My background as a tax attorney with practical experience in the areas of estate planning and trusts, marital property agreements, executive compensation including both qualified and non-qualified plans, and corporate and partnership formation has given me the tools to mix and match otherwise traditional business and tax planning tools to develop domestic based asset protection planning techniques. Domestic asset based protection differs from foreign based asset protection, which generally requires the establishment of foreign trusts to hold assets. As discussed below and in a separate article that discusses Foreign Spendthrift Trusts in more detail, these two forms of asset protection can be integrated and coordinated with each other. Fundamental to the purposes of contract law, estates and trusts, retirement planning and entity formation is the fact that inherent in these tools and disciplines of law are mechanisms that are intentionally designed to protect and direct wealth to lawfully designated individuals.
In asset protection and preservation planning, each client will have a varied and diverse financial and family circumstance that will affect his or her overall plan. It is not as simple as “forming a limited partnership” or a “establishing a trust.” Even if the client is not focused at this time on the benefits of an asset protection plan, one day they may be, and when that day comes, hopefully their form of doing business will be easily adaptable into an asset protection and preservation plan, without having to create additional taxes or risks. For this reason alone, prudent businessmen and businesswomen, should seek advisors and counsel who can help them to evaluate the important aspects of asset protection and the associated costs, so that they can make clear choices to accept or reject those risks of doing business.
The most simple of corporate forms for doing business can, for nominal charges, be made “asset protection ready.” Such planning could save and preserve the name and goodwill of a company that gets hit with a crippling lawsuit, and can also protect a good portion, and possibly all, of a shareholder’s investment, loans and loan guarantees, made to or for the benefit of his or her corporation.
Many of the common misperceptions that professionals are “generic” in nature, or that the “hourly” rate of a professional can reveal if one professional is more competent than another, are becoming less and less significant, as clients come face to face with the results of their professional’s handiwork. Even those professionals who can pass the “bedside” manner test, the size of the professional practice test, or otherwise appear credible on the basis of their reputation and financial wealth, are becoming more scrutinized as clients become more sophisticated and cases of malpractice and regulatory sanctions become more and more known.
As a general rule almost any professional and para-professional can draft a document. There are enough legal documents of all types generally available to the general public and law practitioners from numerous sources. The areas of concern when selecting a professional, or attempting a “do-it-yourself” service are two-fold:
1. Diagnosis: What type of document or structure best suits the needs of the client in the first place?
I am always intrigued when a potential client calls up to get a quote for a partnership agreement or an incorporation. They are asking for the price of the medicine, before anyone has diagnosed the situation. While there may be a reasonable chance that they need what they are asking for, in more cases than not, if asked proper questions about their business,its potential, their partners, their family, their concerns about asset protection and their financial situation, a whole new picture will develop, and in many cases an entirely new method of doing business can be called for.
Unfortunately many attorneys are more interested in generating another client and will gladly quote a fair fee, instead of “practice law” and will not make further inquiries that will enable them to make a valuable diagnosis. The diagnosis is really the hardest part of practicing law. Unless that attorney has broad experience in business and law that goes beyond any “narrow” focus of his or her practice, they will be ill-equipped to offer a comprehensive diagnosis.
Business attorneys must now be both “specialists” and “generalists” at the same time. It is the “generalists” who must be knowledgeable of tax, asset protection, real property, employer-employee relationships, trusts, estate planning, contract law, etc. so that he or she can make a comprehensive diagnosis of the legal needs of the client. It is the specialist who must implement the recommended course of action.
2. Not all documents are created alike
Most legal documents of similar type tend to look very similar to each other. The reason for this may be because local state bars generally recommend a standard bar approved form, which is usually the starting point for most legal documents. If there is no bar approved form, then the major publishing firms who charge law firms thousands of dollars annually for legal research publications and tools, offer form documents, which become standardized and serve as good starting points for most legal documents.
These starter documents are commonly called “boiler plate” and are generally inexpensive to produce for clients. However, it is the attorneys peculiar knowledge of his or her area of expertise and the overall objective of the client that will require the “boiler plate” to be modified. This is like a surgical procedure. Documents are living and breathing, and must be drafted so as to handle both known and many unknown situations that will tend to evolve out of the type of business activities and the business plan of the client.
Even the modifications that are used may be a form of “boiler plate”, that by sanction of the local bar or a major publisher, are acceptable forms of clauses to achieve specific and peculiar objectives. However, the finished document, while it may look similar to the original starter document, will contain some obvious and many well hidden words, phrases and paragraphs, designed to achieve a unique objective and to handle the client’s future growth and needs, in an what may result in a non-modifiable, irrevocable document.
