familyownedbusinessblog

Asset Protection Trusts

A common misconception is that a trust provides asset protection for the person who created the trust.  Generally, that is incorrect.  Most trusts do not provide asset protection for the settlor (the person who creates the trust).  When a settlor creates a revocable trust (a trust that the settlor may change) the settlor's creditors have the right to access the trust's assets to satisfy claims against a settlor.  If a settlor creates an irrevocable trust (a trust that cannot be modified) and the settlor is a beneficiary of that trust, the general rule is that the settlor's creditors can reach the trust's assets.  

However, if a settlor establishes an asset protection trust (APT), the APT can provide liability protection to the settlor for the trust assets and the settlor may have limited access to those assets. There are generally two types of APTs – foreign and domestic.  A foreign trust is one that is established in a country other than the

United States

.  A domestic trust is one that is established and governed by the laws of a state in the United States. There are less than 15 states that have provisions for an APT.  Each state has different rules and requirements to create an APT. 

An APT may be an appropriate asset protection tool for (1) professionals at high risk of litigation (physicians, engineers, architects, etc.); (2) couples seeking an alternative to a prenuptial agreement; (3) people wanting to protect a nest egg; and (4) people who are vulnerable to financial scams.

Estate planning for the closely-held business: freeze techniques

The gist of an estate “freeze” technique is to lock-in for estate tax purposes a low valuation of any assets—such as an ownership interest in a small or medium sized business—that is likely to appreciate in value in the foreseeable future. Such techniques are well-regarded even in the best of economic environments, let alone times such as these when many owners of small and medium sized businesses have seen valuations on those businesses drop, albeit hopefully only temporarily.

A simplified example is illustrative. Say Ms. Howard is the 75-percent shareholder of a medium-sized business. As of August, 2009, the value of Ms. Howard’s shares is $3,000,000. Let’s presume that Ms. Howard implements a freeze technique on the value of those shares, which are still valued at $3,000,000. Let’s also assume that Ms. Howard goes on to live an additional 15 years, eventually passing in 2024. Upon Ms. Howard’s passing, her ownership interest in the business is valued at $5,000,000. If Ms. Howard’s freeze technique is successful, then her ownership interest in the business will still be valued at $3,000,000 rather than $5,000,000 for estate tax purposes.

Please keep in mind, however, that as with most tax related issues, there are multiple conditions associated with freeze techniques to which business owners and their advisors should pay close attention. Moreover, there are a number of different mechanisms available to implement a freeze, including gifts, loans, and trust agreements. This blog post outlines the conditions for one particular freeze technique, with more discussion about alternative methods and other attributes coming in future posts.

One technique for freezing the value of business ownership interests is to execute a buy-sell or option agreement with a business associate or partner who does not also happen to be a family member. If three conditions are satisfied, the buy-sell or option agreement should effectively freeze the value of those ownership interests. First, the buy-sell or option agreement must be a “bona fide business arrangement.” Second, the buy-sell or option agreement must not be a devise to transfer the property to family members “for less than full and adequate consideration in money or money’s worth.” Finally, the terms of the buy-sell or option agreement must be “comparable to similar arrangements entered into by persons in an arm’s length transaction.”

A common hurdle for owners of closely held businesses attempting to satisfy those three conditions is establishing that the buy-sell or option agreement is "comparable to similar arrangements entered into by persons in an arm’s length transaction." Many closely held businesses do not, for example, make those types of agreements public. Nonetheless, determining whether a buy-sell or option agreement is comparable to similar agreements entered into by persons in an arm’s length transaction will entail a consideration of such factors as:

• The expected term of the agreement;

• The current fair market value of the property subject to the agreement;

• Anticipated changes in value of that property during the term of the agreement; and

• The adequacy of any consideration given in exchange for the rights granted.

One method that can be effective in addressing the above “comparability” condition is to commission a professional appraisal of the business interests, and then to use that appraisal in negotiating a price for the buy-sell or option agreement.

Of course, each business and business owner is different, so please evaluate the viability of any freeze technique with your business and tax advisors. Future posts will discuss some alternatives to the above freeze technique.

Prenuptial Agreements - Estate and Asset Protection Planning

A prenuptial agreement can be a useful tool for contracting around a surviving spouse's statutory rights.  This is especially true in the case of a second marriage or domestic partnership where there are children from prior relationships.

If a married or registered domestic partnership couple reside in Oregon at the time of death, the surviving spouse or registered partner is entitled to elect against the decedent's will and take a portion of the decedent's estate.  Under current law, that share is 25% of the decedent's estate.  This right can be waived by an agreement in writing signed before or after the marriage.

