Tax Planning Opportunities With BAPTs

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

Estates, Trusts & Gifts

A new tax planning idea that the authors of this item call a Business Asset Protection Trust (BAPT) creates a variety of income tax planning opportunities touching on international transfer pricing, S corporation trust eligibility rules, Sec. 355 split-offs, and captive insurance companies. It also creates user-friendly internal swaps that do not need to meet the draconian requirements of Sec. 1031. (BAPT is a registered trademark of the Horwitz Group LLC.)

How Does a BAPT Work?

A BAPT is a trust that a company creates in a state that allows for the formation of asset protection trusts. It is set up as a grantor trust with a company and its shareholders (or other persons) as beneficiaries. As an asset protection trust, it allows the company to retain control but shields the assets in the trust from the company’s creditors. Under most of these state laws, the company creating the BAPT could be a corporation, limited liability company, limited partnership, general partnership, or sole proprietorship. The ability to create a BAPT has existed for decades; however, the first comprehensive article on this topic was published less than a year ago (see Horwitz and Damicone, “Asset ­Protection Trusts for Businesses,” 152 Trusts & Estates 16 (December 2013)).

The BAPT is a paradox in that its substance comes from its being a tax nullity (a disregarded entity for tax purposes). Rev. Rul. 85-13 and Secs. 671-676 of the Code provide that if a trust is treated as a grantor trust, any dealings between the grantor and the trust are treated as a nullity for federal income tax purposes. If the company creates a BAPT that qualifies as a grantor trust, any transactions between the BAPT and the company are ignored. This is where the fun begins. (Note that the IRS has not yet ruled on BAPTs; some possible issues are discussed below.)

Minimizing the Need to Expatriate Funds

Many small to medium-size foreign companies (SMSFCs) expatriate their U.S. funds as quickly as possible overseas. This results in a loss of U.S. tax revenue from a combination of the loss of income-earning assets formerly located in the United States and the loss of income tax from transfer-pricing “games.” Unlike Fortune 500 companies whose main motivation for expatriation is generally to reduce or eliminate taxes, SMSFCs are often concerned with losing their profits not to taxes but rather to lawsuits and/or fines for violating myriad governmental regulations. Despite the hyperbole to the contrary, the United States has a very favorable corporate tax rate when compared with other industrial countries.

The authors have been told by clients that they would love to keep funds in the United States; however, they have genuine concerns about the United States’ litigious society. Another challenge for foreign companies doing business in the United States is that, for example, whether a German company’s project is located in France or in Germany, it is subject to very similar rules, whereas companies in the United States have city, county, state, and federal regulations to comply with. If the project crosses multiple boundaries within the United States, the complexity can be daunting. The purpose of this item is neither to advocate for fewer government regulations nor to reduce the number of lawsuits. Rather, if funds can be protected inside a BAPT, these issues fall away, and then the need for transfer-pricing games to move the funds offshore also goes away. Most importantly, if the funds are not expatriated, everyone benefits as the earnings on these funds become subject to U.S. taxes.

S Corp. Eligibility Rules

Sec. 1361 sets forth a number of restrictions on qualifying as an S corporation, such as the number of shareholders, distributions from the company (and from the shareholder, in the case of an electing small business trust (ESBT)), and the type of shareholder that may hold S corporation shares. Adoption of a BAPT may give the practitioner latitude in all these areas.

Qualified shareholders: Sec. 1361(b)(1)(B) provides that only U.S. resident individuals, estates, and certain trusts may qualify to hold shares in an S corporation. If a BAPT is a nullity, its owner would be regarded as the shareholder. Treating the BAPT and the company as the same entity could still create a problem if the IRS takes the position that the beneficiaries of the trust own a pseudo-equity interest in the company. Therefore, if one of the beneficiaries of the BAPT is not a qualified shareholder, problems could arise.

100-shareholder limit: Sec. 1361(b)(1)(A) provides that an S corporation may not have more than 100 shareholders. If the IRS adopts the pseudo-equity approach to BAPT beneficiaries and if the company is close to the 100-shareholder limit, this could create a problem.

Second class of stock: Sec. 1361(b)(1)(D) provides that an S corporation can have only one class of shares with respect to distribution rights. Again, if the IRS rules that the BAPT beneficiaries have an equitable interest that is different from the other shareholders’, this could be problematic. One way to circumvent this issue is to make the list of beneficiaries (and the amount of distributions each year to each beneficiary) mirror the current shareholders. Will there be a second class of stock if each shareholder holds identical rights?

Because the answers to these questions remain open, it is recommended that the first few taxpayers adopting a BAPT apply for private letter rulings with the IRS, particularly where an S corporation is involved.

An Alternative to a Sec. 355 Split-Off

To implement a split-off, split-up, ­spinoff, etc., on a tax-free basis under Sec. 355, the taxpayer needs to satisfy many requirements. For example, ABC Co., an Ohio-based company, manufactures grenades. ABC has been very profitable and has a large cash reserve. ABC approaches its accountant and tax lawyer and asks if there is a way to protect this reserve by putting it in a separate company with no possible adverse tax consequences. Unfortunately, the advisers inform the client that Sec. 355 requires that both “brother-sister” companies, after the split-up, be engaged in an “active business.” If one of the companies simply holds cash, it is not an active business. One alternative is to set up a new subsidiary and contribute all of the operations to it, leaving the cash in the parent company. However, the advisers discover that there are many favorable leases and other contracts that cannot be assigned.

Alternatively, the company could simply park the cash in a BAPT. Although it is not perfect protection (certain federal and domestic law claims can attach in Ohio), there should be no tax risk because the trust is a grantor trust that is a nullity. Further, there is specific statutory protection given under Ohio law, so piercing the entity and reaching the assets is less likely.

An Alternative to Captive Insurance Companies

Captive insurance companies (CICs) can provide a means to segregate funds within a vehicle that is protected from a company’s creditors. To satisfy the requirements for a CIC, a taxpayer must comply with myriad restrictions, pay a sizable amount to set up the CIC, and pay significant annual fees to maintain the structure. Even then, there is some exposure to not only the company’s creditors but also to outside creditors if an insurance pooling arrangement is chosen. Finally, there is a limit to how much funding can go into the CIC.

BAPTs, however, have no limits on funding. The initial setup fee should be significantly less, and the ongoing annual fees will certainly be less. The requirements for qualification are fairly easy, and specific statutory asset protection is provided. While there may be slight income tax benefits to a CIC, on the whole, BAPTs are easier to set up and monitor and are much more affordable.

Sec. 1031 Exchanges

If we assume the BAPT is a grantor trust because of Sec. 675(4), then the company will be able to exchange any type of asset of comparable value it wishes for assets contained in the BAPT.

Example: ABC Co. initially funds the BAPT with lots of cash. Subsequently, ABC becomes cash-strapped since it purchased lots of illiquid machines.

ABC can sell the machines to the BAPT (no tax effect due to grantor trust status) if the trustee agrees. If the trustee does not agree, the retained swap power would let ABC effectuate the same result (assuming appraisals of the machines show they are of comparable value). Unlike Sec. 1031, Sec. 675(4) does not require that the assets be of “like kind.” This ability to swap can help cash-strapped companies work through down periods without losing the economic benefit of an asset protection trust.

Conclusion

BAPTs can provide a superior result for many issues companies are facing, the only limit being the adviser’s imagination.

EditorNotes

Anthony Bakale is with Cohen & Co. Ltd., 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 & Co. Ltd.