The Business Purpose Doctrine Revisited

By Ryan Fowler, Consultant - Email Editor

Date : 15-Feb-2007

Dear Subscriber:

I have asked Ryan Fowler to give us some of his thoughts on key techniques in structuring Asset Protection Plans in order that they are solvently respectable by the courts. He mentions some key recent cases presenting that a valid business purpose is imperative to every foreign and domestic Asset Protection Plan. Just remember when reading this thoughtful article that most foreign banks will not open an account in the name of an individual U.S. Citizen unless that person is doing so through the vehicle of an offshore trust. That fact, in and of itself, can provide a powerful business justification for any offshore planning involving trusts. Enjoy Ryan’s perspecttive, and as always, have a healthy and protected week. (Rob)

Asset Protection Plans are put to the ultimate test when scrutinized in court. Knowing how to structure a Plan to survive such scrutiny is what separates a great planner from the mediocre masses. Fortunately, the courts themselves have told us what types of planning will and won’t be respected.

Having a Legitimate Purpose for Your Plan

In one case, a court gives clear instruction on what kinds of Asset Protection Planning are or are not acceptable when it says:

“'Asset protection' is not illegal and is honored by the law if done for a legitimate purpose. For example, an individual may do business through a corporation or limited liability company and will not be held personally liable for the debts of the entity. The assets of the corporation or limited liability company will not be considered the assets of the individual interest holder. However, an entity or series of entities may not be created with no business purpose and personal assets transferred to them with no relationship to any business purpose, simply as a means of shielding them from creditors. Under such circumstances, the law views the entity as the alter ego of the individual debtor and will disregard it to prevent injustice.” [1] .

It is of further note that this case mentions the defendants' meeting with and use of an Asset Protection Planner as evidence that the Plan was implemented to thwart creditors. The Asset Protection Planner was even subpoenaed and forced to testify! Subsequently, the defendant's structure was deemed a sham, and the defendants lost their wealth. The best way to avoid such mishaps is to have a legitimate purpose for your planning besides just Asset Protection.

The three most common “alternate” purposes that are integrated into Asset Protection Planning are business, tax, and estate planning. LLCs, corporations, and LP's are primarily business entities. Trusts are great for estate planning, and they are often statutorily protected from creditors if they contain a spendthrift clause and are not self-settled (meaning the trust grantor is not also a beneficiary of the trust; offshore trusts, however, may provide significant Asset Protection even if they are self-settled) [2] . We must remember that using business entities, such as family limited partnerships, solely for estate or tax planning, with no business purpose, can be a recipe for disaster. This was the case with Strangi v. CIR, wherein a family limited partnership was pierced because it had no business purpose and had not invested its assets in any form of business venture [3] .

The above cases lead us to deduce that business entities, such as LLCs, corporations, and limited partnerships, should always have a bona fide, demonstrable business purpose [4] . If the business entity holds investments, then it is best to trade or exchange more than just a de minimis amount of its investments from time to time to demonstrate that the entity is actively engaging in business rather than merely holding assets.

In addition to the foregoing, there is a simple and effective litmus test for determining whether an Asset Protection program is likely to pass court scrutiny. Simply ask yourself: “If a judge asked me why I set up my affairs the way I did, what will I say?” (I put this litmus test in bold print because it is very important! It should be used when structuring ANY Asset Protection program that does not have a built-in business purpose.) If the only answer you can think of is “I set up my financial affairs so as to avoid creditors,” then you have a program that will likely fall apart when challenged. This is not only true when a program is set up after a lawsuit arises; it may also be true even if the Plan is set up while creditor seas are calm. The case U.S. v. Townley validates this fact [5] . In this case, Mr. and Mrs. Townley had transferred their home into a non-self-settled trust years before they ran afoul of the IRS. However, Mr. Townley's own testimony as to the reason for the trust proved to be his undoing. The court notes:

