Today, trusts are frequently recommended for a variety of good reasons – including protecting assets against creditors, minimizing taxes, and providing for the future of family members.  Trusts must be correctly established and carefully managed, however.  Here are some basic guidelines to follow when establishing a trust fund.

• A trust fund is simply an arrangement that allows for asset transfers to take place between parties. Your fund’s beneficiaries can be your children, a charity or non-profit organization.
• A trust fund can set it up to produce cash flow. You can structure it to generate money so that the fund pays out dividends to its recipients, leaving the principal untouched. (For this reason, most trust funds have a manager who is paid an annual fee or a percentage of the yearly profits.)
• A trust fund is governed by rules and limitations to the fund. It’s important to note that a trust fund normally follows rules and limitations. For example, recipients may have to reach a certain age before collecting benefits or pay out a set amount as living expenses to the recipients.
• A trust fund is not only for the rich. A trust fund can be established by anybody with the discipline to save.

To avoid some of the more common pitfalls relating to trust funds, make sure your trustees follow some basic rules.

• Trustees must understand the duties of trustees arising from both the Common Law and Trust Property Control Act.
• Trustees must carefully read and understand the provisions of the trust deed of any trust of which he/she is a trustee.
• Trustees must comply with all the administrative requirements of the trust deed. Of special importance are those rules regulating what the trustees are empowered to do and how decisions are to be made.
• Trustees must ensure that a qualified and independent trustee (such as a lawyer, accountant or a trust company) is appointed to the trust and that the independent trustee is party to all trust decisions.
• Trustees must record all the decisions of the trustees and books that account all the trust’s financial dealings.
• Trustees must ensure that letters of authority exist for each of the trustees, and that at all times there are as many trustees appointed as required by the trust deed.

Remember the fundamental purpose of a trust is the separation of ownership.  Once you have transferred assets to a trust fund, you have placed the control of those assets in the hand of the trustees. You no longer own those assets, the trust does.

Issue #1:  Can the IRA purchase real estate such your building lots?

                Answer: Yes, but there are a few caveats.  Most IRA administration companies do not allow the IRA to purchase assets, such as real estate, in any manner other than securities or other interests in partnerships or property that  are traded on public markets.  However, self directed IRAs are permitted by the IRC and there are now many companies who offer these services. 

Issue #2:  Is purchasing the lots from myself by my IRA a “prohibited transaction” that will subject me to penalties?

                Answer:  Yes.  And it makes no difference whether the lot is owned by your spouse or whether the IRA is owned by her.  Prohibited transactions are of two types: property and/or parties.  An example of a prohibited asset would be a life insurance policy (but not an annuity) regardless of the identity of the seller of the policy.  An example of an asset purchase from a prohibited party would be one from yourself, your spouse, your children and grandchildren (includes their spouses), your parents and grandparents, your fiduciary (usually a trustee), an entity (corporation, LLC, LLP, LP or partnership) in which you own directly or indirectly 50% or more of the equity  (this latter group includes those held by a fiduciary or service provider such as a CPA, financial planner, etc), and an entity that is a 10% or more partner or joint venture of an entity that is 50% or more owned directly or indirectly or held by a fiduciary or service provider.

                The penalties include the re-characterization of the consideration paid as taxable income, the payment of any applicable early distribution penalties, any other penalties and interest charges by reason of your income taxes being understated or paid late, and a 15% prohibited transaction penalty.

Issue #3:  If the real estate is sold to a party who is not a prohibited party and that party then sells the real estate to my IRA, is that a prohibited transaction?

                Answer:  No, providing both transactions when taken together are not deemed to subject to the “Step Transaction Rule”.  This court made doctrine allows the IRS to merge the two transactions as if they were both done at the same time.  In this case, the result from the application of the rule would be a prohibited transaction.  This doctrine is always a concern in any complicated multi-stage transaction and experienced counsel can, in almost all cases, avoid its application by careful plannin 

Issue #4:  What can be done to avoid the step transaction rule?

                Answer:  Several things.  There is no check list of items that creates a safe harbor.  But the case law reveals that the typical steps are (i) building in a time period between the transactions during which market and other forces can affect the economics of each transaction; (ii) making sure there is no oral or written agreement between the parties to carry out the transactions in a particular way to achieve a particular tax result; and (iii) constructing the transactions in the form and manner of analogous commercial transactions.

Issue #5:  What is the best way for a self directed IRA to hold and manage non-market traded assets such as real estate, business investments in partnerships, joint ventures and privately held stock?

