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My colleague Jay Adkisson has written a summation of a new domestic asset protection trust case at Forbes. Another colleague, Steve Oshens, has weighed in as well. Mr. Adkisson argues this case is the final nail in the asset protection trust industry; Mr. Oshens argues for a less sweeping interpretation. I counsel against these structures for a number of reasons, which are listed below in no order of importance. 1.) We have yet to see a grantor of a foreign or domestic asset protection trust (APT) win a case. Planners who still like APTs correctly argue that these cases have a potent negative combination: blatant fraudulent transfers and unsavory characters — an admittedly very bad combination of facts. Regardless, there are now a number of decisions where the APT failed when challenged. Why? That leads to point number two: 2.) APTs are bad public policy. At the heart of any case involving an APT is a creditor enforcing a judgment. A court upholding an APT will be opening the door to the idea that a debtor can “have his cake and eat it too;” he can be adjudicated to owe somebody money, have the financial capability to satisfy the debt, yet not do so — and, in fact, have a court say they don’t have to. That’s a detrimental holding in a capitalist economy that depends on credit financing to fuel economic growth. So far, courts don’t want to play. 3.) Point number 2 is derived from the Uniform Trust Code’s commentary to §505 which “… follows sound doctrine in providing that a settlor who is also a beneficiary may not use the trust as a shield against the settlor’s creditors. The drafters of the UTC concluded that traditional doctrine reflects sound public policy.” Several courts that have ruled against APTs have referenced this section of the UTC. 4.) Are courts turning against asset protection planning? It depends on where you do it, but in California they are: As indicated by Defendant’s testimony that prior to filing his bankruptcy petition, he met with an asset protection firm, and one of his goals in doing so, was to potentially protect his assets from potential creditors . . . and while he changed his mind about using the asset protection firm, the evidence of his consideration, meeting and paying the asset protection firm supports a finding that Defendant intended to hinder or delay his nonpreferred creditors. One could argue that this decision should be taken with a grain of salt because it’s from California — a valid point. But, you can see the argument being effective regardless of the jurisdiction. Imagine this line of questioning in a deposition or at trial: Lawyer: And on this date, you saw John Smith, correct? Defendant: Yes. Lawyer: Doesn’t Mr. Smith hold himself out as an “asset protection lawyer?” Defendant: Yes Lawyer: why did you feel the need to consult with him? There’s no answer to this question that can’t be spun in a negative light. 5.) Creditors have a number of well-defined and clearly articulated methods of obtaining a judgment. Even Texas — my home and debtor’s haven — has a statutory path for creditors to obtain a judgment and satisfy it. What usually keeps creditors from pursuing a claim is time (litigation is an inherently long and drawn-out process), money (they will probably have to pay at least a portion of their ongoing legal bills), and effort (litigation takes an inordinate amount of time away from running a business). If a debt is small, it’s far easier to write it off as a business loss (see §165) and be done with it. But an aggressive creditor will eventually get his money. 6.) Every time I hear someone extol the virtues of a spendthrift trust, I’m reminded of the following line from the movie, A Princess Bride:“That word doesn’t mean what you think it means.” A spendthrift provision prevents the voluntary or involuntary alienation of the beneficiary’s interest (§502 of the Uniform Trust Code). So, let’s assume that beneficiary John Smith owes $10,000 to Mr. X. Mr. Smith cannot transfer his interest to Mr. X to satisfy the debt (For more, please see Nichols, Assignee v. Eaton Et Al, 91 U.S. 716, 23 L.Ed. 254 (1875) ). But a spendthrift provision only applies to the trust; once the money is distributed, it can be attached any number of ways. If it’s transferred to a pass-through entity such as a family limited partnership, a creditor can use a charging order to obtain his funds. If the money is transferred to a bank account, the creditor can simply levy the bank account. For a discussion of the procedures in my home state of Texas, please read “Post-Judgment Remedies: Garnishment, Execution, Turnover Proceedings, Receiverships Under the DTPA, and “Other Stuff” by Donna Brown. Ultimately, this gets back to point number 5: an aggressive creditor is going to get his money eventually. 7.) Why would you choose to be shielded behind an APT’s spendthrift provision — which is a new legal concept (in legal years) — when you can use a pass-through entity like an LLC whose liability shield is very well-developed? Brief history: the corporate limited liability shield came about sometime in the mid-1800s. I believe New York was the first state to adopt the concept. It caught on like wildfire and has now been praised as a key concept of a capitalist society (For an in-depth discussion, please see Stephen Presser’s book, Piercing the Corporate Veil). Corporate limited liability is now a very well-developed legal concept developed over hundreds of cases. This is great news for planners because we have exacting detail about what works and what doesn’t. Why not use this area of law — that also has a number of favorable decisions — instead of APT law which so far has issued a large number of anti-APT decisions? Again, these are presented in no order of importance. But with yet another asset protection trust failing when challenged, I believe these points have a great deal of merit. In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. I often refer to reading the tax code as "hop, skip and jump" reading because one paragraph or section of the code will require the reader to reference several other sections in order to comprehend the meaning behind the first code section. §402, which explains the taxation of deferred compensation, is a prime example of this approach. Section (a) states: Except as otherwise provided in this section, any amount actually distributed to any distributee by any employees’ trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to the distributee, in