The Los Angeles County Bar Blog

Asset Protection for a Married Couple

There are several scenarios for married couples to consider in asset protection planning: To protect assets from creditors or potential lawsuits, to provide for a spouse and/or minor children after death, and to protect oneself in the event of a divorce. 

When it comes to ownership of assets between spouses there are two legal systems in play in the United States: common law and community property. 

In common law states, assets acquired during marriage but in only one spouse's name are treated as separate property in regards to debts and/or lawsuits, but in the event of a divorce, are considered marital property in the division of assets.  In common law states, it is good practice to hold assets in the name of the person with the least debts or who is least likely to be a party to a lawsuit. 

California is a community property state.  This means is that all assets acquired during marriage are considered community property.  A creditor of one spouse can reach all community property.  This extends to contracts signed by either spouse, as well as debt acquired prior to marriage. 

Community property may be converted or "transmuted" from community to separate property of either spouse by utilizing a transmutation agreement.  But be careful--transmutation of real property will only be effective with third party creditors if it is in writing and properly recorded.  The law of fraudulent transfers does apply to transmutation agreements, so transfers must occur prior to any collections or judgments to be effective in protecting assets. While transmutation agreements are generally desirable from an asset protection standpoint, they may have adverse tax consequences.

Another effective form of asset protection for a married couple is asset protection through a trust, which can provide a barrier of protection for trust beneficiaries in the event of death.  When assets are owned by a trust instead of an individual they are more likely to be protected from creditors (as well as from any potential unwise decisions or spendthrift habits of the beneficiaries.) 

A trust can also help blood relatives to protect property against divorce, thereby keeping "family" property in the family.  Putting family assets (vacation property, family heirlooms, or "old money") in trust will allow blood family--parents, and siblings--specify that assets owned by the trust can only be managed by blood relatives and descendents, thus keeping them out of the hands of spouses or ex-spouses.

For any married couple, the first step in protecting assets should be a prenuptial agreement.  Prenuptial agreements may be drafted to be neutral as to the two spouses, but offer protection from third-party creditors. 

NEW ESTATE TAX LAW PUTS VIABILITY OF MOST EXISTING ESTATE PLANS IN DOUBT

On December 16, 2010, Congress passed and sent to the president the "Middle Class Tax Relief Act of 2010."  The law contains the most sweeping change in the taxation of estates in 29 years.  It also contains a ticking time bomb that might explode in the faces of the beneficiaries of many trusts.  As a result of the new law, many existing estate plans no longer work, and many others will cause actual harm.  Every married couple's existing estate plan should at least be reviewed, if not scrapped.

Here are the major estate tax changes:

            · The exclusion from estate tax for citizens and residents is increased to $5 million.  If a person dies with an estate under valued at under $5 million, his or her estate pays no estate tax.  The $5 million exclusion will increase based on cost-of-living adjustments.  The exclusion was $3.5 million in 2009.

            · If a decedent's estate exceeds $5 million, the rate of tax on the excess is reduced to 35%.  The highest rate was 45% in 2009.

            · A married couple can shield $10 million from estate taxes.  If the first to die of a married couple (the "deceased spouse") does not use his or her $5 million exclusion, the administrator of the deceased spouse may elect to give the unused exclusion to the surviving spouse.

It is this last change, the "portability" of unused estate tax exclusions, that will cause many estate planners--and their clients--to question the viability of their existing estate plans. 

In order to understand the problem, we must focus on a basic estate tax concept, the "unlimited marital deduction" (UMD).  With a couple of minor exceptions, if a person dies and leaves his or her estate to his or her surviving spouse, the UMD says that there are no estate taxes on the first death, regardless of the size of the estate.  No fancy estate planning is required in order to qualify for the UMD.  For example, were Bill Gates to write a one-sentence will on the back of an envelope saying "I give everything to my wife when I die," the UMD would kick in, resulting in his widow receiving the entire estate free of estate taxes.  The theory behind the UMD is that married couples should be treated as a unit, with estate tax coming due only on the death of the surviving spouse.

The interplay of the exclusion and the UMD resulted in married couples losing one estate tax exclusion.  Let's assume Mr. and Mrs. Jones, a married couple with a $7 million estate.  If Mr. Jones had died in 2009, when the exclusion was $3.5 million, leaving everything to Mrs. Jones, the UMD results in no estate taxes on Mr. Jones's death.  If Mrs. Jones had also died in 2009, the IRS would have allowed a $3.5 million exclusion to Mrs. Jones's estate and would have taxed everything above $3.5 million, resulting in a estate tax of $1,455,800.  If Mr. and Mrs. Jones had never met and never married, and each had died in 2009 with a $3.5 million estate, the combined estate tax would have been zero!

