Asset Protection: When Bootstrapping Backfires

Marriage, Technically Speaking

Reprinted from The Estate Analyst, August, 2009

By Robert L. Moshman, Esq.

In This Issue:

• Self-Settled Trusts
• Offshore Trusts
• Single Member LLCs
• Step Transactions, Gifts

If you are looking for a
bullet-proof entity, the single
member LLC still has an
Achilles heel…or two.

elf reliance is a virtue to be admired but when there are potential creditors in one's future, can you lift yourself out of harm's way by your own bootstraps?

Here we take a look at asset protection approaches that involve a bit of self-help magic, i.e, self-settled trusts, single member LLCs, and step transaction LLCs.

Self-Settled Spendthrift Trusts

"Dear Creditor, I know I owe you money, and I would so like to pay you right now. However, I've put all of my assets in a spendthrift trust for myself and as trustee, I am duty bound to protect myself from creditors like you. So you see, there is nothing I can do. Sorry. Very truly yours, Debtor."

Does this approach actually work? Can an individual bootstrap himself or herself into a protected position as beneficiary of a trust that he or she has set up for that purpose? Can an individual be a trustee as well as a beneficiary?

IRREVOCABILITY: As a prerequisite to having a viable asset protection trust of any kind, the trust would have to be irrevocable. There are impressive numbers of people with revocable trusts for themselves who are confused about this point. They may have avoided probate for trust assets but not creditors during their lifetimes. If the beneficiary can revoke the arrangement, then it isn't going to be binding on a creditor of that beneficiary.

FRAUD: Another prerequisite is good faith. A fraudulent transfer to a trust (or a family member or an LLC for that matter), can be challenged. The time to set up asset protection arrangements and make bona fide transfers is when the coast is truly clear. No litigation, no creditors, no fraudulent plans.

MERGER DOCTRINE: The next hurdle is the merger doctrine. Historically, a settlor who becomes a trustee for himself as beneficiary would not be recognized as two or three separate people. This is especially apparent where there is a single trustee and a single beneficiary.

Offshore Trusts

Scour the globe for financial havens and there are nations that not only provide secret bank accounts, tax havens, and other more esoteric financial maneuvers, but also more mundane arrangements such as self-settled spendthrift trusts.

For each such jurisdiction there are rules to research and inconveniences. Generally, by the time someone goes to the trouble of moving assets into a foreign trust, they are often so deep in trouble of some kind that the transfer will be deemed fraudulent. At first blush, a debtor transferring assets to a jurisdiction like St. Vincents in the West Indies might feel reassured that creditors will be forced to prove a transfer was fraudulent by a high burden of proof (beyond a reasonable doubt) and will have a one-year statute of limitations that begins to run from the time of the transfer.

On the other hand, bankruptcy and other cases in this country have ruled against debtors attempting to rely on foreign trusts. In, Dexia Credit Local v. Rogan, 2009 WL 648634 (N.D. ILL. 2009), for example, an offshore trust from the Bahamas was disregarded when the court determined that a choice of law provision would violate Illinois public policy against self-settled trusts.

These arrangements may discourage creditors and work in limited circumstances but aren't as reliable for asset protection purposes where some assets remain in the United States. Offshore trusts also have income and estate tax benefits, often avoid the rule against perpetuities, and provide greater privacy. Note: A transfer to a foreign trust can be treated as a sale that realizes capital gains unless a grantor trust is established.

Domestic Havens Arrive

In the late 1990s, several domestic jurisdictions vied for the distinction of being attractive havens for wealth on several fronts such as relaxing the rule against perpetuities, allowing LLCs that limit creditors to charging orders, and providing for self-settled discretionary trusts.

On April 2, 1997, Alaska's statute on point arrived and was followed by Delaware on July 1, 1997. Nevada followed suit on October 1, 1999. The list of jurisdictions with some form of self-settled discretionary trust grew to 10 in 2009 with the addition of New Hampshire. The ten-year sequence went something like this.¹

Alaska
Delaware
Nevada
Missouri
Rhode Island
Utah
South Dakota
Tennessee
Wyoming
New Hampshire

Each of these jurisdictions has various rules such as having a connection to the state with some assets actually being located in the state and a local trustee being appointed.

Do these arrangements work?

That's a matter of opinion. If you live in one of these jurisdictions and all your assets are there and you meet all the requirements in good faith, then yes, the arrangements work. If you depart from any of those ground rules, then the trust could work in part or may serve as an impediment to discourage a creditor.

This is where academic statutes meet reality. We live in a free country where anyone can sue anyone else for anything. If assets are moved to a remote jurisdiction into a self-settled trust, a determined creditor will still file suit and allege a fraudulent transfer or failure to meet all of the host state's requirements.

Interstate Respect

Under Article IV, clause 1 of the United States Constitution, each state is supposed to respect the laws of other states. A judgment in one state is therefore enforced in another state. A notable exception to full faith and credit was created under the federal Defense of Marriage Act (1996). That law allows a state to refuse to recognize a same sex marriage from another state.

There is total uncertainty about how well the full faith and credit clause will hold up as applied to self-settled trusts. For example, an Illinois creditor sues an Illinois debtor in Illinois and the defendant claims his assets are in an Alaskan trust. Will the victorious creditor be able to enforce the Illinois judgment in Alaska? Or will Illinois respect and apply Alaskan law?