the taxable year of the distributee in which distributed, under section 72 (relating to annuities) Section 401(a) provides the relevant rules for a trust to obtain tax-exempt status. By way of quick review, these include certain vesting timelines, minimum participation standards, and non-alienability requirements. Section 501(a) is the tax code section that grants tax-exempt status to certain organizations as well as trusts specifically mentioned in §401(a). And §72 contains the rules for annuities, which provide rules allowing the recipient to not be taxed on his return of principal. In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. The online Merriam-Webster dictionary defines "vesting" as "the conveying to an employee of inalienable rights to money contributed by an employer to a pension fund or retirement plan especially in the event of termination of employment prior to the normal retirement age" The purpose of the vesting rules is to make sure that the money the employee contributes to the plan is his, and can never be taken away. Here, there are actually two rules -- one for contributions made by the employee. These rights are "nonforfeitable" -- they cannot be taken away. The second rules apply to the employer's contributions. The statute contains two approved vesting schedules. The first is the "3-year rule." If an employee has at least three years of service, he has a nonforfeitable right to 100% of the employer's contributions. The second is a schedule based on the years of service:  Due to its somewhat stricter nature, most this schedule is more attractive from the employer's perspective.
Adding a profit-sharing component to your 401(k) plan can increase your contributions while also motivating employees. All of the previously-discussed rules apply: you can't have a top-heavy plan, you can't discriminate in favor of certain employees, etc...
Here's a general description of what's involved from the code: A profit-sharing plan is a plan established and maintained by an employer to provide for the participation in his profits by his employees or their beneficiaries. The plan must provide a definite predetermined formula for allocating the contributions made to the plan among the participants and for distributing the funds accumulated under the plan after a fixed number of years, the attainment of a stated age, or upon the prior occurrence of some event such as layoff, illness, disability, retirement, death, or severance of employment. A formula for allocating the contributions among the participants is definite if, for example, it provides for an allocation in proportion to the basic compensation of each participant. The best part is the company is not required to make contributions every year; they can also determine the total amount of their contribution in the first quarter of the year, after sitting down with their accountant and getting a good idea for the previous year's performance. The total contribution is limited to the lesser of 25% of compensation or $55,000 (for 2018; $54,000 for 2017, subject to cost-of-living adjustments for later years). In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. In general, a plan cannot specifically require that employees work for the company at least 1 year or attain the minimum age of 21. For large employers with several divisions, this can happen accidentally. Here are two examples from the accompanying Treasury Regulations:
Example 1. Corporation A is divided into two divisions. In order to work in division 2 an employee must first have been employed in division 1 for 5 years. A plan provision which required division 2 employment for participation will be treated as a service requirement because such a provision has the effect of requiring 5 years of service. Example 2. Plan B requires as a condition of participation that each employee have had a driver's license for 15 years or more. This provision will be treated as an age requirement because such a provision has the effect of requiring an employee to attain a specified age. Second, the plan cannot exclude an employee who attains a specific age. Finally, there are minimum participation standards, which must comply with one of the following three rules. 1.) The plan must benefit at least 70% of "non-highly compensated" employees 2.) The plan benefits-- (i) a percentage of employees who are not highly compensated employees which is at least 70 percent of (ii) the percentage of highly compensated employees benefiting under the plan. 3.) The company sets up its own classification system approved by the Secretary that benefits at least 70% of the non-highly compensated individuals. In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. When a person declares bankruptcy, all of their property becomes part of the estate -- the total assets that are used to pay existing creditors. Here is the exact definition contained in the bankruptcy code:
(a) The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held: (1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case. (2) All interests of the debtor and the debtor’s spouse in community property as of the commencement of the case that is -- (A) under the sole, equal, or joint management and control of the debtor; or (B) liable for an allowable claim against the debtor, or for both an allowable claim against the debtor and an allowable claim against the debtor’s spouse, to the extent that such interest is so liable. This is very similar to the definition the gross estate in the estate tax code or gross income in §61 -- it's an exceedingly broad definition, designed to include every piece of property owned by the debtor. The code, however, does allow several specific exemptions. Under the federal statute, the debtor may choose federal or state law exemptions. Under federal statute, retirement plans are excluded §522(b)(1) Notwithstanding section 541 of this title, an individual debtor may exempt from property of the estate the property listed in either paragraph (2) or, in the alternative, paragraph (3) of this subsection. ..... (C) retirement funds to the extent that those funds are in a fund or account that is exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986. Most states allow this exemption as well. According to §401(a)(4), a deferred compensation plan cannot discriminate in favor of highly compensated employees (HCEs), which is a person who either owned 5% of the business at any time during the year or made more than $80,000 (inflation-adjusted) during the preceding year.