I have to emphasize that sometimes many modifications may be “well hidden” because, in many cases there is no real desire to create “red flags” that call attention to third parties reading the document about the private objectives of the client, whether they be tax based, asset protection based, or stronger negotiated positions.
As one can observe, attorneys who are not fully knowledgeable of all of the possible related events that can affect the client or the business relationship formed by a document, or otherwise who are not intimately knowledgeable of the “boiler-plate” language contained in their own documents, may not be apt to provide a document that is comparable or as beneficial as one prepared by experienced counsel. Although the price of the document and the legal services may be the same!
As a result of the “overly” litigious nature of our society, individuals who have or desire to accumulate wealth must now have to be concerned with protecting that wealth from spurious claims not otherwise protected by insurance. The cost of litigation in many cases is reason enough to settle frivolous claims, because the anticipated cost of the legal expenses to defend oneself is too great.
While there are numerous techniques to plan and protect one’s wealth, I have focused on a few of them to give you some ideas that have to be evaluated in light of all relevant circumstances. As a California attorney, I have couched my analysis in light of California law. The laws of each state varies, however in most situations there are similar provision and planning methods available in each of the 50 states.
Each of the following ideas have been well received by clients, as not being too cumbersome or expensive, and many of them have undergone creditor attack and bankruptcy court scrutiny.
Marital and Estate Planning
California as a community property state, has traditionally protected the separate property of one spouse from the creditors of the other spouse. Community property however is subject to the claims of creditors of both spouses. Most simply, unless a husband and wife agree otherwise, all “sweat” income, income earned from the labors of the spouses, will be considered community property.
As a result, a good deal of planning evolves around the elimination and termination of community property and the creation of separate property to take advantage of the protections afforded to the separate property of spouses.
It is well known that Community Property is divided in divorces and can be avoided from creation under pre-marital property agreements. However, there is a body of law that authorizes the termination or “partition” of community property, if for fair consideration, even while the husband and wife are married and living together. If creditors are making claims against assets that are the subject of a partition, the Husband and Wife may run afoul of applicable fraudulent conveyance rules and prohibited transaction rules, enacted under the U.S. Bankruptcy laws and under the laws of most states and jurisdictions. As a result, another approach to effective a division or partition of the community property may have to be pursued, if at all possible.
In the California case of American Olean Tile Company v. Horst Schultze (1985) 169 Cal. App.3d 359, the Court of Appeals denied a creditor recovery who was claiming a violation of due process arising out of the implementation of the California law that protects the separate property of each spouse from the creditors of the other. The court relied upon public policy arguments to deny the husband’s business creditors any rights to pursue the wife for debts that she never directly incurred, but were incurred by the husband personally during marriage.
There are a variety of estate planning techniques that can be used to divest an individual of his or her wealth, and/or protect the corpus from the claims of creditors of the beneficiary of the estate planning device. These include as College Trusts, irrevocable and Life Insurance Trusts and Generation Skipping Trusts, Q-tip and Unified Credit Trusts.
California law will, however, generally be able to penetrate an irrevocable trust if the grantor retains a beneficial interest in that trust, notwithstanding the existence of other beneficiaries.
Inter-family transactions between and among family members can be integrated into an asset protection plan. The California Uniform Commercial Code and real property law affords priority and protection to security interests that are duly filed or recorded against personal property and real property, respectively. For example, loans by a shareholder to his or her corporation can and should be secured by UCC-1 filings at the time when made. Continuing marital property obligations resulting from property divisions can and should be fully secured. Leases involving real property and options to acquire real property granted to children, while they have to comply with Internal Revenue Code inter-family rules and regulations, can and should be recorded against real property interests.
Within guidelines established by the tax laws, family members can partnership and joint venture together to form and operate businesses. When ownership of business entities are shared among family members, there are unique and specialized laws enforced by the Internal Revenue Service, that are designed to limit transfers of wealth for less than fair consideration, or shifting of income tax burdens, when not justified. However as more fully discussed in these articles, there are available means to select and organize entities that that can achieve both an asset protection and tax savings result.
The real question is which form of entity should be pursued, from the list of available forms of entities and the available forms of operation typical for the subject matter of the business and the relationships among employees and family members being created. The answer to this important question is hinged upon the ultimate objectives and concerns of the client, relative to the costs that they want to incur to protect achieve their objectives and protect against their concerns. As more fully discussed in these articles, the simple selection of a limited partnership, or a gift of an asset, may have more negative ramifications that contemplated, or a more simple solution may be available after proper analysis of all material and relevant factors.