“…a transfer of property made with actual intent to delay, hinder, or defraud a creditor is prohibited… Mr. Townley stated in his deposition that he was concerned about potential ‘lawsuits from the exposure we had from liability from troubled boys in the State of Washingtion.' (Ct. Rec. 58, Ex. 1). Additionally, Mr. Townley stated that it was his goal to protect his assets from anyone who might get a judgment against him… Plaintiff asserts that Mr. Townley's statements that he intended to protect his assets from anyone who might get a judgment against him is conclusive, direct evidence of intent to hinder, delay, or defraud. The Court agrees.” [emphasis is mine]

Some people might think structuring a program with a bona fide business purpose would require an excessive time and effort commitment. For the most part, this is simply not so. For example, cash can be placed in an LLC and then invested into stocks, bonds, real estate, or other assets that are likely to appreciate and generate profit. Retirement funds may be rolled over to a self-directed IRA that invests in an offshore LLC, which in turn either operates as a business or actively engages in investment activity. Life insurance policies could be placed in an Irrevocable Life Insurance Trust (ILIT), which need have no business purpose as they are a valid, court-honored estate planning tool. The list goes on and on. These are things many financially savvy individuals would do anyway, regardless of whether they were trying to protect assets. Of course a skilled planner needs to be knowledgeable about a wide variety of business entities and trusts, so as to be able to creatively and skillfully use these entities in a manner that will appear legitimate when scrutinized in court.

If desired, many of the above entities can be structured so as to be disregarded for tax purposes. This minimizes or even eliminates the requirement to file informational tax returns. Instead, incomes from the entities are often simply reported on the owner's or grantor's 1040 Schedule C return [6] .

The Offshore Annuity and Other Economic Reasons for Going Offshore

But what about going offshore? Even if your offshore program has a valid business purpose, a judge may well ask “why couldn't you have just done that onshore?” [7] We need to have a plausible response. Fortunately, the trend of a weakening U.S. dollar provides us with an answer. For example, between January 2002 and January 2005, the dollar weakened against the Euro an astounding 56%. Imagine how much better off you would have been financially had you invested in an offshore annuity earning 4% annually, especially if that annuity had been based on the Euro! Personally, I think it's essential for anyone of significant wealth to invest a portion of their liquid assets in an offshore annuity based on a stable, nearly debt-free currency such as the Euro or Swiss Franc. And although an offshore entity is not needed to merely buy these currencies, you must have an offshore entity if you want to avail yourself of certain tax-deferred annuities and/or life insurance products in order to receive a guaranteed additional return on your investment. Therefore, going offshore may give you a bona fide economic benefit you wouldn't be able to achieve any other way.

In light of the above, do you think a judge would agree that it sometimes makes economic sense to go offshore, in order to gain a benefit you couldn't obtain otherwise? Of course he would, and that's what we need to get a judge to agree to in order for him to respect your program.

Ryan Fowler

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[1] In re Turner, 335 B.R. 140 (Bkrpt. N.D. Cal 2005).

[2] A spendthrift clause prohibits a creditor of a beneficiary from attaching trust assets so long as they remain undistributed.

[3] Albert Strangi v. CIR, 417 F.3d 468 (5th Cir. 07/15/2005).

[4] Some statutes, including the LLC Acts of several states, do not require a business entity to have a business purpose. For example, §53-19-6 of the New Mexico LLC Act allows LLCs to be formed for “any lawful business or purpose.” [emphasis is mine] However, because New Mexico courts have not yet ruled on this matter, and New Mexico LLCs might be subject to litigation in other, more restrictive states, it's safest to use LLCs for only legitimate business endeavors.

[5] U.S. v. Bryce W. Townley, No. CS-02-0384-RHW (USDC E. Wash., Jul. 29, 2004).he intended to protect his assets from anyone who might get a judgment against him is conclusive, direct evidence of intent to hinder, delay, or defraud. The Court agrees.” [emphasis is mine]

[6] The general rule is that domestic entities that are disregarded for tax purposes need file no informational or other return. Offshore entities, however, always file some sort of return if their owner is a U.S. person. Note, however, that these returns may be simpler than the return filed by an offshore entity that is not disregarded from its owner(s) for tax purposes, e.g. an IRS 5471 (offshore corporation) or 8865 return versus the simpler 8858 disregarded entity return.

[7] A judge asked this exact question in Brown v. Higashi No. A95-00200-DMD (Fed.B. Alaska 03/11/1996).