Authored by Mark Lobb
Business Owner Considerations
During Volatile Economic Times
On October 17, 2022, Bloomberg’s statistical projections showed a 100% probability of a recession within the next 12 months. The US economy continues to reel from decades-high inflation, Federal Reserve interest rate hikes, and growing geopolitical tensions. At the same time, many states continue to impose high taxes, pass anti-business legislation, and embrace litigation against businesses. California, New York, New Jersey, Pennsylvania, Georgia, Illinois, and Louisiana are routinely ranked as the most plaintiff friendly states in the US.
If a business or business owner is subject to the laws of an unfriendly state as we enter the looming recession, a comprehensive asset protection analysis needs to happen sooner than later. A top to bottom understanding of the potential weaknesses of an asset protection plan should be a top priority. Utilization of the laws of business-friendly states should be considered when scrubbing down on asset protection issues. There are ways to be in an unfriendly state and take advantage of the business-friendly laws in other states.
Before getting into an analysis of utilizing the laws of business-friendly states, it is imperative for all business owners to go through a basic checklist of specific risk factors which may create or exacerbate liability exposures. For instance, California and New York both passed new employment laws in 2022. It is imperative for business owners to be compliant ready to stem the tide of employee lawsuits or government fines.
Many business owners are ignorant of the importance of “capitalization” in the context of corporate veil protections. In a closely held company, if shareholders do not adequately capitalize the company, the protections of having a corporation or limited liability company may be lost. The liabilities of the company become the personal liabilities of the shareholders. Each state has its own rules regarding alter ego liabilities and business owners should do a thorough analysis of those rules to make sure personal assets are not exposed to the liabilities of the company.
Stepping back to the utilization of the rules of a business-friendly state, a first step is to identify states which have low taxes, strong asset protection laws and a business-friendly environment. For years now, Nevada has ranked as the best state in the US to fit the mold of this first step. Nevada has no state income tax, no state estate tax, some of the strongest asset protection laws in the US and an incredibly business-friendly environment.
Nevada has several tools which mitigate taxes in unfriendly tax states and provide substantial asset protection. For residents of high tax states, integration of an incomplete non-grantor trust into a tax optimization structure may eliminate state capital gains taxes on the sale of intangible assets. For an article on Nevada Incomplete Non-Grantor Trusts (NINGs) go here.
One of the most effective tools to employ in utilizing the asset protection laws in Nevada is a domestic asset protection trust (DAPT) which is frequently referred to as a Nevada Asset Protection Trust or NAPT. The structure of a NAPT is normally in the form of what is referred to as a self-settled trust. Seventeen states permit self-settled trusts to have asset protection qualities. The “self-settled” nature of a trust is important to many people who want an irrevocable trust for asset protection purposes without losing complete access to the assets funded into the trust.
A NAPT is a separate entity from the grantor/beneficiary under state law; therefore, creditors cannot take assets owned by the NAPT because they are not the assets of the grantor. In California, a self-settled trust such as a NAPT would not be deemed a separate entity from the grantor/beneficiary, allowing a creditor the ability to take the assets from such a trust. However, this does not mean a California resident cannot benefit from the use of a NAPT.
For some background, NAPTs are creatures of Nevada statutory law and have been for nearly twenty years. These trusts have been tested and proven to withstand attacks from creditors under statutory law and by the Nevada Supreme Court.
A NAPT can be structured to include the same person as the grantor (creator) as a beneficiary of the trust. The grantor/beneficiary can receive discretionary distributions of income and principal from the trust. The grantor/beneficiary can also serve as the Investment Trustee of the NAPT, which allows the grantor/beneficiary to manage investment decisions for the trust assets. To add an additional layer of asset protection, the NAPT can form limited liability companies (“LLCs”) and contribute investments into the various LLCs, allowing the grantor/beneficiary to have certain management responsibilities of the business activities of the LLCs.
While the grantor/beneficiary can be involved in the operation of the NAPT as explained above, the grantor cannot be in-charge of distributions to the beneficiaries. Distributions are to be made by a Distribution Trustee. The Distribution Trustee must be an independent Nevada person or entity, such as a trust company, bank, lawyer, or CPA. A family member and/or employee should not act as the Distribution Trustee.
Although a third party controls the trust assts, distributions can only be made in compliance with the Trust Agreement. The Trust Agreement prohibits the Distribution Trustee from making distributions when the trustee knows the beneficiary will not receive a benefit from the distribution or to directly pay a judgment creditor. Otherwise, the Distribution Trustee is free to distribute as much, and as often, as the trustee deems to be in the best interest of the beneficiary. If a Distribution Trustee abuses its powers, the trustee may be removed and replaced immediately.
NAPTs are normally drafted to be tax neutral. Transfers to the NAPT do not trigger income tax nor gift tax. Furthermore, the NAPT does not pay income tax. All income tax generated by the NAPT’s investments flows to the individual tax return of the beneficiaries. Additionally, the beneficiaries are not taxed separately on the NAPT’s distribution. In essence, the tax position of the grantor/beneficiary does not change. A NAPT can be drafted to incur income tax or trigger a gift tax, but this would only be done in unique situations, normally involving the integration of intangibles which do not derive sourced income from a high tax state and have low basis.
Why would a resident from a state other than Nevada use a NAPT for asset protection? Ideally, a non-Nevada resident will employ the use of a NAPT to hold intangible assets such as ownership in a private business, ownership in an LLC which owns real estate in and out of Nevada, stocks in publicly traded companies, bonds, etc. Some assets immediately receive the full protections of a NAPT, while others require a change in form to receive complete protection from creditors. An asset-by-asset analysis is required when structuring and funding a NAPT. The Passage Trust is an example of a comprehensive NAPT structure and for more information on The Passage Trust, you can go to this link.
In 2023, my team and I will continue to provide our clients with asset protection ideas and updates on new laws which impose burdens on business owners. Our firm will continue to assist our clients to make sure our client’s assets are protected and the looming economic turbulence can be skillfully navigated.