For many years, the IRS has allowed married couples to avoid this result by means of a trust that, unlike Bill Gates's hypothetical one-sentence will, does require some fairly sophisticated estate planning.  The planning device is an “A-B” trust, and it operates as follows:  Let's assume that Mr. and Mrs. Jones's estate is valued at $7.1 million, and that Mr. Jones died in 2009, when the exclusion was $3.5 million.  Upon his death, the estate divides into two subtrusts, a "Marital Deduction Trust," (the "A" trust) and a "Credit Shelter Trust" (the "B" Trust.)  The "B" Trust is allocated an amount equal to the exemption in effect in the year of the deceased spouse's death ($3.5 million).  The "A" Trust is allocated the balance, i.e. $3,600,000.  On Mr. Jones's death, the Marital Deduction Trust is not subject to estate tax because it qualifies for the UMD.  The "B" Trust is subject to estate tax, but the assets allocated to it equal Mr. Jones's exemption, resulting in no tax.  So far, we have not done anything to avoid estate taxes for Mr. Jones or Mrs. Jones; a one-sentence will leaving everything to Mrs. Jones would have sufficed to completely avoid estate taxes on Mr. Jones's death. 

The magic that is the A-B trust becomes apparent on the second death.  Let's assume Mrs. Jones also died in 2009.  The $3.6 million in the "A" trust is subject to tax, Mrs. Jones gets her $3.5 million exemption, and only $100,000 is subject to tax.  None of the assets in the "B" trust are subject to tax. 

In order for the A-B technique to work, the "B" Trust must restrict Mrs. Jones's use of the property. She may not have a "general power of appointment" over the property, i.e. the unfettered right to dispose of the property.  Usually, her power to invade the trust is limited to Mrs. Jones' "health, education, support and maintenance" needs, which shouldn’t cramp her style, but is less than the complete discretion she has over the "A" Trust.  Not having a general power of appointment over the assets means that she is deemed not to own the assets, and if she is deemed not to own them, her estate is not taxed on them.

All this will be unnecessary on January 1, 2011.  Starting then, Mr. Jones's executor will be able to give Mr. Jones's unused $5 million exemption to Mrs. Jones, even with a one-sentence will written on the back of an envelope.  The potential problem lies in those A-B trusts that pre-date the new law, and the problem is not an estate tax issue; it's an income tax issue.

One of the biggest benefits of the Internal Revenue Code is the "step-up" in basis when a person dies.  For example, had Mr. Jones bought Ford Motor Company stock for $10 per share, and sold it during his lifetime for $100 per share, he would have realized a $90 capital gain.  But if Mrs. Jones had inherited the stock from Mr. Jones, she would have obtained a $100 date-of-death basis in the stock, and all of the gain inherent in the stock would have been forgiven.  Had she later sold the stock for $101, her capital gain would have been $1, not $91.  But in order to obtain a step-up, the asset must be included in a decedent's estate, and none of the assets in the "B" trust are included in the decedent's estate.  In our example, if the Ford stock had increased in value from $100 to $300 following Mr. Jones's death, their children would receive a $100 basis in the stock, not $300.

In prior years, we weren't much troubled by this result.  We were willing to forego the step-up in basis in order to avoid the estate tax, because estate tax rates were always higher (45%) than capital gains rates (15%).  But with a married couple now able to shield a $10 million estate from estate taxes without an A-B trust, any married couple with an estate small enough so as to likely not incur an estate tax will now find that their "B" trust is an income tax albatross.  These married couples will lose the basis step-up, with all of the resulting capital gains taxes, without any corresponding estate tax savings.

In addition to the tax detriment that is inherent in the A-B trust, there is a non-tax reason that many existing A-B trusts may now no longer meet their creators' needs.  In order to qualify for the estate tax benefits of the A-B trust, the tax code instructed us how to write those trusts.  Specifically, following the first spouse's death, the surviving spouse may freely alter or amend the "A" trust, the "B" trust becomes irrevocable following the first spouse’s death.  Many people were willing to suffer this consequence if it meant a substantial reduction--or elimination--of estate taxes.  But for married couples with an estate that is not likely to reach $10 million, this consequence may no longer be acceptable.