Selection of entities to hold assets or do business
It is recommended that you review the separate article entitled “Business Entities – Limited Liability Companies, Corporations, Partnerships, Business Trusts, Retirement Plans, and Domestic and Foreign Spendthrift Trusts” which more fully discusses the process of selecting entities to hold assets or do business.
The point to be made here is that entities recognized by the legal systems of each state, are in one sense “fabricated persons” solely created to do business and/or hold assets, for specific reasons and with specific benefits. The idea of conveying title to another person or newly created entity, can remove from the individuals seeking asset protection, those incidence of ownership that would otherwise allow a creditor to reach the asset or business. As noted below, there are state and federal laws to prohibit mere transfers of property and assets to protect the rights of creditors, when the transfer render the transferor insolvent or is not for “fair” and “adequate consideration”. These laws in certain instances even allow the authorities to bring claims against advisors and legal counsel who have participated in the asset transfers. As a result, competent legal counsel must generally limit their advice so that it is not contrary to these laws. The bottom line is that we all have a constitutional right to contract, provided that such contracts do not contravene the public interest.
A properly selected entity to receive a transfer of assets pursuant to a valid and otherwise appropriate business contract or agreement, has the ability to defend against attack. The success of that defense will depend upon a variety of factors and cannot always be guaranteed. Here again, I must caution you about the great care and skill that is required when evaluating the type of entity, the timing of the transfer, and the type and terms of the business contact or agreement. This requires the skill of knowledgeable counsel, not merely counsel who can draft documents, but counsel who understands the economic realities of the transactions. In addition, you want counsel who can help you make a cost benefit analysis of those safeguards that you consider implementing.
Keep in mind that every entity that is formed has an organizational cost, in terms of legal fees to form the entity, fees to the state and local governments, and taxes. In addition, the creation and use of several entities requires that the integrity of those entities be observed or else under the laws, the entities can be disregarded entirely. This may result in confusion among those who have to make business decisions, confusion that might hamper the ability to operate the business smoothly and profitably. As a result, the most expensive form of planning may be the least desirable. Your solution could be best suited with an inexpensive business trust, or a simple incorporation or limited liability company. Here again, you must rely upon your counsel to help you understand the risks, costs and benefits of any planning.
Further issues are raised by the income tax and estate tax consequences created by the form of the transfer. Keep in mind that the Unites States government will assess a gift or estate tax for any transfers that are not for “fair” or “adequate consideration”. In addition income taxes or capital gains taxes will be imposed for any transfers when the “fair” or “adequate consideration” exceeds the tax basis of the property. The Internal Revenue Code has a plethora of rules and regulations to evaluate the “fairness” and “adequacy” of the consideration in all forms of transactions. There are special rules for transfers among family members, transfers to controlled entities, and transfers to designed to appear as something that they are not. These rules create a myriad of obstacles that again require that you to select counsel who also has expertise in these areas.
Business contracts, agreements, etc.
The topic “Business Contracts, Agreements” by its name includes almost every form of doing business and agreement available, wherein one or more parties makes an offer, one or more parties makes an acceptance of the offer, and both parties receive consideration. This is the general form whereby our society transacts business and politics.
What most non-legal persons do not realize is that the number of variations of a contract are infinite, as numerous as a creative client or counselor can imagine. The only real limitation is whether or not the creation can be put into a concise writing that is understandable by the parties to the transaction, for a reasonable fee.
Each contract is designed to provide a benefit and create an obligation or liability. That benefit and the liability may be moral, emotional, or financial. The law will generally always enforce the contract if there is a meeting of the minds between the parties, and sufficient consideration has passed. The sufficiency of the consideration is ascertained by an objective standard, one that does not attempt to value the consideration, but only attempts to identify if any has in fact passed, regardless of value.
When evaluating forms of contracts and agreements in the realm of asset protection, there are a variety of federal and state laws, designed to protect existing and legitimate third party creditors of the parties to the contract, that require among other things that the consideration be “fair”, in accordance to a subjective standard.
While these rules, generally known as the rules to prohibit “Fraudulent Conveyances”, “Preferences”, or “Transfers in Defraud of Creditors”, may limit the creative use of contracts to achieve asset protection, the field is still limitless, when one attempts to evaluate the various types and forms of contracts that individuals and businesses sign daily. You see, fairness is generally ascertained by using a “comparability” standard. Would reasonably prudent persons or entities sign such a similar agreements. Therefore, the more typical the form of agreement and the form of the consideration, the more evidence to support its “fairness”. Or to put it another way, the more difficult to challenge its “fairness”. The cost of litigation must cut both ways. The plaintiff’s attorney has evaluate whether or not there is a collectible recovery to pay his or her contingency fee sufficient to make the case worth pursuing in the face of otherwise typical agreements that on their face glean of “fairness”.
