Asset Protection

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I have been involved in many premarital agreement situations where the parties got upset and decided the negotiations were hurting their relationship, so they decide to drop it.  In Texas, there is an option, however, for the person of means to pursue that can be done without the knowledge or consent of their fiancee.

The moneyed fiancee can create a limited partnership and contribute the assets he or she wants protected to it.  This should maintain the separate property character of the assets contributed to the partnership during the marriage as long as the assets remain in the partnership.  Distributions from the partnership are thought to be community property, and the moneyed finacee should be aware that some assets, such as royalty payments, are separate property and contributing them to the partnership could convert those payments to community property.

The moneyed finacee also should be aware of the Jensen rule, and pay him or herself reasonable compensation for his labor and services rendered to the partnership to avoid a claim for community reimbursement.

While not as effective as a well-drafted premarital agreement, the use of a  limited partnership offers the moneyed finacee a way to provide significant protection if things don’t work out for better or worse.

Recently, the Alaska Supreme Court in Toni 1 v. Wacker put a nail in the coffin of domestic asset protection trusts as effective creditor protection for out of state donors.   After a Montana state court issued a series of judgments against Donald Tangwall and his family, the family members transferred two pieces of property to the “Toni 1 Trust,” a trust allegedly created under Alaska law. A Montana state court and an Alaska bankruptcy court found that the transfers were made to avoid the judgments and were therefore fraudulent. Tangwall, the trustee of the Trust, then filed suit, arguing that Alaska state courts have exclusive jurisdiction over such fraudulent transfer actions under AS 34.40.110(k). The Alaska Supreme Court concluded this statute could not unilaterally deprive other state and federal courts of jurisdiction, therefore it affirmed dismissal of Tangwall’s complaint.

Planners have long wondered if the full faith and credit clause of the US Constitution would prevail over state laws in DAPT states.  The answer is “yes” in Alaska.  It likely is “yes” anywhere else in the United States.

You can still do a DAPT for estate planning reasons, and they do provide asset protection as a trust in the state of the donor’s residence would.  You just can’t avoid a judgement in the donor’s state of residence by fraudulently transferring assets to a DAPT created in another state.

You can still create a foreign trust which isn’t subject to the constrains of the US Constitution, but foreign trusts raise another set of issues.

When in comes to asset protection planning, do it when the skies are clear and have other reasons for doing it.

Proposed regulations were issued in November under Code Section 2010 addressing the possibility of “clawback” when the temporary high exemption amount reverts to pre TCJA levels (adjusted for inflation).  The good news is that the proposed regulations state that clawback will not occur if one fully uses his or her exemption amount prior to sunset.  The bad news is that the proposed regulations did not address the issue of what happens if you only gift the temporary exemption increase during the period when the temporary high exemption is in effect.

The consensus at Heckerling was that if you only gift the exemption increase you will not have any remaining exemption left after sunset, other than annual increases for inflation.  So it is “use it or lose it.”

Here in Texas and other community property states, we can offer you ways to fully utilize the temporary high exemption amount without losing income on gifted assets and obtain some asset protection in the process.   The time to act is now, however, since it is very possible that the current political environment could result in a termination of the temporary high exemption amount as early as 2021.

If you own real property outside of your state of residence when you die, you will have to conduct an ancillary probate in that state to transfer title to the property to your beneficiaries.  In some states, like Texas, ancillary probate is a simple process of recording copies of the out of state probate in the state in which the real property is located.  In others, the process is more complicated and will require hiring an attorney in the state and prosecuting a court proceeding.

One way to avoid ancillary probate is to form a limited liability company (LLC) or limited partnership (LP) to own the out of state property.  If the client does this then he will no longer own real estate out of state.  Instead, he or she will own an interest in an entity that owns real estate in that state.  Accordingly, there is no longer the need to prosecute an ancillary probate.  The entity can be formed in the client’s state of residence, the state the property is located or some other jurisdiction.  It doesn’t matter.  Use of the LLC or LP also adds a layer of asset protection for the client.

Note that using an LLC or LP doesn’t mean the client will not owe property taxes or income taxes (if a rental property) in the state in which the property is located.

Texas has one of the most expansive homestead laws in the country.    Homestead designation protects the homeowner from creditors claims, other than certain taxes and loans secured with the homestead. This blog post will cover the types of Texas homesteads, and who benefits from homestead designation.

Types of Homesteads

There are two types of homesteads, urban and rural.  You have one or the other, not both.  An urban homestead is limited to ten acres and is located in a municipality served by police and fire protection with at least three municipal services provided, such as water, electricity and gas.   A rural homestead is any homestead that doesn’t meet the criteria for an urban homestead.  A family can have a rural homestead of up to 200 acres, a single person 100 acres.

Tex. Prop. Code Ann.  41.002

Who May Claim Homestead Protection

Family

A family may claim homestead protection.  A family is a head of household, and those bound by blood or marriage that are depend on the head of household for support.  This covers a spouse and minor children, but may include adult children in certain cases, such as an adult child living with a parent while attending college.

Single Adult

A single adult can claim homestead protection for an urban or rural homestead, but, in the case of a rural homestead, the homestead is limited to 100 acres instead of 200 acres.

Surviving Spouse

The deceased spouse’s homestead rights pass to the surviving spouse so long as the surviving spouse continues to occupy the homestead.