Oregon also provides a homestead allowance for a suriving spouse, registered domestic partner and/or dependent children.  They have the right to continue to occupy the place of abode after a decedent's death for a period of one year.  The occupants must keep the property insured, pay property taxes and maintain the residence.

The court may also order support for the surviving spouse or registered partner or dependent children from a decedent's estate.  This support may include the transfer of title of property or periodic payments.  This support has priority over other creditors and designated beneficiaries within a will.  Also, the support is not counted against the recipient's inheritance from the decedent.

If a decedent dies without a valid will, then their estate will be distributed according to intestate succession.  Under Oregon intestate succession law, a surviving spouse or registered domestic partner will receive all of a decedent's estate, unless there are children from a prior relationship.  In such cases, all of the decedent's children will receive 50% of the net intestate estate and the surviving spouse or registered domestic partner will receive the other 50%.

If your estate planning intent is something other than these statutory rights for your future spouse or registered domestic partner, then you should consider a prenuptial agreement as part of your asset protection or estate planning.

Managers found independently liable for unpaid wages under the FLSA

Stacey Mark, partner at Ater Wynne, recently posted an article on our aterwynneblog.com about a Ninth Circuit decision that individuals may be liable for unpaid wages as "employers" under the Fair Labor Standards Act (FLSA). You can view that article here.

Reasonable Compensation

A common problem for family-owned corporations involves compensation.  The Tax Code allows the corporation to deduct "reasonable" compensation.  Pay too much, and the IRS might re-characterize the excessive compensation as a non-deductible dividend.  Pay too little and the IRS may assess penalties and interest for underpaying employment taxes. 

A common example: mom and dad own the business but their three sons run it.  Their daughter is listed as a corporate officer but does not provide services to the company.  She receives payments equal to her brothers, in order to avoid hurt feelings.  Since she provides no services, all of the payments are nondeductible, taxed at the corporate level (at corporate rates) and again taxed to daughter personally.

When considering how to compensate family members, keep in mind several things:

• Compensation is payment for the value of services rendered to the corporation.  If someone is not providing services, they should not receive compensation.  Those family members providing services should be paid the fair value of those services, not based upon ownership interests, relationships, or other factors unrelated to their service.
• Document compensation arrangements with written employment agreements signed at the beginning of a fiscal year (or that cover several years in advance).  The agreement should describe the services provided and the compensation (both in cash and benefits) paid for such services.
• When making changes to compensation arrangements of corporate officers or executives, document the reasons for the change and the new amount in the minutes of the Board, then update the written agreement.
• Avoid large year-end bonuses, especially those based on a percentage of corporate profits, which looks very similar to a dividend.  Instead, use larger salary amounts, and base bonuses on stated performance metrics and the recipient's salary.
• Consider electing S corporation status, which entirely eliminates the corporate-level income tax concerns.  Since taxes accrue and are paid only at the individual level, electing S corporation status eliminates the income tax distribution versus compensation issue (although it may still exist for employment tax purposes).

In our example above, since the sister does not work for the corporation and is not an owner, she cannot receive either compensation or distributions.  If the goal is to provide income to the sister, that will require she provide services to the corporation (perhaps as a Board member, if not as an employee) or become a shareholder entitled to dividends. 

Intersection Between Estate Planning and Asset Protection-Tenancy by Entirety

This is the third in the series discussing the intersection of estate planning and asset protection. This discussion features tenancy by entirety which is a form of tenancy only allowed for married couples and, where available, registered domestic partners  The deed must either include the words "Harry and Wilma, tenants by entirety" or "Harry and Wilma, husband and wife". For registered domestic partners, it would be "Sally and Sara, registered domestic partners as tenanats by entirety."  (No court has inerpreted the Oregon Family Fairness Act with regard to this issue yet).

If the ownership is characterized as tenancy by entirety, Oregon case law provides that the debts of one spouse cannot attach to the property unless both husband and wife (or domestic partners) are liable for the debt.

For example:  Wilma's creditor obtains a judgment lien against Wilma's interest in the home she shares with Harry as tenants by entirety. In this case, the creditor cannot force the sale of the home because Harry has an one-half undivided interest in the entire home and he is not a party to the judgment. The creditor must wait to see which of Wilma or Harry dies first. If Harry is the first to die, the creditor can force the sale. If Wilma is the first to die, her creditor is out of luck.

In the event Harry and Wilma divorce, their tanancy by entirety is automatically converted to a one-half interest as tenants in common. The creditors of either Harry or Wilma can attach the property and force a sale of the one-half interest.