                Answer: The IRA organize an LLC as a single member entity with the IRA holder being the sole manager.  There is a caveat however, the recognition of this method for managing IRA assets has not been given regulatory approval by the IRS and the one or two cases on the subject are unclear.  Nevertheless, it has become a common practice.  I am sure careful planning and operation of the IRA can avoid any possible negative outcomes.

Issue #6: With the above considerations in mind, is it possible for you to avoid the prohibitions and issues identified above?

                Answer:  Yes, but there are unavoidable risks which is the very reason the step transaction rule would be held not to apply.  The risks are that the purchaser could sell to some third party for their use or investment and not to your IRA.

• Insufficient capital
• Miss-direction of available capital
• Non-existent or insufficient business plan
• Non-existent or insufficient finance plan

A prudent business plan when coupled with a prudent financial plan will reveal capital insufficiencies and how existing capital can be best used.  This means that planning is the lynchpin or crucial element or precursor to the success of a new business. 

Who should you seek to secure advice from?  Before reaching for the telephone directory or calling your business friends and associates or going on line, make a list of what skills and knowledge you have and what skills and knowledge you do not have or need assistance with.  This list is then your guide to who you must seek out for advice.  Typically this list will include:

 Attorney who is experienced and knowledgeable in organization of small businesses

• Accountant who is likewise experienced and knowledgeable
• Banker who has the capability of providing financing support

Beyond those, the nature of your business, its location, need for public access, equipment requirements, personnel requirements, real estate requirements, and others will dictate who you need to secure advice and information from.

When should the plan be started and what are its contents?  The plan should be started ASAP even though many parts will take some time to complete and many parts will be modified as other parts are developed and information is obtained.  It is an evolutionary process that certainly does consume productive time and personal resources.  But short cuts in the development of a plan will usually lead to the undoing of the business as the statistics on new business success bear out.  There are many published and on line guides that offer excellent places to begin but do not fall into the trap of following any particular model business plan where your business diverges from what is offered.

A typical business plan will start out with a description of the business, its scope and what makes it unique.  This is similar to the mission statement of a non-profit entity.  What follows are sections devoted to the business:

• Organization type (i.e. corporation, LLC, partnership, proprietorship, etc.)
• Ownership and capital structure
• Management needs, organization, and responsibilities
• Marketing methods, costs and resources
• Production means, methods and equipment if products are being made
• Inventory management and controls
• Sales operations and controls
• Identification of competitors and their possible impact on the business
• Emergency plan

Typically, the financial plan for a business will be focused on the financial aspects of the various elements in the business plan and then project the anticipate revenues, expenses and costs  onto spreadsheets that project what the owners think the business can do if all of the parts of the business plan perform as planned over the next several years.  It becomes the initial budget of the enterprise.

Financial plans need to be actively used from day one.  Divergences from the plans need to be carefully noted and when the differences become so great that a different business is emerging then the plans need to be updated and amended so that the modified plan becomes the map for the developing business.  Keeping business and financial plans up to date can be burdensome but changes in the plan when compared to the original plan will give management important clues to how best operate the business.

Since most new ventures fail (survival rate is in the 20-30% range), why would you not have an emergency plan so that you and your family will have some economic survival.  If you are going to make this gamble then you should have some way of extricating yourself with the least possible damage.  The emergency plan may included the titling of assets in the name of a spouse, limitations on personal guarantees to lenders and fellow investors, preservation of cash, security interests in selected business assets, casualty insurance, life insurance on key employees, personal disability insurance (you are five times as likely to be disabled as die while operating your business), bankruptcy and insolvency law considerations.  The real point of an emergency plan is to have an exit strategy should the enterprise not develop as planned or other forces or events occur that make the business unlikely to survive.  Many small businesses were destroyed by 9/11.  Once the emergency has arisen it is too late as steps that could have been put in place early on can no longer be done or if done can be easily unraveled. 

Any effective asset protection plan is customized to your individual needs – designed to preserve and protect your wealth from those predators who would take it away.

Although each asset protection plan is unique to the circumstances, most will have the similar goals, including:

• Establishing a legal barrier between you and your assets.
• Insulating your family wealth from potential liability by minimizing the economic incentive to sue.
• Deterring workplace lawsuits by requiring mandatory arbitration of disputes as a condition of employment.
• Integrating new or existing estate or asset protection planning into a solid legal strategy for protecting your net worth against attack, while avoiding unnecessary estate taxes and related costs.
• Periodically updating, annually is best, to ensure it keeps pace with your changing family, business, and financial circumstances.

However, be aware that all asset protection plans and providers are not created equal. There is, unfortunately, a seedy side of the asset protection industry. It includes those who run scams in the guise of providing asset protection plans or who mislead people about their organization or qualifications.