In, Dexia Credit Local v. Rogan, 2009 WL 648634 (N.D. ILL. 2009), an offshore trust from the Bahamas was disregarded when the court determined that a choice of law provision would violate Illinois public policy against self-settled trusts. To make an Alaskan trust hold up in Illinois, for example, the debtor better be living in Alaska, have no powers of withdrawal as trustee, have a trust protector provision, and have a lucky rabbit's foot.

Weighing The Options

Under the theory of creating impediments to lawsuits, having an imperfect protection is better than no protection. So a creditor might accept a lower settlement amount or give up before bringing action to break a trust set up in one of the permissive domestic trust jurisdictions.

If one holds by such a theory, then compounding impediments would further discourage creditors. You can sue me, but my assets are in trusts set up in Alaska, Nevada, Delaware, and Rhode Island. Someone inclined to over do things might have a series of foreign jurisdiction trusts as well. It's one thing to deal with multiple American jurisdictions but going after trusts in Nevis and other exotic locales starts to get daunting.

On the other hand, there are firms that specialize in debt collection from multiple jurisdictions that like a good challenge and nothing motivates an angry creditor more than a laughing debtor who thumbs his nose from Nevis and Alaska. The debtor/beneficiary who is too smart by half gets tripped up by having to defend lawsuits on multiple fronts. Not fully complying with all the requirements in one of these jurisdictions can also be a problem.

Another pitfall could be an incomplete asset protection. You can secure $1 million in 10 different locations but if you still have one asset exposed, that's what a creditor will go after.

Asset Protection Alternatives

Those who anticipate future creditor attacks have other asset protection techniques to consider:

• Utilize trusts that have multiple trustees and multiple beneficiaries.
• Shift assets to others outright.
• Buy life insurance.
• Set up multiple LLCs and other entities.
• Set up retirement plans.
• Buy a homestead in Florida.

Caveats: All of these efforts come at a price to one's self and one's estate. All have rules to be satisifed. It takes time and money to set up all these impediments and devices and someday will take one's executor time and money to undo all this magic. The simplest solution is to make an irrevocable gift in trust to a third party when there is no litigation or debt on the horizon. A clean transfer that can't be challenged.

The Single Member LLC

Meet Mr. Lonely. He works alone. He is a one-man unincorporated business. One is the loneliest number. But why be a sole proprietor when there is readily available protection in the form of an off-the-shelf, all-purpose limited liability company?

Presto! Mr. Lonely, LLC is now an entity. An LLC is supposed to provide an individual with the same protection from litigation as a traditional corporation yet revenues to the LLC pass through to the owner without being taxed at the corporate level.

However, the single member LLC has an Achilles heel or two to be concerned about. Courts are starting to view the single member LLC as an alter ego of the single member. Since revenues pass through the LLC to the individual member, any creditors of the individual are able to access any revenues the member has access to.

Bankruptcy courts in Idaho, Maryland, Colorado, and Minnesota have ruled that the bankruptcy trustee for a single member LLC succeeds to all management rights of the LLC and can therefore terminate the LLC and distribute assets to satisfy creditors of the single member. In, Olmstead v. FTC, law professor Daniel Kleinberger filed a brief in September 2008 arguing that Florida's charging order protection for LLCs is irrelevant and should not be enforced for a single member LLC.²

Solutions: Instead of a single member, have a bona fide second member. Don't file for bankruptcy. Have an operating agreement that anticipates and addresses numerous issues.

TECHNICAL REFERENCES

¹ For a superb and detailed outline of self-settled trust statutes, see Gideon Rothchild's recent presentation. This is available online: Asset Protection Planning (With Audit Checklist) ALI-ABA Estate Planning Course Materials Journal (April 2009).

² See, Richard Keyt, Single Member LLCs Lack Asset Protection; and see Jay Adkisson's website, www.assetprotectionbook.com for statutes and cases from all 50 states.

Step Transactions Tripped Up

July, 2009 brought news of recent cases involving taxpayers being tripped up by step transactions and indirect gifts.

A step transaction is where a taxpayer sidesteps a taxable transfer by instead making a series of separate steps that fail to fool the IRS, which treats the steps as one transaction. An indirect gift is one made indirectly, such as through a third party. Now those doctrines are being applied to some LLC maneuvers and other arrangements.

In, Linton v. U.S., parents transferred assets to an LLC and transferred LLC interests to trusts for their children. The intent was to obtain valuation discounts since the trusts would end up holding minority shares of the LLC. However, all the transfers were made on the same day. After applying step transaction analysis, the court denied the valuation discounts.

The analysis left open the potential to obtain discounts by waiting a sufficient time between the transfer to the LLC and the transfer to the trusts. A shorter time would apply to volatile assets such as stocks.

Three alternate tests are applied to determine if a multi-stepped process was really one transaction, i.e., whether there was (1) a "binding commitment" to undertake the later steps when the first step was taken; (2) an "end result" that was pursued by the series of steps; and (3) "interdependence" of the various steps and whether each would have been undertaken for its own merits without being integrated in the series.

In, Heckerman v. U.S., a District Court applied step transaction analysis in similar circumstances and found that transfers to an LLC and then to the trust were taxable as indirect gifts.

References: Linton v. U.S., U.S. Dist. Ct. W.D. Washington, Cause No. C08-227Z (July 1, 2009). Heckerman v. U.S., U.S. District Court for the Western District of Washington, (July 29, 2009). Anyone with access to the Steve Leimberg website should appreciate the excellent coverage of this topic. We referred to LISI Estate Planning Newsletters 1490 by Paul Hood and 1494 with analysis by Steve Akers.