Dust Off Your S corporation, Convert to an LLC Taxed as an S Corp for Better Asset Protection!

The number of new businesses forming as traditional “S” corporations has decreased dramatically in recent years. That is due in large part to the popularity of limited liability entities such as Limited Partnerships or Limited Liability Companies (LLCs). An entity such as an LLC offers all of the same protection that a corporation offers from business creditors, but it has the added benefit of protecting the business assets from the personal creditors of the business owner.

As an asset protection planner, there are two types of creditors that I account for: inside creditors and outside creditors. An inside creditor is one that arises against the business such as a slip and fall on business property. The injured party may have a claim against the business itself, not against the owners of the business if it is established and run properly. Thus, if the injured party has a judgment, he or she can only have that judgment satisfied by business assets and not the personal assets of the owner.

An outside creditor is one that is not related to the operation of a business, rather the creditor has a claim against an individual. It is the outside creditor protection that makes an LLC a no-brainer over a corporation. A personal creditor with a judgment that is not related to the operation of the business may seize the debtor’s shares in a corporation and thus, control those shares and possibly the company itself. Once the creditor controls the shares it can liquidate the entity and satisfy its judgment.

If a LLC is used to own the business, however, a personal creditor of a business owner that owns a membership interest in an LLC will be limited to obtaining a charging order instead of seizing the membership interest itself. A charging order is an equitable remedy which allows a creditor to receive distributions if made from the entity. A charging order would not carry voting or liquidation rights and a creditor that holds a charging order cannot control the limited liability entity.

For tax purposes, limited liability entities are much more flexible than corporations. A corporation can be taxed one of two ways: as an S corporation or as a C corporation. An LLC, for example, can be taxed as an S corporation or a C corporation, however, it can also be taxed as a partnership or it can even be treated as a disregarded entity if it has only one member.

Traditional corporations are becoming obsolete, and due to the asset protection and tax flexibility it is almost always more advantageous to operate a business or own property through a limited liability entity. When starting a business or forming an entity to own real estate, a limited liability entity should be utilized. For those with existing entities already up and running, you can convert the entity into an LLC in a tax-free reorganization. Please contact our office for more details.

Be Careful Naming a Revocable Trust as Beneficiary of Life Insurance

A 2012 Florida case underscores the risk in naming a Revocable Trust as a beneficiary of a life insurance policy. The decedent named his Revocable Trust as beneficiary of two life insurance policies. The Revocable Trust provided that the Trustee shall pay all of the debts and expenses of the decedent’s estate prior to making distributions. A clause of this nature is quite common in Revocable Trusts.

Normally life insurance is exempt from creditors of a decedent. Fla.Stat. §222.13(1) provides: “Whenever any person residing in the state shall die leaving insurance on his or her life, the said insurance shall inure exclusively to the benefit of the person for whose use and benefit such insurance is designated in the policy, and the proceeds thereof shall be exempt from the claims of creditors of the insured unless the insurance policy or a valid assignment thereof provides otherwise.”

When life insurance is payable to an estate, however, the proceeds are administered like any other asset subject to probate and are available to pay the decedent’s debts.

The Court held the proceeds would not be exempt because the Revocable Trust contained a provision which required trust assets to be used to pay debts and expenses and the decedent had effectively waived the exemption that normally exempts life insurance from probate claims.

Thus, it is very important to seek legal advice before naming a Revocable Trust as beneficiary of life insurance policies. Every person that owns life insurance should have the beneficiary designation reviewed in conjunction with a review of his or her Revocable Trust to determine whether or not a change needs to be made in light of the Morey decision. I typically recommend naming a sub-trust created under the Revocable Trust (or under a Last Will and Testament) as beneficiary because in that case the exemption will apply and the proceeds will not be available for estate creditors.

Estate Tax Back on the Bargaining Table?

In early January, in order to avoid the so called “Fiscal Cliff,” the estate tax exemption was “permanently” increased to $5.25 million, indexed for inflation. In addition, the gift and generation-skipping transfer (GST) taxes were increased to $5.25 million. This law removed almost the entire national population from concerning themselves with the estate tax and allowed people to focus on other aspects of estate planning.

Now, with Obama’s new budget proposal, those permanent provisions are back on the bargaining table. The President’s budget proposes reinstating the estate, gift, and GST taxes to 2009 levels beginning in tax year 2018.

Thus, the estate tax exemption would be reduced from $5.25 million to $3.5 million and will not be indexed for inflation, and the estate tax rate would be increased from 40% to 45%. The gift and GST tax exemptions would be reduced to $1 million.

The portability of unused exemption amounts between spouses would be made permanent, however.

In terms of sophisticated estate planning, the proposal also seeks to eliminate many techniques that are used to reduce estate, gift and GST taxes. For instance, the duration of GST trusts would be limited to 90 years. Currently in Florida GST trusts can last up to 360 years.

Other strategies on the chopping block include valuation discounts and grantor retained annuity trusts (GRATs).

Although the estate tax appeared to be a closed issue, the President has highlighted changes that will no doubt spur debate between democrats and republicans. Without the certainty of permanent legislation, proper planning must account for these proposed changes. Lowering the exemption to $3.5 million and removing the inflation adjustment will produce more taxable estates and people must plan accordingly.

Estate Planning for Young Parents

I have represented many parents with young children in connection with their estate planning needs. Young parents are often just starting out in their careers and haven’t accumulated the same wealth, assets and liabilities that older parents have, however their needs are just as critical (if not more) to plan for.

Typically a young couple will come to me without an estate plan in place. It is common for the couple to have already purchased life insurance, however I have rarely met with a young couple who has coordinated the life insurance and their other assets with their estate plan.

Usually the spouses will name each other as the primary beneficiary of the life insurance and the children as the alternates. When a minor child is named as an outright beneficiary of life insurance, it is very likely that those proceeds would need to be paid to a court-appointed guardian to represent the minor’s interests. The guardianship would continue until the child reaches the age of majority. Guardianships are extremely costly and unnecessary and can easily be avoided.

Any time there is a court process (such as a guardianship) a lawyer is needed, court costs are incurred and the guardian gets paid as well. All of these expenses can quickly deplete the guardianship assets.

For these young parents I have been establishing testamentary trusts in their estate plans which are created at the time of death. However, it is equally important to actually name the testamentary trust as the alternate beneficiary on the life insurance beneficiary designation form. If this step is not taken then the proceeds will bypass the testamentary trust and go to the minor child through the guardianship. If the testamentary trust is named, however, the life insurance proceeds will be distributed to the Trustee and court intervention can be avoided.

A similar structure can be utilized for retirement plan benefits when naming the minor children as contingent beneficiaries, however there are tax consequences that must be addressed in the estate planning documents.

It is also critical to name a guardian for the minor children in the Wills. This is often a contentious issue among the married couple because each spouse typically wants to name his or her family members to serve as guardian. One way to involve both families is to name one family member as “guardian” and another as “trustee.” The guardian will have legal custody of the minor but the trustee will manage the money in trust and make decisions regarding distributions. This not only separates the powers but it involves both families in the minor’s life.

These issues are very important for young parents to consider and although they may not think that their “estates” warrant an “estate plan,” I think their needs are critical to address.