July 2006
Domestic Asset Protection Trust Ownership Options
To further enhance the protections offered by your FLLC, you may
wish to consider layering in a domestic asset protection trust (DAPT)
to hold your membership interests. Until recently, these types of
self-settled spendthrift trusts were not domestically available.
The overriding public policy in the U.S. has dictated that if a
person creates a trust for his or her own benefit, the Settlors
creditors should be able to reach the maximum amount that the trustee
could pay to the Settlor under the terms of the trust. In an effort
to provide an alternative to International Asset Protection Trusts,
however, some states (of which Alaska, Delaware, Missouri, Nevada,
Colorado, Rhode Island, and Utah are a few) have adopted legislation
prohibiting a Settlors creditors from attaching the assets, even
where the Settlor is permitted to receive distributions from the
trust and to share in the trust principal.
These types of trusts have been around internationally for many
years, and there is a significant body of supporting case law. In
the U.S., however, DAPTs are relatively new and there is a great
uncertainty as to their effectiveness since states differ on whether
these trusts violate basic public policy. This difference of opinion
presents the inevitable legal battle to balance the competing concerns
regarding the states promoting DAPTs with those that prohibit them.
The primary issues yet to be resolved involve the choice of law/conflicts
of law doctrines as well as the impact of the Full Faith and Credit
Clause in the U.S. Constitution. In short, we do not yet know which
states laws will apply in a given case, nor do we know if a resulting
judgment will be upheld. Until these issues are resolved through
the federal court system or legislature, some uncertainty will remain
regarding the overall value of DAPTs. Consequently, we recommend
using DAPTs only in conjunction with your ownership of a properly
formed FLLC. In this manner you enjoy two levels of protection,
with the charging order protections of the FLLC serving as a back-upin
the event the DAPT is held to be invalid.
June 2006:
1. Family Limited Liability Company
To revisit from above, the liability protection associated with a properly formed LLC is derived from the protective statutory provisions of certain jurisdictions as well as the courts, which provide two layers of protection: 1) creditors of an LLC cannot attach the assets of the Members to settle a claim, and 2) through what is known as a charging order, creditors of the Members cannot attach the assets of the LLC to settle a claim. A charging order only grants the creditor the right to step into the economic shoe of a member, which essentially provides that, in the event there are distributions to Members, then, and only then, will the holder of the charging order receive payment. Since you will maintain control over the Manager of the LLC, and can control such distributions, it is unlikely that the LLC would ever make such distributions as long as a creditor held a charging order of significant value. Moreover, even if distributions are not made to the Members, it is believed that the holder of a charging order is still subject to taxes on his or her percentage ownership of Company profits (a tax which the creditor would have to pay on phantom income). Consequently, a holder of a charging order faced with paying taxes on income he or she has not received will typically have a strong incentive to withdraw or settle a claim, and disappear.
2. Single Member Limited Liability Companies / Limited Partnerships
LLCs combine the best features of state substantive law with the best features of federal income tax law. Generally, LLCs offer limited liability to their owners, a choice of either centralized or owner management participation, transferable interests, only one level of tax, income allocable by agreement and the pass-through of losses, all without significant ownership restrictions.
LLCs are generally treated as partnerships or disregarded for income tax purposes. The advantage of an LLC over a partnership is that an LLC offers limited liability to all of its members, whereas, in a partnership, even a limited partnership, at least one partner (the general partner) has liability exposure. In contrast, no member of an LLC has personal liability for the debts of the LLC, barring guarantees or other special arrangements between members and creditors. Although this problem can be handled in a partnership by using a corporate general partner, if the corporate general partner is a C corporation, tax will be imposed on the profits of the partnership at the corporate level to the extent they are allocated to the corporation.
The advantage of an LLC over a C corporation is that an LLC is treated as a partnership or disregarded entity for income tax purposes. A C corporation pays tax on its earnings at the corporate rate and upon a distribution to the stockholders, the stockholders pay tax on the dividends. Partnership tax treatment, under which only a single tax is paid at the member level, is therefore, preferable.
An LLC owned by a single member is disregarded as a separate entity for income tax purposes. This means a single member LLC will not file a separate income tax return and will not necessarily be taxed as a partnership. Instead, the single member LLC takes on the tax attributes of the parent. If an individual owns the LLC, it is taxed on Form 1040. If the owner of the LLC is a partnership or corporation, the LLC is reported on the parent's tax return as a separate division. Even though there are no tax benefits to a single member LLC, it is a powerful tool for other reasons.
A single member LLC can be a useful asset protection device. Like multiple member LLCs, the single member LLC provides limited liability for the owner, even though it is similar in appearance to a sole proprietorship. A client may use this entity to provide a layer of protection between liability generating assets. In a multiple asset LLC, a judgment related to one of the assets can be satisfied by the collective assets of the LLC. In other words, the liability exposure of one asset in a multiple asset LLC could in effect contaminate the other assets. For example, a judgment against one rental property in a multiple property LLC could be enforced against the other rental properties. As a solution, each of the properties of the LLC could be segregated into separate single member LLCs.A judgment against the single member LLC will only be satisfied with the assets in that LLC, thereby separating the liability exposure from the other properties.