There are some circumstances when a "B" trust may be desirable for nontax reasons, and those still remain intact.  For example, the first-to-die spouse may want some assets to be placed in an irrevocable trust to make certain that the children receive those assets, and not the survivor's new love interest.

Bottom line: Any married couple with an A-B trust should, at the very least, have it reviewed.  Depending on the size of the estate and the nature of the assets, many married couples will wish to amend or revoke their existing estate plans. 

McCourt Divorce Sheds Light on Asset Protection

Show of hands, who has not heard of the McCourt divorce case?  If you live in Los Angeles there is barely any other news coverage.  While public divorces of the rich have always made great fodder for gossip journalists, this divorce sheds some light on a frequently used, but infrequently discussed, asset protection technique. 

In community property states like California, assets that are deemed community property can be reached by creditors of either spouse.  Whenever we have a client that is married and has a creditor problem, we will always consider making some community property assets the separate property of the other spouse.  This is commonly accomplished through a form of a post-nuptial agreement known as the transmutation agreement (more on those below).

Advantages of Foreign LLCs

Many foreign jurisdictions have enacted LLC statutes.  A lot of these jurisdictions are so-called tax havens, which generally means that an entity organized in that jurisdiction will not be taxed by that jurisdiction if the entity is not conducting any business in the jurisdiction.  If a U. S. business or U. S. real estate is owned by an entity organized in a tax haven, the entity will not be doing any business in the tax haven and will not be taxed there.

In most offshore jurisdictions with LLC statutes, the LLC laws are similar to the U. S. state LLC laws.  Thus, LLC members enjoy limited liability, and the protection of the charging order.  Additionally, many offshore jurisdictions provide that the charging order is the sole remedy of the creditor, with no right to foreclose.

Pursuant to the traditional choice of law analysis, the law of the jurisdiction where an entity is organized will govern the entity, even if the business is transacted elsewhere.  For example, California Corporations Code Section 17450(a) provides:

The laws of the state or foreign country under which a foreign limited liability company is organized shall govern its organization and internal affairs and the liability and authority of its managers and members. 

The only time when this choice of law will not be respected is when the application of the laws of the foreign jurisdiction will violate the public policy of the state where the LLC is conducting business.  Because the LLC statutes of offshore jurisdictions are very similar to the U. S. LLC statutes, it is unlikely that the offshore statutes will be ignored for public policy reasons.

Thus, as opposed to exporting the assets to a foreign jurisdiction, a foreign LLC allows to import the law.  While the asset protection safeguard is not as high, for many debtors it may be the only viable option.

This means that if a California resident organized a Nevis LLC to hold Idaho real estate, a creditor attempting to collect against the California resident would have to rely on the Nevis charging order statute.  The Nevis charging order statute limits the creditor to the charging order, with no right to foreclose.

It is important to remember that a foreign entity that does not want to be taxed as a corporation for U. S. tax purposes should make an affirmative election to be taxed as a partnership or a disregarded entity by filing IRS Form 8832.

Some U. S. jurisdictions (like, Nevada) similarly restrict creditors to the charging order, with no right to foreclose.  What is the advantage of a foreign LLC to a domestic LLC all else being equal?

The advantages are: (i) extra costs and expenses incurred by a creditor in pursuing a debtor to a foreign jurisdiction, and (ii) the favorable asset protection laws of the foreign jurisdiction.   This is especially significant in light of the Olmstead decision.

Florida Supreme Court Limits Application of LLC Charging Orders

In a recent decision (Olmstead v. FTC, Supreme Court of Florida, June 24, 2010), the Florida Supreme Court held that the charging order protection, an "exclusive remedy" for creditors pursuing LLC interests, is actually not the exclusive remedy, despite the plain meaning of the statute.

In a fairly difficult to read and follow opinion, the Court held that Florida's general collection statute authorizing liens and levys on all assets, was not limited by the charging order statute despite the fact that the charging order statute provides that it is the exclusive remedy for a creditor pursuing an LLC membership interest.

This is really a case of statutory interpretation and nothing more.  But as far as statutory interpretation goes, this is more of a case of judicial legislation. 

The dissent opinion is a lot more logical (and easier to read).  I particularly enjoyed the fact that the dissent partially relied on an article written by me a couple of years ago on LLC charging order protection.

I hope the Florida legislature will act quickly to re-write the statutes to read that the charging order is "really, really, really the exclusive remedy."

The text of the decision follows:

Swiss Parliament Blocks Disclosure of Information, For Now

A week after the upper house of the Swiss parliament voted to allow disclosure of UBS clients to the US government, the lower house of Switzerland's parliament voted to prevent the disclosure of the names and financial secrets of as many as 4,450 Americans who held undeclared accounts at UBS.

