Asset Protection Planning Legacy Trusts: Ohio’s New Model Law

By Nils P. Johnson, J.D., Canfield, Ohio, not affiliated with Cohen & Company Ltd.

Editor: Anthony S. Bakale, CPA, M.Tax.

"Asset protection planning" is about organizing one's affairs so that the risks of future claims by third parties can be reasonably dealt with—it is not about avoiding paying existing bills or present claims. It is about minimizing exposure to future risks by dispersing asset ownership within the family, by using appropriate liability-limiting business structures, by thinking about the consequences of a potential health or business reversal resulting in lost income, and by maintaining appropriate insurance coverage.

These days, with notable new statutes in several states, including Ohio, asset protection planning can also mean "bulletproofing" assets by moving them into irrevocable trusts. This item briefly addresses basic asset protection issues and then describes Ohio's new asset-protection ("Legacy") trust statute, which moves the state to the head of the class of asset protection jurisdictions.

Asset Protection Strategies

The first line of defense in protecting assets is insurance: It is better to have more rather than less. Professionals need malpractice protection, while businesses should carry not only casualty and liability insurance, but also business interruption coverage. Cyber insurance should be considered to deal with identity theft, damage to records, theft of customer lists and trade secrets, disclosure of sensitive information/breach of privacy, and recovery from malware and malicious codes. In assessing risks, be concerned with catastrophic claims. To keep the cost down, clients can use high deductibles. Young clients with children should prefer cheap term life insurance in large amounts over expensive whole life policies with smaller payouts. Homeowner's policies should provide for replacement-cost coverage, as opposed to fair market value. With the homeowner's policy as well, clients should consider carrying a $1 million or $2 million "personal umbrella" of liability insurance; the cost is not great. Finally, young families are wise to purchase disability insurance for the principal breadwinner. To save costs, the family can self-insure for the first 60–90 days until coverage would begin to pay.

The second line of defense is maximally using qualified retirement plans: One must first understand the difference between creditor claims in bankruptcy and nonbankruptcy contexts. ERISA-qualified retirement plans, such as profit sharing plans, 401(k) plans, or 403(b) plans, are protected from creditors in both cases. In Ohio, traditional IRAs (which are not ERISA-qualified) are similarly protected, as are Roth IRAs and Coverdell IRAs (for education). (However, according to the 2014 U.S. Supreme Court case of Clark v. Rameker, 134 S. Ct. 2242 (2013), an inherited IRA is not protected.) SIMPLE IRAs, owner-established IRAs, and simplified employee pension plans (SEPs) are protected only in the context of a bankruptcy filing and then up to a limit of $1 million, as adjusted for inflation.

Where a debtor has not filed bankruptcy, a creditor with a judgment can attach a SEP account. Rolling SIMPLE and SEP accounts into a traditional IRA, however, appears to provide nonbankruptcy creditor protection in Ohio because of recent changes in Ohio law. (Keogh plans enjoy only partial protection in Ohio.) In light of this, individuals should try to fully fund qualified retirement or profit sharing plans every year. Furthermore, they should consider rolling legacy SIMPLE IRAs and SEP IRAs into a traditional IRA or Roth IRA.

Dividing assets between spouses: Couplesoften keep joint accounts for convenience sake. This is a bad strategy because it subjects the combined assets of the spouses to third-party claims. It is preferable to have spouses keep roughly half of combined assets in their individual name or individual living trust of each spouse.

Using appropriate business entities: Clients should creatively use limited liability entities (corporations, limited liability companies (LLCs), limited partnerships, etc.) to hold business interests. Ohio has recently rewritten its LLC statute to provide enhanced creditor protection. In Ohio, for instance, if the owner of an LLC holding an apartment complex were sued, the creditor would be able to obtain only a "charging order" and could not foreclose against and seize the buildings. A charging order entitles the creditor to any disbursements the LLC's managing member cares to make; it does not give the creditor the right to vote the debtor's interest in the LLC, and therefore, the creditor cannot force distributions. A single-member LLC treated as a disregarded entity does not have to file a separate tax return.

Ohio Legacy Trusts

Under traditional law, placing assets in a revocable living trust does not protect them from creditor claims. In an effort to attract more trust business to the state, Ohio (along with a handful of other states, such as Alaska and Delaware) has recently changed the traditional rule. Now, Ohio's Legacy Trust (OLT) Act (Ohio Rev. Code Ch. 5816) allows a person to establish and fund an irrevocable trust, the assets of which, if the trust is properly established, are exempt from creditor claims. The process of setting up the trust and funding it with the appropriate amount of assets is somewhat complicated, as explained below. However, correctly established, the trust can act as a family "safety net" for a portion of a client's assets. Here is the process:

Solvency analysis: A central concept is that an OLT is funded with "excess" assets, assets that are not needed to take care of existing obligations and assets that are not "already protected" assets. One cannot successfully fund an OLT with assets over which third parties have actual or contingent claims. Thus, one begins with a solvency analysis, first listing assets, then deducting current debts and actual and contingent liabilities (lawsuits, personal guarantees, etc.). Next are subtracted assets that are already protected from creditor claims (such as insurance and qualified retirement plans). One might call the result "exposed net worth." Because contingent liabilities are often hard to evaluate, it is advisable to apply a "cushion" when calculating their value. Finally, a solvency analysis should contemplate the client's prospective earnings.

