifts wealth among your natural heirs, they should prove beneficial. The use of the foreign trust does create a myriad of tax issues, which are beyond the scope of this article. As a result, a qualified international tax advisor should be consulted. 

CONCLUSIONS

Each form of entity has its benefits and its drawbacks. It is also possible to devise a structure that includes more than one type of entity in order to achieve most of the benefits and less of the drawbacks. However the drawback to a multi-entity structure is loss of simplicity, and possibly greater complications when dealing with the public, bankers and employees, and the Internal Revenue Service, not to mention the increased fees to service the structure. As noted above, most of the various forms, through proper planning and contractual relationships, to some extent can be made to emulate another form of entity, and thereby mitigate some of its own drawbacks. However all of these matters must be evaluated relative to the ultimate profit objectives of the trade or business.