Domestic asset protection trusts (DAPTs) for individuals have been around since 1997. Their focus has always centered on protecting a principal owner’s assets from a business’ liabilities. DAPTs have become an integral part of many comprehensive asset protection plans, along with family limited liability companies (FLLCs), family limited partnerships (FLPs), insurance policies and retirement plans.
Instead of focusing solely on the owners, we suggest that business/company level actions be taken to truly maximize a DAPT’s asset protection ability. The “new” technique has actually been around since the inception of DAPTs. If you polled attorneys who draft DAPTs and asked them who can form a DAPT, most would probably say, “only individuals.” However, the new Ohio DAPT statute provides that a “person” may form a DAPT, and “person” is defined as:
... an individual, corporation, business trust, estate, trust, partnership, limited liability company, association, joint venture, government, governmental agency or instrumentality, public corporation, or any other legal or commercial entity.1
This definition means a corporation, LLC, limited partnership or other type of entity could form a domestic business APT (DBAPT or BAPT) or a domestic corporate APT (CAPT).2
Why would you want or need a DBAPT (or other business-level techniques discussed later in this article) when you can use an individual DAPT, FLP, FLLC, insurance policy or retirement plan protection? Because you want to use as many techniques as possible to protect the “golden goose.” Also, the standard for asset protection focuses on assets held outside a company; there’s very little focus on protecting the assets held within a company.3 A large portion of a business owner’s wealth may actually be held by her company.4 Posed with this dilemma, many asset protection attorneys would say, “that’s easy to remedy, just distribute the funds from the company to its principals.” However, that simple solution could be problematic in many ways. First, the company may not want to distribute funds to its principals because some of the principals could include minor children, spouses of children or disgruntled principals (problem owners). Also, if the funds are really working capital, loans back to the company from problem owners may not be viable. Second, large distributions from the company may cause breaches of loan covenants. This danger could be circumvented by using a DBAPT that either guarantees or joins in as an obligor. While this technique might reduce the asset protection, it could still protect the company’s assets from all other creditors of the company, other than the prime lender. Third, there could be adverse income tax consequences if there are large distributions from the company. In contrast, a DBAPT should be drafted with grantor trust provisions (Internal Revenue Code Sections 671-679), which means there would be no income tax consequences.
The DBAPT isn’t the only way to protect business assets. If your company has two or more lines of business, you can effectuate a split-up or split-off of the lines into two or more separate brother-sister companies. This partitioning isolates the risky line of business and insulates the other lines in separate companies. If your company is a corporation (C corporation or S corporation), then you must comply with the myriad rules of IRC Section 355.5 One key requirement of Section 355 is that both the distributed and undistributed companies be actively engaged in a trade or business. This rule means you can’t park all your cash and marketable securities in one company and the operating risky business in another. If you have a partnership or an LLC taxed as a partnership, you need not comply with Section 355 (it only applies to corporations). Not surprisingly, there are particular concerns for partnership splits as well. There could be construction distributions under IRC Section 752, income recognition due to the distribution of “hot assets” under IRC Section 751 and deemed distributions of Section 751 assets if there’s recapture, to name a few. Therefore, if you have one active line of business and cash, or if you have an entity taxed as a partnership, you may want to consider a parent-sub structure instead of a brother-sister structure.
A parent-sub relationship occurs when the principals create a holding company and then contribute their interests in the operating company to the holding company. Then, the principals could cause the operating company to park the excess funds in the parent company. The contribution of the interests in the operating company to the holding company should be a non-taxable event under IRC Section 351, if a corporation, or IRC Section 721, if a partnership. The eventual distribution of funds from the subsidiary to the parent should be a non-taxable event under IRC Section 337, if two corporations are involved, and a non-taxable event as a distribution if an upper tier partnership owns
100 percent of a disregarded entity subsidiary.
Benefits of DBAPTs
While split-ups and split-offs should always be explored, there are numerous hurdles to overcome. The requirements for a DBAPT are, generally, much easier to satisfy. DBAPTs are also better than simple parent-sub relationships because there’s statutory asset protection. With a parent-sub relationship, judges may apply a variety of techniques in addressing any asset protection (such as piercing the corporate veil or substance over form)6 to allow creditors to obtain the assets. Protection under DBAPTs is cleaner and more straightforward.
Best State for DBAPTs
Most of the states’ rules are very similar, and the usual suspects are, generally, a good choice here (that is, Alaska and Delaware). However, we believe that Ohio’s new asset provisions may provide the best protection available.7 First, Section 5805.04(B) of the Ohio Revised Code (ORC) provides that:
(B) Except as otherwise provided in divisions (C) and (D) of this section, whether or not a trust contains a spendthrift provision, a creditor of a beneficiary may not compel a distribution that is subject to the trustee’s discretion, even if the discretion is expressed in the form of a standard of distribution or the trustee has abused the discretion.
Abuse of discretion is a critical issue with any DAPT. Ohio’s absolute language, even in the case of an abuse of discretion, provides a client tremendous protection. Also, Ohio has the shortest statute of limitations.8
Any company with excess funds is a good candidate for a DBAPT. For instance, with Apple sitting on over $100 billion, it seems prudent to park a portion of the funds in a DBAPT.9 On the flipside, if Bill’s Bait Shop (with six convenient locations) has $250,000 of cash (excess working capital), why not have the company create a DBAPT? Query whether all companies must form DBAPTs or face exposure to their shareholders for mismanagement (in the event of bankruptcy).