Solvency affidavit: Having done a careful financial analysis, the client takes the second step of preparing a "solvency affidavit." This must attest the client is the legal owner of the property (not the result of illegal activities) being transferred; that creditors are not being defrauded and the client will not be rendered insolvent by the transfer; that no lawsuits or administrative proceedings have been filed or are threatened; and that no bankruptcy is contemplated.

The affidavit is then recorded at the courthouse. Once the grantor has created the OLT, filed the solvency affidavit, transferred property to the trust, and waited in most instances 18 months, a creditor or claimant cannot bring an action that would reach the particular assets transferred into the OLT, unless the creditor could prove by clear and convincing evidence their transfer constituted fraud. This is a difficult standard to demonstrate.

Structure of an OLT: An OLT is an irrevocable trust of which the client (and possibly the client's spouse and children) is the lifetime beneficiary. The OLT's trustee can be any person other than the client. It also may be a qualified financial institution. It is advisable, however, not to use a person holding a subordinate relationship to the client as trustee. A spouse also should not serve as trustee. In many cases, married clients both transfer assets to the OLT. At least one trustee must have ties to Ohio.

Retained rights of clients: Under the OLT law, the client can retain significant rights and powers over the trust. He or she can hold:

  • The right to receive all trust income;
  • The right to be a beneficiary of principal distributions from the trust: For the trust to be "bulletproof" it is preferably structured so that distributions from principal are wholly discretionary to the trustee and are not based on a fixed standard of support of the client;
  • The right during the client's lifetime to appoint who will receive the assets of the trust, but the client may not appoint trust assets to himself or herself or to his or her creditors;
  • The right to appoint trust beneficiaries by will, but the client may not appoint trust assets to himself or herself, to his or her creditors, or to his or her estate;
  • The right to veto distributions to other current trust beneficiaries: For instance, a client may veto a potential distribution to a child where a divorce is pending;
  • The right to remove the trustee and appoint a new one;
  • The right to remove the trust protector and appoint a new one;
  • The right, on the happening of a defined event, to terminate the client's interest in the trust: For instance, if a creditor brings suit in another jurisdiction to attempt to attach trust assets, the client could terminate his or her interest in the trust, leaving a spouse and/or children as beneficiaries;
  • The right to demand up to 5% of the trust property annually; and
  • The right to reside in a residence owned by the OLT.

Income tax status: Typically, an OLT is structured as a grantor trust under Secs. 671–679. Therefore, the client (grantor) will pay the tax on trust income. The OLT document can provide, however, that the trustee has the right to reimburse the client for taxes paid.

Investment control: The client need not give up control and management of assets moved into trust. This might be achieved as follows:

  • An LLC is created to hold certain assets, such as stocks and bonds or real estate;
  • The client is named the manager of the LLC, perhaps under a long-term contract;
  • The member's interest in the LLC is then assigned to the OLT.

The result is that, while the client owns no member's interest that could be attached, he or she still controls management of the business.

Trust protector: An OLT typically has a "trust protector" who acts as an adviser to the trustee and can hold certain powers including:

  • The right to remove and replace the trustee;
  • The right to approve trust investments;
  • The right to veto hiring and firing; and
  • The right to make future amendments to the trust to deal with changes in the law that could not be anticipated or to deal with changes of the circumstances of beneficiaries.

The trust protector can be appointed by the settlor after the trust is in effect.

Attorney's due diligence: The attorney (and conceivably the accountant) who helps a client put into place and fund a legacy trust must take steps to ensure that he or she is not assisting a client in defrauding existing creditors. If he or she were to do so, the creditor could make a claim against the professional. For this reason, lawyers must exercise due diligence in investigating the client's financial circumstances to make sure of the client's solvency and that assets contemplated to be transferred to the OLT can be classified as "exposed net worth" as discussed above.

In sum, clients can achieve a great degree of asset protection by taking common-sense steps in arranging their affairs, including segregating assets between spouses, having adequate insurance coverage, using appropriate limited liability entities for businesses, and fully funding ERISA-qualified retirement plans. For clients such as health care professionals, who have a large net worth and whose activities subject them to potential extraordinary claims, new creditor protection statutes—such as those of Ohio—allow for the protection of aportion of a client's assets by placing them in irrevocable trusts.

EditorNotes

Anthony Bakale is with Cohen & Company Ltd. in Cleveland. For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com. Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.

Newsletter Articles

SPONSORED REPORT

Year-End Tax Planning and What’s New for 2016

A look at year-end tax planning strategies for individuals and businesses, as well as recent federal tax law changes affecting this year’s tax returns.

PRACTICE MANAGEMENT

CPAs Contend With Tax ID Theft

Tax-related identity theft fraud remains a widespread problem that is often difficult for victims and their tax preparers to correct.