But what details does your business plan include? How do you create one?  How do you even get started? These are just a few of the questions you need to consider as you plan to start or expand your business. To create an effective business plan, you need to get down to basics.

Answering a few questions up front can simplify the process greatly and give your business a chance for success. 

• What is the primary purpose of your plan – a road map or to attract capital?
• What elements should your business plan contain?
• What kind of information or projections should be part of the plan?
• What elements are important or even essential to include?
• What can be left out?

A big part of your business planning will include what form your small business will ultimately take. Will it be a Limited Liability Company, single proprietorship, partnership, S corporation or C corporation? The answer to this question will have much to do with your business model and strategy. Make sure the form of business is included in your business plan and that you have thought through the implications of the choice you make.

Will you use your business plan to attract investors?  The classic application of the business plan remains as a means of attracting investment capital. And if this happens to be your purpose too, then it would be best to know what investors want.

A word of warning: no matter what your projections are, they’re probably wrong. The one place where small business plans fail, particularly in the beginning, is in of projections. Most projections are overly optimistic. Don’t let this discourage you from being optimistic. But being a little skeptical about your financial projections is a good habit.

The fact is, writing an effective business for your small business can be a daunting task. But professional help is available to help you put together you plan or review and critique the plan you have developed. For info visit http://www.greentreeplanning.com

INTERESTING QUESTION

Suppose a grantor trust or disregarded entity[i] becomes insolvent or bankrupt – but its owner is not.  Is the owner exempt from income tax if the trust or entity is discharged from indebtedness? 

Some taxpayers take the position that the exception described below is available to the extent the trust or entity is insolvent or bankrupt since the taxpayer is considered for income tax purposes as “owner” of the trust or disregarded entity’s assets and liabilities.

EXECUTIVE SUMMARY

The proposed regulations make it clear that the IRS and Treasury will take the position that[ii] the insolvency exception under Code Section 108(a)(1) is available only to the extent the owner is insolvent.  The proposed regulations also clarify that the bankruptcy exception is available only if the owner of the grantor trust or disregarded entity is subject to the bankruptcy court’s jurisdiction.

THE LAW

Income from the discharge of indebtedness is generally includable in gross income.[iii] A limited exception applies under Code Section 108.  Under that Code Section, an amount that normally would be includable in gross income by reason of the discharge of indebtedness of the taxpayer[iv] is excludable – if the discharge occurs (a) in a Title 11 bankruptcy case or (b) to the extent the taxpayer is insolvent when the discharge occurs.

THE SUB-QUESTION IS: WHO IS THE TAXPAYER?

A grantor trust is any part of a trust that is treated as being owned by the grantor or another person so its items of income, deductions, and credits attributable to the trust are includable in computing the taxable income and credits of the owner.

The activities of a disregarded entity are treated in the same manner as those of a sole proprietorship, branch, or division of the owner so that all assets, liabilities, and items of income, deduction, and credit of a disregarded entity are treated as assets, liabilities, and items of the owner of the disregarded entity.  Accordingly, for Federal income tax purposes, all assets, liabilities, and items of income, deduction, and credit of a disregarded entity are treated as

MORE ON THE PROPOSED REGS

First, the proposed regulations specify that, for purposes of applying section 108(a)(1)(A) and (B) to discharge of indebtedness income of a grantor trust or a disregarded entity, the term taxpayer refers to the owner(s) of the grantor trust or disregarded entity and, therefore, the trusts or entities themselves will not be considered owners for this purpose.[v]

Second, the proposed regulations further provide that grantor trusts and disregarded entities themselves will not be considered owners for this purpose.

Third, the proposed regulations provide that, in the case of a partnership, the owner rules apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable. 

PROPOSED EFFECTIVE / APPLICABILITY DATE

The regulations are proposed to apply to discharge of indebtedness income occurring on or after the date final the regulations are published in the Federal Register. No inference is intended that the provisions set forth in the proposed regulations are not current law. 

Source: LISI Income Tax Planning Newsletter #8  (April 19, 2011) at http://www.leimbergservices.com   Copyright 2011 Leimberg Information Services, Inc.  

Citations:   REG-154159-09; IRC Sec. 108

The regulations are proposed to apply to discharge of indebtedness income occurring on or after the date final the regulations are published in the Federal Register. No inference is intended that the provisions set forth in the proposed regulations are not current law. 

Footnotes:

[i] Several types of disregarded entities exist under the Code and regulations. For instance, § 301.7701-2(a) of the Procedure and Administration Regulations provides that the term business entity includes an entity with a single owner that may be disregarded as an entity separate from its owner under § 301.7701-3; an example of a disregarded entity under this provision is a domestic single member limited liability company that does not elect to be classified as a corporation for Federal income tax purposes. Additionally, some disregarded entities are created by statute; examples of statutory disregarded entities include a corporation that is a qualified REIT subsidiary (within the meaning of section 856(i)(2)), and a corporation that is a qualified subchapter S subsidiary (within the meaning of section 1361(b)(3)(B)).

