Higher FDIC Protection for Trust Accounts

As most people know, the Federal Deposit Insurance Corporation (FDIC) is a federal government agency that insures customers of insured banks so that even if the bank fails, the depositors do not lose their money. The basic FDIC insurance amount is $250,000 per depositor per insured bank per account category.

The account categories include single-owner accounts, joint accounts, revocable trust accounts, and entity accounts. In other words, a single depositor can multiply their FDIC coverage by spreading their deposits across a single-owner account, joint account, etc. Of course, coverage can be multiplied by spreading deposits across multiple banks as well.

One benefit of establishing a revocable trust and opening a bank account in the name of the trust is that the maximum FDIC coverage for a revocable trust account at a single bank is $250,000 multiplied by the number of unique beneficiaries of the trust. To qualify for this increased coverage, the account name must indicate trust ownership, the trust beneficiaries must be identified in the trust agreement, and the beneficiaries must be living persons or qualified charitable organizations.

Of course, such a trust account will also have the benefit of never needing probate to administer, and the successor trustee will easily be able to manage the account upon the death or incapacity of the grantor of the trust. Increased FDIC insurance coverage is one more benefit of establishing a revocable trust.

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Comparison of DAPT Statutes

The law has long allowed individuals to establish spendthrift trusts for the benefit of third-party beneficiaries and thereby remove the trust assets from the reach of creditors. However, until relatively recently, the law did not allow individuals to establish spendthrift trusts for their own benefit and successfully remove trust assets from the reach of their own creditors.

Alaska became the first domestic jurisdiction to allow this type of planning by passing an asset protection trust enabling statute in 1997. A Domestic Asset Protection Trust (DAPT) allows an individual to transfer assets to a trust, remain a beneficiary of the trust while removing the assets from the reach of creditors, and also achieve numerous tax planning objectives.

DAPTs offer significant protection for individuals residing in states that have adopted DAPT legislation. Whether a trustor residing in a jurisdiction that has not adopted DAPT legislation can form a trust pursuant to the laws of a foreign DAPT jurisdiction and successfully protect their assets from creditors has not been adequately settled by the courts.

A number of factors must be weighed in determining which jurisdiction a trustor should select as the situs for their DAPT. An excellent resource for comparing the provisions of the various DAPT statutes is David G. Shaftel's Comparison of the Domestic Asset Protection Trust Statutes. Sixteen states have passed DAPT enabling laws, the latest being Mississippi in 2014, and Mr. Shaftel's chart compares and contrasts the applicable laws in each of these jurisdictions.

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Utah DAPT Update

Two recent developments in Utah Domestic Asset Protection Trust law are worth mentioning. First, the Utah Supreme Court issued a ruling in the case of Dahl v. Dahl, dealing with a DAPT in the context of a divorce. Ms. Dahl appealed a lower court's decision, arguing that it erred in holding that she had no enforceable interest in the assets of a DAPT established by Mr. Dahl, and the Utah Supreme Court agreed.

Although the trust agreement specified Nevada law as the law governing the trust, the Utah Supreme Court applied Utah law for public policy reasons. Whereas under Nevada law the trust would have been irrevocable, under Utah law the Court found that the trust was revocable. Even though the trust agreement stated that it was irrevocable, another provision said that Mr. Dahl could amend the trust with the consent of the beneficiaries, and the trust did not include any express restrictions on this power.

This case is not a "traditional asset protection planning case," according to Jay Atkisson writing for Forbes. However, it reminds planners and clients alike that in order for a DAPT to be effective, it should, at a minimum, be formed pursuant to the law in which the settlor is domiciled and not be used to try and "cheat another spouse."

In another development, a bill has been proposed in the Utah legislature, H.B. 318 - Domestic Asset Protection Trust Amendments, which would repeal and replace Section 25-6-14, the current Utah asset protection trust statute. The "new type of asset protection trust" the bill creates would, among other things, require asset protection trusts to be registered with the Utah Division of Corporations and reduce the value of a settlor's assets that would be protected from creditors. Specifically, a DAPT could assert only the following exemptions:

The Median Exemption is an amount equal to the sum of the median value of a Utah owner occupied housing unit and the median Utah household income as determined in the most recent American Community Survey conducted by the United States Census Bureau.

The 50% Exemption is determined on a claim by claim basis and is an amount equal to the sum of [certain amounts] reduced by the Median Exemption...

For 2013, the Median Exemption would appear to only be $211,400 for median owner-occupied unit value plus $59,770 for median household income. This would represent a significant creditor-friendly change to Utah's DAPT law.