As discussed elsewhere in this article, Marital Property Agreements and Estate Planning offer typical forms of protection, especially when there are no creditors or claimants in sight. This is because, the rules that a transaction must be for fair consideration, can only be invoked if and when there is an intent to hinder the ability of a creditor to be paid his or her lawful claim. If no such creditor exists or is reasonably contemplated to exist, then it will be difficult to demonstrate a show of intent to hinder a creditor’s payment. Therefore there is a lesser need to achieve “fairness” in the contract, agreement, or estate plan. If this is your situation, then given a legitimate estate planning objective, you have most every form of contract, agreement and means of two parties relating to each other, at your disposal.
The various values, rights and benefits inherent in an asset that has a perceived value can also be segmented and divided from the whole. By identifying the most valuable aspects of an asset, whether that asset be a core technology, a client or customer list, a secret formula for doing business or a manufacturing process, your own pure and simple talent as a good worker or a salesperson, an interest in real or personal property, a business plan, etc., you can segment your interests in property and retain control of those elements that, under the United States Bankruptcy Laws and/or the United States Constitution, can never be taken away from you. Those other elements of the same property, the ones that are susceptible to claims of creditors, can therefore be segregated and transferred to others or a newly formed entity in protected transactions for fair consideration. Entities can be formed to achieve your short term and long term objectives, and can be owned and controlled in ways that will not cause themselves to be tainted by claims of creditors.
The mechanism of dividing and segregating an asset could include the use of simple and typical agreements generally used in business. These have been briefly referenced and include, agreements and contracts used for sales, options, licenses, services, royalties, syndications and fund raising, stock subscriptions, franchisor- franchisees, etc.
The segregated assets are transferable by contract or agreement to an acceptable business entity that can generate value from the asset (such as a corporation, trust, limited liability company, partnership, retirement plan, or another individual). Contracts can be entered into between the various entities that own the various segregated parts of the whole asset.
The client’s estate planning objectives will shape the method and manner of segregating the assets, the type and ownership to the various entities selected and the contracts that enable the various entities to work in conjunction with each other. This form of doing business is no different from how our government does business, or how major conglomerates do business. I.e. Just take a closer look into the AT&T; break-up or the various mergers and acquisitions that are prevalent in our corporate world. Examine more closely corporate spinoffs of unwanted divisions and subsidiaries. Best of all, this mechanism is generally legally and constitutionally protected.
However the key to the planning is (1) to come up with a plan that can accommodate the unique and individual facts of each matter, (2) the asset appreciation objectives of the client, and (3) tax, mechanical and cost of implementation constraints. This generally will require the use of counsel that will do more than recommend a family limited partnership, or one who has expertise in limited areas of law, wherein the plan is to fit a square peg into the round hole.
Creditor and bankruptcy court caveats
Each planning technique is subject to certain tests which determine whether or not they can work. No asset protection plan can work if it is implemented as part of a plan to defraud creditors.
As a general rule if there is “inadequate” consideration (as opposed to “insufficient consideration”) at the time assets are transferred or entities reorganized, the plan can be found to be fraudulent with the intent to injure creditors.
And, even when there is adequate consideration, transfers between related parties must have occurred at least one (1) year before there is a bankruptcy, and at least three (3) months before a bankruptcy for any transaction involving unrelated (arms-length) parties. (The California Uniform Fraudulent Conveyance Act provides for a four (4) year statute that could be extended into a seven (7) year statute of limitations for creditors to challenge the transfers. However, those statutes of limitations extending beyond one (1) generally require a failure of consideration and/or a showing of actual intent to defraud creditors.)
These broad brush authorities that authorize challenges to transactions and reorganizations emphasize the need for proper planning to provide a strong defense to any challenge. While any one creditor can challenge a transaction as being entered into with the intent to defraud him or her proper planning can make it too costly for that creditor to pursue its challenge. For this reason, whenever possible, it is suggested to obtain and receive an administrative or court decree that rules that the transactions are reasonable and legal. This can include IRS private letter rulings for non-qualified plans, actual divorce decrees, separation decrees, or probate court orders that authorize the allocation of trust assets among beneficiaries.
When pursuing a course of asset protection, one is generally building a wall or a fortress to protect wealth. The amount of protection is relative to how much the client wants to spend. However, sometimes the most basic of planning techniques can afford sufficient protection. And although a strong fortress cannot guarantee protection, it does however make it very difficult for one to penetrate. This level of difficulty may alone retard attackers. Police tell us that burglars will generally skip the house with the burglar alarm or the deadbolt. The same rationale should apply.