[ii] Subject to the special rule for partnerships under Code Section 108(d)(6).

[iii] Code Section 61(a)(12).

[iv] Section 7701(a)(14) defines a taxpayer as any person subject to any internal revenue tax, and section 108(d)(1) through (3) provides other relevant definitions.

[v] For a partnership, the ownership rules would apply at the partner level to the partners of the partnership to whom the discharge of indebtedness income is allocable.

The typical advantages of a living trust are as follows:

1. Flexibility in replacing trustee(s) when the trustor(s) are unable to function.

2. Imposition of fiduciary duties upon the trustee(s) to fully and faithfully perform their duties as provided in the trust instrument and according to state law.

3. Commercial acceptance by insurance companies, government, security firms and other financial service organizations.

4. Clear instructions on the management and control of all or select assets.

5. Prompt disposition of assets on death outside of the judicial system.

6. Privacy of estate composition and management.

7. Resolution of issues relating to property ownership, control and valuation prior to the trustor(s) death.

What are the usual asset protection devices?

Most asset protection plans include one of more of the following devices:

a. Offshore trust                                                        

b. Self-settled trust                                                    

c. Liability insurance                                                  

d. Limited liability company                                      

e. Irrevocable life insurance trust                             

f. Irrevocable trust

g. Charitable trust

h. Gifting plans

i. Life insurance policy

j. Joint ownership

K. Debt instrument

What other issues are involved?

Very significant in the development of an asset protection plan is what is the cost to implement the plan and then what is the cost to maintain the plan.  Such costs then need to be measured against the cost of the risk.  Also to be factored in is (i) the likelihood that the plan will be effective; (ii) the ability to reverse or undo the plan should the client’s situation change; and (iii) any significant tax costs.

As a fictitious entity, a trust differs from a corporation which is created under statutory authority, but it is like a partnership which is created by a contract or similar instrument (deed, will, or other writing).  It also differs from both a corporation and a partnership in its organizational structure.  Instead of having shareholders, directors, and officers like a corporation, or partners like a partnership, it has trustors (sometimes called settlors or grantors), trustees and beneficiaries.

The rights, duties and obligations of each party to a trust developed over time in the English common law system.  In the United States, each state has retained the concept and added an overlay of statutory law for the orderly administration and oversight of trusts.  The creator or creators of a trust are the “trustors”.  If they retain the right to amend or revoke the trust, the trustors have continued power over it; conversely if no such powers are reserved then the trustor’s role is at an end and the trust is therefore irrevocable.  The “trustees” are the persons or entities who are charged with the responsibilities of carrying out the terms of the trust in accordance with the trust document and state law.  The trustees own the trust assets and therefore take title to all of them.  The trustees are bound to perform their duties at the highest level imposed by law.  These duties are termed “fiduciary duties” and for a trustees failure to perform at that level, the trustee is personally liable.  Such a liability is not dischargable in bankruptcy.  Thus a trustee has all the duties and obligations that go with ownership but none of the benefits, these are reserved for the “beneficiaries”.  This division between ownership and benefit is the distinguishing characteristic of a trust, and the characteristic which makes trusts so useful in tax avoidance, and general estate planning.

The “beneficiaries” are the persons or entities who have been identified in the trust document as entitled to receive the benefits of the trust.  The benefits are in the form of income or principal disbursements.  The beneficiaries may be individuals, a class or group of unnamed individuals, charities or any other conceivable entity.  The benefit may be conditioned upon a specific age, event or occurrence.  It may also be terminated the same way and directed to other beneficiaries.  Typically the beneficiaries are ones spouse, children, parents, grandchildren, siblings, nieces and nephews.

WHY IS A TRUST USED IN ESTATE PLANNING?

The principal reason for using trusts in estate planning is due to the fact that trusts separate property ownership and control from property benefit.  Because taxation is almost always based upon ownership or control and not benefit, and because the fundamental nature of a trust places ownership and property control with the trustees and allows the benefit to go elsewhere, a trust is ideal for funding with the unified credit equivalent amount from the estate of the first spouse to die while giving the surviving spouse the entire benefit of the assets placed in the trust.  It is also ideal for controlling the method and manner of gifting income and principal to intended beneficiaries or to incapacitated members of a family.  The fact of the assets being owned and controlled by the trustees according to the terms of the trust is the trustors control mechanism.