A Swiss court had already ruled that commitment illegal, and the Swiss Federal Council had sought the parliament's retroactive endorsement in a creative effort to salvage the deal.

"We expect that the Swiss government will continue to honor the terms of the agreement," IRS spokesman Frank Keith said in a written statement. "We continue to monitor the events in Switzerland, and we stand ready to pursue all legal options available to us should the Swiss fail to provide the required information."

If the Swiss fail to comply with the deal by the deadline in August, the U.S. government will face difficult choices. It can proceed with the indictment of UBS, which could, in theory, shut down UBS operations in the US, or impose multi-million dollar fines.  They can also reach some other compromise with the Swiss.

The CFO for UBS AG told analysts, earlier today, that he expects that ultimately the names will be handed over.

Because the two houses of parliament voted differently, they would need to try and work out a compromise.  If they cannot, it will set up a national referendum in Switzerland.  While the Swiss banking sector is an extremely important part of the Swiss economy, many Swiss view their banks as a cause of current financial woes.

HIRE Act Incorporation Foreign Account Reporting Requirements

The Hiring Incentives to Restore Employment (HIRE) Act (Pub. L. No. 111-14) was signed into law on March 18, 2010. The Act creates tax breaks for businesses hiring new workers and extending higher expensing limits for small businesses that make capital investments. The Act also incorporates provisions of the Foreign Account Tax Compliance Act of 2009, which has far-reaching implications for foreign financial institutions that may have U.S. clients.

A. Withholding Tax Provisions
There are withholding taxes to enforce new reporting requirements on specified foreign accounts owned by specified U.S. persons or by U.S.-owned foreign entities.

Every foreign financial institution is encouraged to enter into an agreement with the United States that would require it to:
- Obtain information regarding each holder of each account to determine if the account is a U.S. account;
- Comply with verification and due diligence procedures set by the United States;
- For every U.S. account, annually report to the IRS information regarding account holder, balances, income and withdrawals;
- Withhold 30 percent on all payments to recalcitrant account holders and to other foreign financial institutions that have not entered into such an agreement;
- Provide any other information regarding the account requested by the United States and;
- Insist that the owners of U.S. accounts waive local bank secrecy laws, and close the accounts of those who refuse to do so.

Those foreign financial institutions that refuse to enter into such an agreement are subject to withholding of 30 percent on all payments to them of U.S. source dividends, interest and similar investment income, and on the gross proceeds of all sales of U.S. securities and other assets that produce interest or dividends.

For this purpose, U.S. accounts are accounts maintained by specified U.S. persons or U.S.-owned foreign entities. The latter includes foreign corporations and partnerships that are more than 10 percent owned by specified U.S. persons; grantor trusts with U.S. persons as grantors; and non-grantor trusts in which a specified U.S. person holds, directly or indirectly, more than 10 percent of the beneficial interest. Among others, "a specified U.S. person" includes a U.S. natural person, a U.S. corporation (other than a publicly held corporation) and a U.S. partnership.

"Recalcitrant account holders" are account holders who refuse to provide information to allow the institution to determine whether the account is a U.S. account.

For this purpose, "financial accounts" include depository accounts, custodial accounts, and equity or debt interests in a financial institution itself, other than interests that are regularly traded on an established securities market.

These rules are in addition to the existing qualified intermediary rules and are effective for payments made after December 31, 2012.

B. Foreign Trust Provisions
The provisions governing foreign trusts have been amended to broaden the U.S. grantor trust rules as applied to a U.S. grantor of a foreign trust, tax U.S. beneficiaries on uncompensated use of trust property, and tighten the foreign trust reporting rules applicable to U.S. grantors and beneficiaries alike.

The U.S. Internal Revenue Code (the Code) is now reconciled with Treasury regulations, which provide that a foreign trust created by a U.S. person is deemed to have a U.S. beneficiary unless for that taxable year there is a specified class among whom distributions may be made, none of whom is a U.S. person. There is now a rebuttable presumption that every foreign trust created by a U.S. person has U.S. beneficiaries. There is now a requirement that a U.S. grantor provide information requested by the IRS with respect to the foreign trust, in addition to ensuring the foreign trust files an annual information report.

There is a new rule that treats the use of real or tangible property held in a foreign trust as a trust distribution to a U.S. beneficiary, U.S. grantor or related person if fair market rent is not paid.