Surviving Minor Children

The surviving minor children of deceased parents, have the right to claim their deceased parents’ homestead for the duration of their minority.  This right pertains even if the minor children were not living in the home at the death of the parents.

The special occupancy rights of the surviving spouse or surviving minor children persist unless abandoned.  The burden of proving abandonment is on the party seeking to terminate the homestead rights.

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Asset protection planning is complicated.  While estate and trust law changes very slowly, debt/creditor law can be quite dynamic in comparison.  Good planning needs to take the long term perspective, and avoid a cookie cutter appearance.

Based on my experience, there are a few general rules I follow.

  1.   Pigs get fat, and hogs get slaughtered.  If there are any potential liabilities on the horizon, do not put assets in excess of those potential liabilities into an asset protection structure.
  2.   Stay Home.  A judge in the state of your residence is not going to like (i) an offshore arrangement, (ii) a nonresident domestic asset protection trust or (iii) an LLC or limited partnership organized under the laws of another state.  There is a lot you can do under the laws of the state of residence.  Focus there first.
  3.   Control.  There is an inverse relationship between the amount of control you retain and the effectiveness of your  planning.  Trust planning is most protective with an independent trustee with unfettered discretion over distributions.   Cultivate a close relationship with a financial institution with a trust company.  A corporate fiduciary with whom you have a close relationship can be a significant asset when undertaking asset protection planning.
  4. Business or Estate Planning Purposes.  The best asset protection planning is planning that has the primary objective of meeting a business or estate planning purpose, with the ancillary benefit of asset protection.

If you follow these general rules, then you castle will have a solid foundation rather than a foundation of sand waiting to be blown away in a storm.

 

In my last blog post I noted that it might be a good time to reconsider discount planning with family limited partnerships (FLP).  That thought has only increased over the last few weeks as the chances for tax reform dwindle.  Indeed, while political predictions are a fools game, we now have to seriously consider a move left in 2020 and, at best, a stalemate until then.  The move left could endanger discount planning again, so the next few years might be a window to make use of this kind of planning.

While this planning can involve transfers downstream via dynastic trusts, it can also involve leveraging the lifetime exemption using FLP discounts via gifts to spousal lifetime access trusts (SLATs).  A SLAT is an irrevocable trust benefiting the spouse, and then descendants.   Each spouse can create their own SLAT, provided they avoid the reciprocal trust doctrine, and the marital estate can still have use of the gifted assets during their joint lives.  In December of 2012, with the risk of the lifetime exemption being reduced, many, many SLATs were implemented.

SLATs raise a number of issues to work through, in addition to the aforementioned reciprocal trust doctrine, but, in the right circumstances, they over an elegant solution that offers a bit of a have your cake and eat it too flair.

Given my experience with my mom, it is not surprising that the first topic I want to cover is who should be named trustee.  The truth is that there is no single answer to that question, because trusts (which are simply vehicles where beneficiary ownership is separated from legal ownership) are created for many different reasons.  The trustee, who holds legal title and owes the beneficiary a fiduciary duty to manage the assets held in the trust for the beneficiary’s benefit, can be an individual, an institution or even the beneficiary, depending on the purpose of the trust.

Spendthrift Protection

Many trusts are created to take advantage of spendthrift protection.  In Texas, like most states, a trust created for a beneficiary other than the grantor (the person establishing the trust) provides some level of protection from the creditors (called spendthirft protection) of that beneficiary if someone other than the beneficiary is trustee or, if the beneficiary is trustee, the trustee is limited in making distributions to an “ascertainable standard.”  The typical ascertainable standard is the “health, education, maintenance and support” of the beneficiary.  Words matter here, and Texas is very strict.  In Lehman v. United States, 448 F. 2d 1318(5th Cir. 1971) the court held that use of the word “comfort” along with support and maintenance was enough to negate an ascertainable standard.

Estate and Gift Taxes

Ascertainable standard is very important for estate and gift taxes as well.  The IRS looks to state law to determine if an ascertainable standard exits, and, if it does, then it is possible for trust property to pass from one beneficiary to another without estate or gift tax consequences.  So, for example, if dad creates a trust for his son for the son’s life and then to the son’s descendants  , the trust property will escape estate taxes at the son’s death.  Of course, the initial funding of the trust by dad is a gift, but that is a topic for another day.

Often trusts are created for estate tax savings where spendthrift protection is a secondary consideration.

May or Shall

As I said words matter here, and the use of the words “may” or “shall” before the distribution standard impacts the creditor protection significantly.  Use of the word “may” means the distribution is discretionary.  Use of the word “shall” means the distribution is mandatory.  Of course, if the distribution is mandatory, it provides less creditor protection than if the distribution is discretionary.

Who is the Trustee

Finally, who the grantor names as trustee impacts the level of creditor protection.  A trust naming the beneficiary as trustee with an ascertainable distribution standard will provide a modicum of creditor protection.  A trust naming an independent person as trustee with a wholly discretionary distribution standard provides the highest level of creditor protection.   Care should also be taken in selection of successor trustees or successor trustee selection methods.

Trusts are not one size fits all.  You essentially start with a clean canvas.  It is up to the attorney to carefully discuss with the client all options and objectives and inform the client about the benefits and risks of each option along the decision tree.