Domestic Asset Protection Tools

Legislatures in several states have passed asset protection laws in an attempt to attract investment capital from people looking for legal tools to protect themselves from creditors.  Creative attorneys, working with state legislators, have passed statutes that protect assets located within their respective states.  As a result, several states have amended their trust and limited liability laws to provide substantial asset protection.  These types of asset protection statutes are intended to help residents of all states, not just residents of the state where the laws were passed.  These tools include, for example, the Delaware Series LLC, Domestic Asset Protection Trusts, and Equity Stripping.

Delaware Series LLC

Many corporations own and operate more than one business, and likewise, many individual real estate investors own multiple properties typically titled under a single name or business entity.  A problem with “single-pot” ownership of multiple businesses or properties is that any legal liability relating to one business or property jeopardizes all other assets.  Therefore, most owners of related businesses and real estate investors with several properties seek to separate ownership so that lawsuits against one business or one property will not jeopardize the owner’s other investments.  Traditionally, liability segregation meant setting up different business entities to own each business or property.

The Delaware legislature created a new type of limited liability company, the Delaware Series LLC, to solve this planning problem by permitting a single limited liability company to own multiple subsidiary limited liability companies each of which owns a single-asset business.  Although a Series LLC must be created in Delaware, it can register to do business or own property in any other state.  This innovative concept allows one LLC to establish separate series, or units, under the same LLC umbrella.  Each unit of a Series LLC can own distinct assets, incur separate liabilities, and have different managers or members.  A Series LLC pays one filing fee and files one income tax return each year.

Under Delaware statutes, liability incurred by one unit does not cross over and jeopardize assets titled in other subsidiary units of the same Series LLC.  The Delaware Series LLC, in theory, offers superior and more economical asset protection under a single roof, although the same liability isolation can be achieved in any state with multiple entities.

Each Series or “cell” in a Delaware Series LLC is supposed to be operated as a separate entity.  This means that each Series should have separate meetings, minutes, and resolutions of action.  Each Series should maintain distinct financial books and accounts.  Failure to segregate the books and records of each Series may give a creditor grounds to pierce the veil of the Series or the entire LLC.

There are practical applications for a Delaware Series LLC.  One such use is ownership of multiple parcels of real property in separate series within a Delaware Series LLC.  This is less expensive than creating, filing, and maintaining several different LLCs to segregate property ownership.  Second, an operating business could benefit from a Delaware Series LLC if the business owns real estate used in its operations.  If the business were formed or merged into a Delaware Series LLC, one series could own the real estate and a different series could operate the business.  Liability incurred by the business operations in a Series, in theory, would not jeopardize the real estate owned by another Series within the LLC.  In addition, there should be no sales tax due on rent paid by the operating series to the real estate series.  Another possible benefit of a Delaware Series LLC is the ability to transfer assets among related businesses without income tax on built-in gain or liability for real estate transfer taxes.

Given the protection possibilities and planning flexibility provided by the statutes establishing Delaware Series LLCs, one might expect to see the Delaware Series LLC prevalent in Florida.  Yet, Delaware Series LLCs remain relatively uncommon in Florida and other states.  One reason is the uncertainty about how a Delaware Series LLC will be taxed for federal income tax purposes.  A recent article by the prestigious and widely-followed BNA Tax Management Service, Tax Management Memorandum, Vol 45, No. 4, February 23, 2004, concluded that the lack of clear federal tax standards for a Series LLC with multiple members restricts adoption of this potentially useful business entity.  The second reason is that the asset protection and planning advantages of the Series LLC are only theoretical and unproven in actual asset protection outside of Delaware.  Florida state courts and Florida bankruptcy courts have not decided the asset protection effectiveness of a Delaware Series LLC.  Therefore, business people, investors, and advisers should proceed cautiously pending further court interpretation before relying on this new device to protect their wealth from creditors.

Domestic Asset Protection Trusts

A domestic asset protection trust is a self-settled trust that is protected from judgment creditors by state statute.  A “self-settled trust” is a trust where the person who creates the trust and transfers the assets to the trust is also a trust beneficiary.  A living trust (used for estate planning) is a common example of a self-settled trust.  Under Florida law established by a long and consistent line of court decisions, a self-settled trust does not protect the trustmaker’s beneficial interest in the income or principal of the trust from the trustmaker’s creditors.

Offshore trusts provide asset protection benefits mainly because statutes in select foreign countries state that a trustmaker’s beneficial interest in a self-settled trust formed in their country is protected from the trustmaker’s own creditors.  These offshore trust statutes include other debtor-friendly provisions to encourage new trust business.  Some states in the U.S. have recently enacted statutes which expressly grant these same type of asset protection benefits to self-settled trusts.  Trusts created under these state statutes are referred to as domestic asset protection trusts (“DAPT”).  These DAPT’s were encouraged by state legislatures in an attempt to provide investors and business owners the protection of offshore trust planning within the United States in order to attract businesses and assets to their states.

