Helping clients to protect their assets from lawsuits, malpractice claims, divorce, and other risks is a vital part of any estate plan. With the waning importance of estate taxes to the process, practitioners can give increased attention to this type of planning. Every practitioner should be able to provide some level of planning service in this regard. However, recognizing the limitations of knowledge and those issues for which a specialist might be advisable to involve will be prudent. Even practitioners with limited knowledge in this area can provide valuable service being the catalyst for this type of planning. Also, being independent of the client, the client’s business and risks, will assure the practitioner the objectivity clients cannot have for their own issues. Bringing a “new eye” of an outside professional alone will often enable practitioners to identify a range of issues for the client to address. Planning can range from the simple (you have to keep independent records for a business) to the much more complex (how might you structure a self-settled asset protection trust to minimize the risks involved). There is much ground in between. The following checklist might be a helpful starting point. But in all instances, use common business sense, general accounting knowledge, an understanding of the client’s business endeavors, and objectivity to identify issues and planning opportunities. Asset protection planning should be undertaken in a broad context looking at every aspect of a client’s business, investments, insurance, estate planning and more. This checklist focuses only on the use of entities in this context.
√ Operate Safely
Is the client operating their business, investment and personal affairs in a safe and rational matter? Many clients become so focused on growing a business that they neglect a myriad of common sense “safe” practices. Has the client reviewed resources made available from business and industry trade organizations on safe practices (have you reviewed articles and materials available from the AICPA on minimizing liability risk? Have you kept current with new ethics pronouncements and cases?). There is a wealth of literature that can provide practical planning ideas for every business.
√ Operate Under Entity Solution
Is the particular business endeavor operated in an entity format to minimize liability exposure in the event of a suit or claim? While larger businesses are typically operated in entity format (S corporation, LLC, etc.) surprisingly many are not. Many clients buy investment real estate, rent that real estate to a tenant and do not realize that the potential liability associated with that common investment. Instead of owning the property jointly, it should be held in a limited liability company. Don’t assume that clients have addressed this obvious planning step.
√ Entity Format Provides Limited Liability
Not every entity will provide limited liability for the client/equity owner. A general partnership provides no liability protection. The use of a limited partnership usually provides liability protection for the limited partners but not for the general partnership. If a client has used a limited partnership entity to own a business or real estate investment and serves as the general partner there will be no protection. It may be feasible to restructure the general partner so that it is an entity owned by the client to address this limitation.
√ Governing Documents Support Intended Result
A properly structured entity may still not achieve the intended results. For example, an LLC may have been formed to hold a real estate investment. Ideally the governing legal documents should have been prepared with an objective to provide and enhance liability protection. While the governing documentation could provide the liability protection desired for the client, if the certificate forming the LLC, or the operating agreement governing the LLC were improperly drafted, it could undermine that objective. An operating agreement that grants each member the right to force the liquidation of his or her interest in the entity, might negate the asset protection permitting a creditor to insist that the same rights be enforced in favor of the creditor. Why might this occur? It might be nothing more than inadvertence. Perhaps the attorney preparing the documents used a form from another transaction that was not appropriate to the instant transaction. Perhaps it was intentionally negotiated for reasons unrelated to liability protection. Practitioners should actively work with the client’s legal counsel to provide this type of technical review.
√ Entity Should be Formed in a Favorable State
The legal entity used to insulate the client’s business or investment should be formed in a state whose laws are favorable to asset protection goals. If the entity has been formed in the client’s home state, or perhaps a different state where the real estate, business or other asset held by the entity is located, inquire of the client’s legal counsel whether consideration was given to forming the entity in a state with more protective laws. Many attorneys automatically form entities in the state where they practice and the client resides with no consideration to the potential benefits of using a more favorable state. If the client’s counsel is not able to address this it might be necessary to consult with an attorney with greater specialization. If the client entity was formed in a state whose laws are not as favorable to asset protection as might be desired it may be feasible to form a new entity in a better jurisdiction and transfer the existing entity to the new entity or merge the existing entity into the new entity.
√ Segregate Assets in Different Entities
Remember what mom said about asset protection planning? Mom always advised never to, “keep all your eggs in one basket.” That was sage advice. If a client has five retail stores each store should be a separate entity. That might facilitate achieving some insulation of liability under each store lease (depending on the terms of the lease and guarantees, etc.). If each store/entity signs its own lease it might be feasible that if there is a problem for one store’s lease the other operations are not affected. Similarly, it may be feasible to limit liability from one store from the others concerning premises liability. So if a customer is injured on store number 2’s premises perhaps the value of Stores 1, 3, 4 and 5 may remain protected. If a client has a manufacturing facility the building might be held in a separate LLC and leased to the operating entity. That segregation of operations may create some demarcation between the different risk levels (e.g., the widget manufacturing operation might have a much higher risk of suit then the mere ownership and rental of the facility). If a client has a fleet of trucks to deliver the widgets manufactured, those might be owned in a separate shipping entity given the potential risk of accident or injury from shipping and operating heavy vehicles. In most situations clients focus on growing their business and direct insufficient attention to entity structural matters. Practitioners are likely to find that all operations might be conducted in a single enterprise. At that point it may be possible to split a corporation into several corporations to achieve better asset protection planning. If this can be brought within the ambit of IRC Sec. 355 it may be done on a tax-free basis. State law may also contain a specific statute permitting corporate divisions. For LLCs the state law may not provide a clear-cut mechanism but the client’s corporate counsel might be able to structure the division.
√ Intercompany Transactions Should be Documented
Loans are often the culprit of a claimant “piercing the corporate veil.” That legal phrase means that a claimant is able to demonstrate that the client so disregarded the legal form and formalities of the corporation that the client should not be able to “hide” behind the “veil” of the corporation and protect his or her personal assets from the reach of a business creditor or claimant. If a client routinely withdraws money from a corporation without any documentation or formalities being adhered to, the claimant might assert that the client has so disregarded the corporate entity, and used corporate funds for personal use, that the corporation should not protect the client’s home and personal investments from attack.
Practitioners that complete business entity returns (e.g., 1065, 1120, 1120S) should insist on copies of all documentation corroborating loans and that interest be paid and proof provided. Doing so might prevent the client from falling into the above morass of having the entity disregarded in a lawsuit. Practitioners should request clients authorize and pay them to maintain proper and complete permanent files for all entities for which returns are prepared. Few clients will understand the importance of this until practitioners educate them. The above planning should be much broader than merely loans and corporations. An LLC might also be pierced. Loans are but one related party transaction that should be addressed. If a client or family member is employed by an entity, steps to corroborate the arm’s length nature of the compensation and perquisites paid could be important to backstopping the proper operation of the entity. If the client’s business is divided into several different entities as discussed above the payments for rent and all related party transactions should be reasonable and should have corroborating legal documentation/agreements supporting them.
Practitioners should recommend that clients authorize them to expand the scope of involvement and services for all client entities for which they prepare returns to help guide clients to use those entities to achieve the liability protection for which they were formed.
Martin M. Shenkman is the author of 35 books and 700 tax related articles. He has been quoted in The Wall Street Journal, Fortune, and The New York Times. He received his BS from the Wharton School of Pennsylvania, his MBA from the University of Michigan, and his law degree from Fordham University.