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Flight Department Companies

If you or your client is thinking about owning an aircraft in a limited liability company or other entity, think again. While an individual aircraft owner can operate an aircraft for personal use, this is not the case when that same aircraft is owned by an LLC, even one that is disregarded for tax purposes. The Federal Aviation Administration has consistently viewed these entities as "flight department companies," which require commercial registration. The following is from a Legal Interpretation to James W. Dymond from Rebecca MacPherson, Assistant Chief Counsel, Regulations Division, dated March 9, 2007:

A company whose sole purpose is transportation by air and receives compensation (amounts paid by the Client needed to pay the costs of owning and operating the aircraft) must obtain certification under Part 119… Section 91.501(b)(4) is drafted to permit an individual owner, not a company, to operate an airplane for his own personal transportation and guests without charge. Thus section 91.501(b)(4) cannot be used by a flight department company.

Jeff Wieand, an expert in this area, explains as follows:

Unfortunately, few business lawyers are well versed in arcane FAA rules and regulations, especially ones as counterintuitive as the flight department company trap. Suppose I buy a business jet and own and operate it in my own name. Since I’m flying myself around in my own aircraft, the FAA says I can follow the non-commercial Part 91 Federal Aviation Regulations. Now suppose I create a wholly owned LLC to own and operate my jet, the company’s only business. I may regard the LLC as a kind of alter ego; after all, I’m the sole owner, and it’s doing only what I could do myself—operating the aircraft. But the FAA doesn’t look at it that way. It considers my LLC a completely separate legal entity. Now I’m not flying myself around anymore; the LLC is flying me around. Put differently, my LLC is providing air transportation to a different person—me. And providing air transportation to others for compensation or hire requires, according to the FAA, a commercial certificate, which the LLC doesn’t have.

As this runs somewhat contrary to conventional asset protection wisdom, it is important to be familiar with these and other FAA regulations when dealing with aircraft.

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The Bypass Trust: To "B" or Not to "B"?

For many years, estate planners recommended planning that involved an "A/B trust" structure whereby assets of the first spouse to die equaling the estate tax exemption in value would end up in a trust to preserve that spouse's estate tax exemption. This prevented the surviving spouse from being "left with the couple's assets, but only their own individual exemption." Depending on a number of factors, this strategy could potentially save millions of dollars in estate taxes.

The costs of this trust, which is known by many names including a "B Trust," "Credit Shelter Trust," "Family Trust," or "Bypass Trust," are not insignificant. The surviving spouse's access to the assets of the B Trust are necessarily restricted, tax returns must be filed each year the trust is in existence and has income, legal responsibilities are imposed on the surviving spouse or a non-spouse trustee for trust management, and there is no step-up in basis for the B Trust assets at the surviving spouse's death.

Until recently, these costs could easily be justified by the potential estate tax savings. After the American Taxpayer Relief Act, however, the law allows the deceased spouse's unused exclusion amount to be transferred to the surviving spouse without the need for a B Trust. The unused exclusion must be calculated, and an election to transfer the unused exclusion made, on a timely filed estate tax return of the first spouse to pass away.

Rev. Proc. 2014-18, effective January 27, 2014, allows for an extension of time to make this "portability" election for decedents who passed away in 2011, 2012, or 2013 and who were survived by a spouse. Such elections, made in conjunction with the filing of an estate tax return, must be filed by December 31, 2014.

There are still benefits of a B Trust, namely, asset protection for the assets held by the trust, asset appreciation value that is excluded from estate tax, and greater certainty that the bequests contemplated by the first spouse to die will be carried out. However, the estate tax benefits to the B Trust have been reduced.

While it a good idea for everyone to review their estate plan every few years anyway, it is particularly appropriate for those with A/B trust provisions included in a revocable trust package to review whether that is still appropriate. For surviving spouses stuck managing a B trust that is no longer justified, it is appropriate to have the trust reviewed to see if it can be modified to better achieve that spouse's objectives.

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Charging Order Remedies

A charging order is a statutory provision of law that allows a creditor of a company’s owner to take distributions made to the owner by the company. It is a limited remedy designed to protect innocent owners by preventing a creditor from disrupting business activities by seizing or controlling company interests. Because the creditors cannot control the entity, they cannot control when distributions are made, meaning that the creditors get nothing if the business never makes a distribution. Limited partnerships and limited liability company statutes, but not corporation statutes, generally limit a creditor to a charging order.