Ohio law provides some latitude to foreign companies operating in the United States. One of the requirements of an Ohio DBAPT is that, “The trust expressly incorporate the laws of this state to wholly or partially govern its validity, construction, and administration.”10 Thus, in certain situations, the foreign company may be able to apply rules it’s more familiar with.11 Even without this benefit, foreign parents may still wish to park funds in an Ohio DBAPT for the benefit of their U.S. subsidiary. If a foreign parent is concerned about future liability, it’s not uncommon to drain out the profits and move them back overseas. The movement of funds is sometimes problematic due to tax concerns both in the United States and the parent country. If the expatriation of funds is due to increased costs of the product, transfer-pricing rules need to be reviewed. If the funds are simply distributed via a dividend or similar device, the appropriate tax treaties (if there are any) should be reviewed. The Ohio DBAPT makes this analysis unnecessary and simplifies operations.
When dealing with an Ohio DBAPT, critical decisions include:
Who will be the trustee? Almost anyone is allowed to be one. ORC Section 5816.02(S) provides that a “qualified trustee” means a person who isn’t a transferor and to whom both of the following apply:
(1) (a) The person, if a natural person, is a resident of this state.
(b) The person, if not a natural person, is authorized by the law of this state or by a court of competent jurisdiction of this state to act as a trustee and whose activities are subject to supervision by the Ohio superintendent of banks, the federal deposit insurance corporation, the comptroller of the currency, or the office of thrift supervision or a successor of any of them.
(2) The person maintains or arranges for custody in this state of some or all of the property that is the subject of the qualified disposition, maintains records for the legacy trust on an exclusive or nonexclusive basis, prepares or arranges for the preparation of required income tax returns for the legacy trust, or otherwise materially participates in the administration of the legacy trust.
The above is the statutory requirement. We generally recommend, if possible, that the trustee not be a subordinate or related party, as defined under IRC Section 672. While there’s no requirement, or even a cross-reference to the IRC, it’s prudent to have such a party acting as the trustee should there be a problem in the operations of the trust. For example, if a husband sets up a DAPT, and his wife is the sole trustee, there could be a strong argument for a sham trust should the wife fail to operate the trust in accordance with its terms.
What type of access does your client want to the funds? An Ohio DBAPT can provide for mandatory distributions of income to the settlor.12 Income is defined in the Uniform Principal and Income Act under Ohio law.13 Accordingly, capital gains will, generally, not be deemed income, unless specifically provided for under the trust agreement.14 In addition, the transferor (that is, the settlor) may reserve the right “to consume, invade, or appropriate property of the trust, but only if limited in each calendar year to five per cent of the value of the trust principal at the time of the exercise of the power.”15 You can also “turn off” these powers under certain circumstances.16
Who can be a beneficiary? Technically, almost anyone can be a beneficiary of an Ohio DBAPT.17 That doesn’t mean you should name whomever you wish. There are many concerns to consider, and each situation should be evaluated individually. For example, if the Ohio DBAPT is drafted as a grantor trust, many issues can go away; however, if the grantor trust provision you use expands access to the funds, you can risk exposing all the assets to creditors. Likewise, if you’re an S corporation and the Ohio DBAPT originally qualifies as a grantor trust, but subsequently loses its status (unknowingly, so that you don’t make a timely electing small business trusts election), the company could lose its S corporation status retroactively.
1. Ohio Revised Code (ORC) Section 5801.01.
2. “DBAPT,” “CAPT” and “BAPT” are registered trademarks of The Horwitz Group, LLC.
3. This reminds me of the movie, “Austin Powers, the Spy Who Shagged Me,” when Dr. Evil said, “Why make trillions, when we can make billions?” See www.youtube.com/watch?v=-vohNUTTx3Ahttps://www.youtube.com/watch?v=-vohNUTTx3A.
4. For example, most of Bill Gates’ wealth is represented by shares of Microsoft.
5. RIA Section F-4602.
6. Belvedere Condominium Unit Owners’ Assn. v. R.E. Roark Co., Inc., 67 Ohio St.3d 274 (1993), as modified by Dombroski v. WellPoint, Inc., 119 Ohio St.3d 506 (2008), states:
The corporate form may be disregarded and individual shareholders held liable for wrongs committed by the corporation when (1) control over the corporation by those to be held liable was so complete that the corporation has no separate mind, will or existence of its own, (2) control over the corporation by those to be held liable was exercised in such a manner as to commit fraud or an illegal act [or a similarly unlawful act] against the person seeking to disregard the corporation entity, and (3) injury or unjust loss resulted to the plaintiff from such control and wrong.
7. “Nevada Trust Big Says Ohio Takes Place of Delaware as Top Trust Choice,” April 28, 2013, thetrustadvisor.com.
8. ORC Section 5816.07—Restrictions on actions, remedies, and claims.
9. Bloomberg Businessweek, www.businessweek.com/articles/2013-02-26/too-much-cash-isnt-good-for-apple.
10. ORC Section 5816.02(K)(1)(b).
11. If the trust provides, in part, for the application of Article 9 of the Hague Convention.
12. ORC Section 5816.05(D).
13. ORC Section 5812.01(D).
14. Supra note 11.
15. ORC Section 5816.05(F).
16. ORC Section 5816.05(A) allows the trust to have “[a] provision that, upon the happening of a defined event, results in the termination of a transferor’s right to mandatory income or principal.”
17. ORC Section 5801.01(C) provides that a “beneficiary” means a person that has a present or future beneficial interest in a trust, whether vested or contingent, or that, in a capacity other than that of trustee, holds a power of appointment over trust property or a charitable organization that’s expressly designated in the terms of the trust to receive distributions. “Beneficiary” doesn’t include any charitable organization that’s not expressly designated in the terms of the trust to receive distributions, but to whom the trustee may, in its discretion, make distributions.