Most state DAPT statutes have several common features.  The statutes provide that the DAPT is irrevocable so that assets transferred to the trust may not be withdrawn by the trustmaker.  The statutes also require at least one trustee to be either a state resident or a corporation doing business in that state and that some trust assets must be located or deposited in the state.  The DAPT statutes, like their foreign counterparts, typically provide for a position of “trust protector” who is a person with power to veto the trustee’s decisions to make distributions if such distributions may be vulnerable to the trustmaker’s creditors.

Alaska, Delaware, Utah, and Nevada are states with favorable domestic asset protection trust laws.  In Utah, the general statute of limitation for fraudulent transfers to the DAPT is four years, and there is a procedure by which a debtor can shorten the limitations time to only 120 days.  In Alaska and Delaware, by contrast, a creditor has four years to challenge a fraudulent conveyance to their states’ DAPTs.  Utah’s DAPT law also has relatively flexible trustee provisions under which a trustmaker can appoint himself as trustee as long as there is a Utah co-trustee.  The Utah trustee does not have to be a bank or trust company, but it can be any individual who resides in the state.  The trustmaker as trustee can retain control of investments and trust distributions.

A DAPT works well in theory, and many qualified commentators have published persuasive legal arguments supporting the DAPT’s asset protection.  The legal issue in DAPT planning is referred to as “conflict of law”: If a Florida resident forms a self-settled trust in a DAPT state where these trusts are expressly protected from all creditors, will Florida courts apply the protective laws of the DAPT state which has encouraged self-settled trust protections or the Florida law opposing self-settled trust protection?  Resolving the conflict between Florida’s public policy against self-settled trusts and contrary policy in DAPT states is legally complicated and involves a multi-step fact analysis.  In general, based upon principles in the Restatement of Trusts, if a Florida debtor establishes a DAPT trust, the more that trust assets, records, and parties are situated in the DAPT state, the more likely the DAPT state laws will apply.  However, the more that the DAPT trust assets and parties are in Florida, the more likely Florida courts will apply Florida law.  To date, no Florida court has held that a debtor’s interest in a DAPT formed under the laws of another state is protected from a Florida judgment.

There are possibilities to structure estate planning trusts in Florida to achieve asset protection.  Although assets in the debtor’s own living trust, a form of self-settled trust, are not protected from the debtor’s creditors, a Florida resident may protect assets in a trust created by another person.  There is authority that a debtor’s interest in a trust which the debtor forms or funds with his own non-exempt money will be protected from creditors if anyone other than the debtor is given control over trust assets.  Therefore, a properly drafted Florida trust may provide the trustmaker effective asset protection even though Florida has not enacted specific asset protection trust statutes.

Equity Stripping

“Equity stripping” is a relatively new term in asset protection law describing an old asset protection technique.  Equity stripping refers to pledging a non-exempt asset as security for a money loan.  In most cases, the debtor obtains a loan from a commercial bank and secures the loan with a mortgage or lien on the non-exempt assets he wants to protect.  The bank records the security instruments which gives the bank’s security interest priority over judgments against the debtor subsequently obtained by other creditors.  In order for these other creditors to attack the encumbered asset, they would first have to pay off the amount of the lender’s secured loan.  Pledging a valuable non-exempt asset to secure a new loan essentially drains the equity from a non-exempt asset and permits the debtor to move the cash borrowed beyond the reach of creditors.  Exempt assets, such as a Florida homestead or retirement plan, should not be pledged to borrow new money because these assets are already protected from creditors and cash obtained from a loan secured by an exempt asset may become unprotected.

Equity stripping is useful in certain situations.  Business owners or professionals often have large accounts receivable or valuable equipment which cannot be assigned or titled in other names.  Banks giving lines of credit almost always ask for a first secured position on a business’s receivables and equipment because these are the most liquid and valuable business assets.  The bank’s security interest is established and recorded when the line of credit is established even though no money is lent to the debtor.  The business can borrow money on the line of credit if and when it preceives a legal problem.  Money borrowed through a line of credit is not protected from creditors, and the business must find other means to protect the borrowed funds such as distributing money borrowed to the business owners to pay principal on their homestead mortgage.

Equity stripping is used by people moving to Florida who mortgage their existing home and use the proceeds to purchase a Florida homestead.  Another example is a real estate investor who owns multiple properties with equity.  Changing title to multiple properties involves the expense of setting up new legal entities and substantial transfer taxation.  An alternative is to buy new properties with loans cross-collateralized by presently owned properties which are otherwise unprotected.

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