The regulations provide two safe-harbor tests for defined contribution plans (which comprise the vast bulk of 401ks). The first is a "unified allocation formula," which requires all plan contributions to be allocated in one of three ways:
While the rules do allow a C-Suite executive to benefit from the plan based on their status within the company, it doesn't allow them to benefit more than their status would allow. The second method uses a "uniform points method" which are determined by summing "the employee's points for age, service, and units of plan year compensation for the plan year." The main point that advisers should take from these rules is that the regulations contain very rigid, mechanical rules that prevent the top of the employee ranks from rigging the retirement plan to their benefit at the expense of the rank-and-file. In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program. He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution. He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog. He is also an investment adviser with Thompson Creek Wealth Advisors. In order for a deferred compensation trust to the “qualified,” it must comply with all of §401's specific requirements. Complete compliance creates tax-deferred status. §501 states (emphasis mine), “An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.” One of 401s most important requirements is that funds can only be used for the benefit of the employees. §401(a)(2) states in relevant part, “(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…” To borrow language from contract law, this section contains a condition precedent, which is, “... an event which must take place before a party to a contract must perform or do their part.” The following hypothetical illustrates: Company A owes a significant amount of money and also has a large, well-funded retirement plan. 401(a)(2) prevents the company from raiding the retirement fund until every possible obligation of the trust is paid. The Treasury Regulations add additional color: (2) As used in section 401(a)(2), the phrase “if under the trust instrument it is impossible” means that the trust instrument must definitely and affirmatively make it impossible for the nonexempt diversion or use to occur, whether by operation or natural termination of the trust, by power of revocation or amendment, by the happening of a contingency, by collateral arrangement, or by any other means. Although it is not essential that the employer relinquish all power to modify or terminate the rights of certain employees covered by the trust, it must be impossible for the trust funds to be used or diverted for purposes other than for the exclusive benefit of his employees or their beneficiaries. The phrasing is unambiguous, providing no legal “wiggle-room.” In my introductory post on the topic, I specifically noted this code section uses trust language, placing a fiduciary duty and obligation on the sponsoring company. This section furthers that observation. 29 U.S.C. Chapter 18 contains ERISA -- the Employee Retirement Income Security Act, which was passed in 1974. Its purpose is to protect employee benefit plans from employer malfeasance, such as using employee plans to fund corporate operations or pay corporate debts. Like the deferred compensation section of the tax code, ERISA itself its own legal specialty. A complete discussion would be the subject of an entire course in law school. For our purposes, the following points are salient: 1.) The statute gives federal courts jurisdiction over a large number of causes of action related to ERISA: ("Except for actions under subsection (a)(1)(B) of this section, the district courts of the United States shall have exclusive jurisdiction of civil actions under this subchapter brought by the Secretary or by a participant, beneficiary, fiduciary, or any person referred to in section 1021(f)(1) of this title. State courts of competent jurisdiction and district courts of the United States shall have concurrent jurisdiction of actions under paragraphs (1)(B) and (7) of subsection (a) of this section.). This greatly increases the weight of potential litigation. 2.) The statute creates a complex compliance burden. Here is a list of the sections contained in 29 U.S.C. Part I: Reporting and Disclosure:  This is yet another reason why an entire industry exists to service deferred compensation plans.
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