As an example of how charging order protection works, assume that Jane forms a new Corporation and contributes $10,000. Jane is the Corporation’s 51% owner, and her husband John owns 49%. The Corporation prospers and is worth $10 million some years later. At that time, Jane is driving her personal car negligently and runs over and kills a doctor; she incurs a $10 million judgment. Because her business is formed as a corporation, the estate of the doctor can levy on Jane’s stock, thereby gaining control of the Corporation, and sell its assets in satisfaction of the judgment. This will result in Jane’s loss of employment and in the liquidation of the corporation at a substantially discounted price, with her husband receiving 49% of the discounted proceeds.

However, if Jane had initially organized her business as a limited liability company, the exclusive remedy for the estate of the doctor in most jurisdictions is a charging order. As such, the estate would be entitled to distributions that the LLC makes, but nothing more; it cannot levy on Jane’s LLC interest, fire her, or liquidate her company.

Because limiting a creditor to a charging order is designed to protect the innocent members in a business entity, this limitation may not apply where a limited liability company has only a single member. In fact, a number of courts have held that creditors of the sole member of an LLC are not limited to the charging order remedy and that they may seize the debtor’s LLC interest. Accordingly, a single member LLC by itself cannot be relied upon to provide meaningful asset protection.

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Defective Grantor Trust Overview

Irrevocable trusts are an essential part of sophisticated estate planning. Such trusts are normally used to hold assets that have been gifted or otherwise transferred by a grantor. Assets within irrevocable trusts, including future appreciation, are not included in the grantor’s estate for estate tax purposes.

A standard irrevocable trust is treated as a separate entity for income tax purposes and will be taxed on the income at the trust level. However, if an irrevocable trust is “defective,” the deemed grantor of the trust will be taxed on the income of the trust instead. This means the trust is disregarded for federal income tax purposes; such trusts are known as “grantor trusts.”

An intentionally defective grantor trust can be an effective planning technique for several important reasons. First, as with any irrevocable trust, the assets held within the trust are generally protected from creditors.

Second, since the trust is not a separate taxpayer, a sale to the trust by the grantor is not a recognizable transaction for income tax purposes and no gain will be recognized. Such a sale is often structured as an installment sale with a promissory note that has a self-cancelling feature effective upon the death of the grantor. This results in the balance of the note being excluded from the estate of the grantor; similarly, any increase in the value of the asset will also occur outside of the grantor’s taxable estate.

Third, since income generated by the irrevocable grantor trust is taxed to the grantor, the payment of that tax liability by the grantor is, in effect, a gift-tax free benefit to the trust and ultimately to the trust's beneficiaries. Since the trust is irrevocable, the trust principal will not be included in the taxable estate of the grantor. Therefore, the grantor can transfer assets into the trust by sale without the recognition of an income tax event, not have the trust assets included in his or her gross estate at death, and continue to reduce the value of his or her estate by the income tax payments on the trust income.

Although President Obama's current budget proposal would eliminate the value of using intentionally defective grantor trusts as an estate planning strategy, such trusts currently remain a useful tool.

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Asset Protection for IRAs

What is the best way to ensure that an Individual Retirement Account (IRA) is protected from the claims of creditors? As with any asset, developing a protection plan should include considering the following questions: Is the asset already protected by state or federal statute? Can the asset be moved or the owner's residence changed so that the asset would be protected by the statutes of a different jurisdiction? Can an unprotected asset be converted to a protected asset? Can the asset be protected by incorporating a protective structure?

Applying this framework to IRAs, the first consideration is whether the IRA is already protected by state or federal statute. The 50 states and the federal government provide a patchwork of statutory protection for various types of assets in various scenarios. IRAs are protected up to $1 million under federal bankruptcy statutes.

However, states may "opt out" of the federal exemptions and require that debtors filing for bankruptcy in a district within that state be subject to the state exemptions instead. While some federal bankruptcy provisions will always trump state law, the IRA provisions do not. California, for example, has opted out of the federal exemptions and only offers limited protection for IRAs.

If an asset is not already statutorily protected, the next question is whether the asset can become statutorily protected by utilizing the laws of another state. For example, Florida has very liberal asset protection laws for real property, so purchasing a property in Florida can offer protection from creditors. However, since IRAs don't have a distinct physical location, they tend to be governed by the owner's state of residence; and the only alternative would be to move and establish residency in a state that protects IRAs, such as Washington state.

If changing domicile is not an option, another is to convert an asset that is not protected into an asset that is protected. Converting cash to real estate is one example mentioned previously. Given the special tax treatment of IRAs, any such strategy would need to avoid tax penalties. While IRAs may not be protected in a particular state, 401(k) and other ERISA-qualified retirement plans are under federal law that trumps any state law affording 401(k)s less protection. In Patterson v. Shumate, 504 U.S. 753 (1992), the United States Supreme Court confirmed that creditors may not reach an individual's interest in ERISA-qualified plans, whether in a bankruptcy, lawsuit, or otherwise.