There is now a minimum penalty of $10,000 for failure to report transfers to, or distributions from, foreign trusts, and a maximum penalty that could be greater than the value of the transfer or distribution.

These rules are effective on the date of enactment and for transfers made or uses of property after the date of enactment, or taxable years beginning after the date of enactment, as the case may be.

C. Other Provisions of Interest
There is a new disclosure requirement imposed on U.S. persons with respect to "specified foreign financial assets" that exceed $50,000; this is in addition to existing Foreign Bank and Financial Account (FBAR) filing requirements. "Specified foreign financial assets" include foreign depository or custodial accounts, foreign stock or securities, financial instruments or contracts issued by or having a counterparty who is not a U.S. person, and any interest in a foreign entity.

There is a new accuracy-related penalty for underpayment of taxes attributable to undisclosed foreign financial assets, and the statute of limitations has been extended to six years in certain cases. An "undisclosed foreign financial asset" is one that is subject to certain information requirements specified in the Code and for which the required information is not provided.

A U.S. shareholder with an interest in a Passive Foreign Investment Company (PFIC) must now file an annual information return, regardless of whether a taxable event has taken place in that year.

These rules are effective for taxable years beginning after the date of enactment, except for the PFIC reporting which is effective on the date of enactment.

Swiss Court Rules Against the IRS

On January 22, 2010, the Swiss Federal Administrative Court published its first judgment with respect to the IRS's request for information. The case relates to a UBS client who failed to provide the bank with a Form W-9.

The Swiss court ruled against the IRS and stated that no information will be provided by UBS to the IRS. The judgment is final and is not subject to appeal. The judgment holds that the U.S. Treasury agreement with the Swiss government dated August 19, 2009, is merely a Memorandum of Understanding and does not derogate the U.S.-Swiss income tax treaty. The court further concluded that the failure to provide the bank with Form W-9 does not amount to tax fraud.

This decision is now persuasive on all other cases pending in Swiss courts with respect to disclosure of information to the IRS on accounts of U.S. citizens.

This decision is good news for US taxpayers, but maybe insufficient in the long run. It is expected that the Obama administration will continue to exert pressure on the Swiss government to amend the U.S.-Swiss income tax treaty, allowing disclosure of information relating to Swiss bank accounts. If the tax treaty is amended and the amendment is ratified by the Swiss parliament, this court decision will be moot.

For now, there is a glimmer of hope for U.S. taxpayers with unreported Swiss bank accounts.

Tax Amnesty Deadline Passes; UBS Sends Sends Warning Letters to Clients

As the October 15 deadline has come and gone, many people have reported receiving letters from UBS. These letters advise clients that after an initial investigation, UBS has determined that the client's account will likely be disclosed to the IRS. This has, understandbly, sent a wave of panic through many clients.  But it is too early to panic.

UBS was ordered a couple of weeks ago, by a Swiss court, to begin notifying clients as early as possible that their identity may be disclosed to the IRS. UBS has not completed its analysis yet and does not yet know the identity of the accounts that will be disclosed.  That is scheduled to happen by November 18.  In the meantime, UBS has played it safe and is notifying all of their U.S. clients that their account may be disclosed.  Which is technically accurate. Statistically, only 10% of all US accounts are expected to be disclosed.

Details of UBS Deal Revealed

The IRS has announced today that UBS will reveal names of 4,450 American account holders.  The actual names have not yet been released, and over the next few months these account holders will receive notices from UBS that their names will be disclosed to the IRS.  The account holders will then have the option of appealing the proposed disclosure to the Swiss appellate court on the grounds that the disclosure would violate Swiss banking secrecy laws.  It is not yet clear how successful such appeals may be.

The IRS has indicated that these 4,450 accounts hold approximately $18 billion, or about $4 million per account (the number is probably even higher because a lot of these accounts have already been closed and money moved out).  Obviously the focus of the disclosure is on the larger accounts.

U.S. taxpayers have until September 23 to voluntarily disclose unreported bank accounts (and possibly avoid criminal penalties and significantly reduce civil penalties).  There is no guaranty that a U.S. person with an undisclosed UBS account will find out before September 23 whether their account will be disclosed.  We strongly caution these individuals to contact UBS and find out whether their name will be disclosed.

Based on the voluntary disclosure program, the IRS has collected names of many other banks where Americans keep undisclosed bank accounts.  The IRS has announced that it may start pressuring other banks to disclose names of American account holders.  If you still have not disclosed a foreign bank account, please talk to a tax attorney to determine your options.