Transfer and Management of Assets in Domestic Asset Protection Trusts

Transfer and Management of Assets in Domestic Asset Protection Trusts

Once a domestic asset protection trust (DAPT) or other type of trust has been created, it is of no benefit until it is funded with assets. Trust assets typically include: (1) cash (2) securities (3) LLCs (4) business assets like intellectual property, inventory and equipment (5) real estate and (6) recreational assets such as aircraft and boats. Each asset under consideration for transfer into a DAPT must be evaluated from different vantage points, including its effect on: legal protection, taxation, business and growth potential, and future distributions to a spouse and heirs. Thus, the asset transfer planning process is a critical planning area requiring the assemblage of a range of skill sets.

Substantial Relationship

To withstand attack, a DAPT should be designed to have its most substantial relationship to the state where the trust is formed, not the settlor’s state of residence. In a closely-contested legal battle, the location of the trust assets in the trust state could be determinative of the case outcome. Consequently, on a case-by case basis, it may be wise to consider these planning steps: (1) office securities accounts in the trust state (2) hold valuable and/or risky business and recreational assets in trust state LLCs, and (3) place real estate in trust state LLCs. Later, we will consider whether settlor businesses should be held in LLCs.

Securities

Settlors should only fund DAPTs with assets having a long-term need horizon. This is particularly true for securities assets which by nature require careful management. Over the decades, we have learned there is a tendency for clients to tilt toward the promise of higher return over lower risk. To overcome this potentially dangerous tendency, the investment process should begin with each client understanding and defining his or her acceptable risk parameters. Then a long-hold portfolio should be developed that maximizes the return potential for the chosen level of risk. Due to the strongly-held belief that skilled risk management will increase returns over time, we believe this is best achieved by applying the asset allocation and risk management principles pioneered by the Nobel Laureates from the University of Chicago. This quantitative approach inevitably provides clients the opportunity to choose from portfolio models offering varying degrees of risk.

Cash

Convenience is an important element in managing a DAPT. We have found it optimal to hold cash and securities in a single investment account. Such an account will allow the trust to easily invest cash in a variety of safe and effective cash equivalent vehicles, such as money market funds, treasury funds and short-term bond funds.

Real Estate

Jurisdictional difficulties are presented with real estate assets because, of course, a piece of land can’t be relocated to the trust state. Restatement (Second) of Conflicts of Laws § 276 provides that “ the administration of a trust of an interest in land is supervised by the courts of the situs as long as the land remains subject to the trust”. With exceptions (e.g., see, Walker v. W. Mich. Nat’l Bank & Trust, 324 F. Supp. 2d 529, 534 n. 3 (D. Del. 2004), aff’d., 145 Fed. Appx. 718 (3d Cir. 2005), this position is supported by case law. The logical solution is to transfer real property into an LLC formed in the trust state. Although this approach should be evaluated with caution (e.g., planners must consider matters like state transfer taxes and mortgage lender approval), the weighing of risk and reward may well lead to the transfer being worthwhile.

The Business LLC

In many cases, the settlor’s business LLC will have been formed by a local attorney in his or her home state. Depending on the state, this may be problematical. To understand the concern, a little background on LLC protection is needed.

All LLCs are designed to insulate their owners’ personal assets from claims arising from the business. Without such protection, it would be too dangerous for entrepreneurs to invest capital in businesses with inherent risks. This concept, called internal protection, goes back to the industrial revolution and is a foundation of our commercial system. Traditional “C” corporations also provide internal protection, but they suffer from the double taxation of income. Contrarily, LLC income is directly passed through to its member owners and taxed only once. LLCs are also simpler to operate. Consequently, most entities formed today are LLCs.

Just as important, LLCs can provide external protection. Suppose you host a Christmas party for friends and an inebriated guest leaves the party and becomes involved in a car accident where someone is injured or killed. As a “deep pocket,” you could be sued and, although you are certain it was not your fault, suffer a judgment for millions of dollars. This is where knowledgeable asset protection planning comes into play. The plaintiff’s attorneys will find the task of seizing assets owned by a properly structured LLC in a legally-favored state considerably more difficult.

LLC protection works like this. Generally, when a creditor obtains a personal judgment against a defendant, it becomes the creditor’s responsibility to identify the defendant’s assets adequate to satisfy the judgment, and then obtain a court order to seize those assets. But, if properly planned, the LLC members’ interests will not be treated like other assets. The creditor’s legal remedy will be limited to obtaining a lien, called a “charging order.” Charging orders allow the creditor to obtain a court lien against distributions made to the member’s interest; but they do not allow the creditor to step into the defendant’s shoes and become a member of the LLC, with rights to its assets. Thus, if the LLC chooses not to distribute assets or income to its members, they will not be available to the judgment creditor. Moreover, only the member owners are entitled to determine whether or when distributions will be made.

The majority of states’ laws do not include the language needed for optimal LLC planning. For an LLC to be truly effective, it should be formed in one of just a few states with favorable LLC laws or in one of an even more limited number of states where true privacy can be ensured. Clients should be aware that, if the LLC owns real property located in the client’s domicile state, a local court may try to exercise jurisdiction over the property, notwithstanding its out-of-state LLC ownership. Whether this “in rem jurisdiction” will play a part in the outcome depends on the case’s specific facts and the LLC’ structure; therefore, knowledgeable counsel should be consulted before creating or transferring assets into an LLC.

Equipped with a better understanding of LLC protection, lets now revisit the question of whether clients who have formed LLCs to hold their business assets should transfer the LLC assets into a trust state LLC or leave them inside the LLC in their home state. Technically, there are several viable techniques available for making tax-free transfers of LLC assets into a new LLC formed in the trust state. The real question is whether the transfer will be viewed by the courts as a ruse.

Definitely, we know that, if the transfer is the result of an effort to hinder, delay or defraud a known or contemplated creditor, it can be reversed as a voidable transaction (fraudulent transfer). Later, in a legal challenge to the trust, the plaintiff may also raise theories such as “alter ego” and “piercing the corporate veil,” but these challenges already exist even if there is no transfer. Such risks can only be reduced by maintaining and managing all LLCs with lawyerly attention. Assuming the transfer is not to avoid an existing or foreseeable creditor, we see no reason why the transfer can’t be made. The legal issue should be strictly a matter of whether the transfer is a voidable transaction. So, in many cases, a reorganization of the LLC into the trust state may be a viable option that should be investigated.

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Liberty Street Advisory Group refers to the separate entities, Liberty Street Law, Liberty Street Capital and Trust & Estate Stewards. None of these entities or persons furnish actuarial, accounting or comprehensive tax advice. Liberty Street Law is a law firm, and does not provide investment management, or any financially-related services. Liberty Street Capital, is a limited liability company registered as an investment advisor in Georgia and other locations. Trust & Estate Stewards is a limited liability company. Past results are not a guarantee of future performance.