However, only certain kinds of IRAs can be rolled into a 401(k). Inherited IRAs may not be rolled into a 401(k), neither can non-deductible IRA contributions. Only IRA funds that constitute tax-deductible contributions or a previous 401(k) rollover can be rolled over into a 401(k). Furthermore, the employer and the 401(k) plan administrator must approve the rollover.

If converting the non-protected asset into a protected asset is not an option, placing the asset into a protective structure such as an irrevocable trust or LLC should be considered. Almost without exception, income-producing property such as rental real estate should be owned by an entity, probably an LLC, for asset protection purposes. While the owner of an IRA must be the individual, an LLC can still be incorporated by changing the investment of an IRA to a limited liability company with a friendly manager. This will work to invoke the protections provided by LLC statutes. In order for this strategy to work, the IRA must be managed by a custodian that allows self-directed investments.

In summary, if an asset is not protected by state or federal statute, consider whether it can be moved or the owner's residence changed, whether the unprotected asset can be converted to a protected asset, or whether the asset can be protected by incorporating a protective structure.

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Section 179 Deductions for Non-Corporate Lessors

For asset protection purposes, business capital assets should normally be owned by a separate entity, as opposed to the business operating entity, and then leased back to the operating entity. A non-corporate leasing entity can still qualify for the favorable tax treatment of newly-purchased business assets under IRC § 179, which allows businesses to expense certain depreciable assets instead of depreciating them over a longer period of time. However, two additional requirements must be followed.

First, the term of the lease (including options to renew) must be less than 50 percent of the class life of the property. Second, for the 12 month period after the property is transferred to the lessee, the lessor's deductions attributable to the property (not including rents and reimbursed amounts) must exceed 15 percent of the rental income paid by the lessee.

In Ross P. Thomann v. Commissioner (TC Memo 2010-241), as discussed by Paul Bonner in the July 2011 Journal of Accountancy, the IRS disallowed a section 179 deduction for farm equipment primarily due to the lack of a written lease that clearly identified the property leased and the lease term. The taxpayer also presented no documentation of class life or a comparison of lease income with the lessor's deductions.

In order to avoid denial of the 179 deduction like the taxpayer in Thomann, documentation is the key. The lease agreement should clearly document each property being leased as well as the asset class life of each property so as to ensure that the term of the lease, taking into account options to renew, is less than half of the class life. Furthermore, the rent attributable to each property being leased should be documented, as well as the expenses, to ensure and demonstrate that deductions exceeding 15 percent of the rent income are taken by the lessor in the first 12 months. The lease agreement may need to specify that the lessor is responsible for expenses under the lease, and the lessor may need to frontload scheduled maintenance, insurance, etc. to ensure the 15 percent requirement is met.

By undertaking these steps, both asset protection and significant tax benefits can be realized.

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Personal Residence LLC and Trust Tax Considerations

Some asset protection attorneys recommend placing personal residences into entities, while others prefer trusts. While both have their pros and cons, no decision should be made without ensuring that the federal tax benefits of owning a personal residence are maintained.

The Internal Revenue Code provides a significant tax advantage to taxpayers who own a personal residence. First is the interest deduction of as much as $1 million of acquisition indebtedness and up to $100,000 of home equity indebtedness on a qualified personal residence. Taxpayers who do not hold legal title to a residence but who can establish they are the equitable owners of the property are entitled to deduct mortgage interest paid by them with respect to the property. Transferring a personal residence into an asset protected entity should not affect this deduction as long as the taxpayer remains the equitable owner of the property.

Second, and more important, IRC § 121 provides for an exclusion from taxable income of $250,000 ($500,000 for married couples) worth of gain on the sale of a personal residence. This exclusion may be claimed every two years as long as the taxpayers owned and used the property as their principal residence for two out of the previous five years prior to the sale.

Treas. Reg. § 1.121-1(c)(3)(i) provides that if a taxpayer owns his or her residence in a trust, as long as the taxpayer is treated as the owner of the trust, he or she is treated as owning the residence for purposes of satisfying the two-year ownership requirement. Treas. Reg. § 1.121-1(c)(3)(ii) provides that if an individual taxpayer owns his or her residence in an entity, as long as the entity has the taxpayer as its sole owner and is disregarded for federal tax purposes, he or she is treated as owning the residence for purposes of satisfying the two-year requirement.

One other possibility exists in community property states where a married couple owns the limited liability company 50-50, as the entity can elect to be taxed as a disregarded entity under Rev. Proc. 2002-69. The couple will be able to own their residence in the LLC and satisfy the two-year requirement.

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