Asset Protection: Limiting Liability & Lowering Taxes
April 21, 2014
By Brad Huss, E.A., CFP
One of the unfortunate realities in today’s America is the risk posed to both businesses and individuals by the threat of litigation. The National Center for State Courts estimates that approximately sixteen million civil lawsuits are filed in the United States every year. The Economic Journal reports that Americans spend more on civil litigation than any other industrialized country; and The Association of Trial Lawyers of America informs us that the annual cost to the economy from these lawsuits is over two hundred billion dollars.
Knowing that the United States is the most litigious country in the world, it is important to be fully aware of how to protect your assets. There are numerous legal strategies that may be employed in order to protect assets from litigation and many also have the benefit of reducing both estate and income taxes. The utilization of corporations, limited liability companies, and trusts can be especially effective.
A corporation is an independent legal entity, separate from the people who own, control, and manage it. Legally, the corporation is a “person” that can enter into contracts, incur debts, and pay taxes apart from its owners. The owners of a corporation have limited liability and are not personally responsible for the corporation’s debts. In order to maintain their status as a separate entity, corporations must observe certain formalities such as holding annual meetings of shareholders and directors, as well as keeping minutes of these meetings. Corporations must also keep detailed financial records, file separate tax returns (Form 1120) and pay taxes at corporate rates. S corporation status may be elected, which allows profits to pass through to be reported on the shareholder’s tax return. Corporations are an excellent entity for operating a business, but are generally not a good vehicle for holding investment real estate.
A limited liability company enjoys the liability protection of a corporation along with the flexibility and pass through characteristics of a partnership. Unlike a corporation, the limited liability company does not have to observe the same formalities regarding annual meetings and minutes. Limited liability companies with two or more members can operate as a partnership, corporation or S-corporation for tax purposes. A single owner limited liability company is considered to be “disregarded” and can operate as a sole proprietorship or as a corporate entity. A limited liability company is a great vehicle for operating a business venture as well as for holding investment real estate. In addition, a family limited liability company can be formed for asset protection as well as estate and income tax reduction.
A trust is an entity created to hold assets for the benefit of certain persons or entities. There are two types of trusts:
1) Revocable trust, which is also known as a living trust. This type of trust provides both privacy and probate avoidance; however, it does not offer asset protection during the life of the grantor. There is also no tax benefit associated with a living trust.
2) Irrevocable trust. This type of trust does offer both asset protection and potential estate and income tax benefits, however, effective control of conveyed assets are governed by the trust agreement rather than the grantor. There are numerous types of irrevocable trusts that may be utilized. Here are some examples:
A) Life Insurance Trust – Trust owns the life insurance policy and excludes the proceeds from the deceased’s taxable estate while still providing for the beneficiaries.
B) Charitable Remainder Trust – Allows you to convey highly appreciated property (real estate/securities) to the trust. There is no income tax upon sale of the appreciated asset(s) and the proceeds may be invested to allow for a lifetime income stream to the grantors. There is also a large charitable deduction generated when the assets are conveyed to the trust and the asset is no longer part of the grantors estate which provides asset protection and reduces the value of the taxable estate.
C) Grantor Retained Interest Trusts – These trusts reduce estate taxes by removing assets from the grantor’s taxable estate. Property is conveyed to the trust and beneficicieries are named, but the grantor retains an interest (income, annuity, property rights) for a set period of time. Once the time period is over, the beneficiaries own the property which, for estate tax purposes, is valued as of the date that the trust was created.
We are all aware of the potential risks that exist in the litigious environment that we live in today. To quote Benjamin Franklin, “An ounce of prevention is worth a pound of cure”. It is crucial that you learn how to protect your assets by educating yourself and putting a strong asset protection plan in place before you need it.