Using Corporations For Asset Protection

Introduction
Very basically, corporations are fictitious legal entities owned by groups of investors, who each individual own equity interests called “shares” in their particular entity. Investors pour capital into the corporation, and return shares of stock (representing their equity interests) in return. The investors are now shareholders. The shareholders elect directors and officers to run the corporation.

Varieties
There are many, many types of corporations, such as: professional corporations, hybrid corporations, limited liability companies, insurance companies, banks, mutual funds, companies limited by guarantee, municipal corporations, constitutional corporations, hybrid corporations, societe anonymes, corporations aktiengesellschaft, and corporations gesellschaft mit beschrankter haftung. Not satisfied with this legal buffet? There are also a couple of jurisdictions which if invest enough money into their economy will allow you to create your own corporation.

Our purpose here is not to catalogue each and every type of corporation. Instead, we will concentrate on those types of corporations which are useful for individual and privately-held business planning. To learn more about types of corporations please view our INC section.

The determination of which type of corporation to form is largely a function of tax law, and not corporation law. Therefore, we will concentrate here not only on the liability-limiting functions of corporations, but also on the basic tax considerations. For U.S. tax purposes, foreign corporations (such as IBCs) are treated much, much differently than their domestic counterpart. Thus, we will initially divide corporations into two broad categories: Domestic Corporations and Foreign Corporations.

DOMESTIC CORPORATIONS

Introduction to Domestic Corporations
The benefit to using a corporation is that the owners are, to a degree, separated from the business being conducted by the corporation. Since the corporation is theoretically distinct from its shareholders, property placed in the corporation by the shareholders in exchange for equity may not be attacked by creditors of a shareholders, and acts resulting in liability to the corporation are not imputed to the shareholders.

The use of a corporation allows assets to be cross-collateralized between corporations and persons. That is, corporation A holds a lien on the assets of corporation B and vice-versa. In the event of a judgment against corporation A, the assets are sold and the moneys set to corporation B because of its lien — but not the creditor.

C-Corporations
By far, the two most popular types of corporations used for planning purposes are “C” Corporations and “S” Corporations. These are both formed more or less the same, but they make a different election for federal income tax purposes – i.e., your Secretary of State will not ask you whether the corporation you are forming will be a “C” or an “S” Corporation.

Most large corporations are “C” corporations (Exxon, Microsoft, General Motors, etc.). Essentially, the corporation makes money and pays the government at the corporate tax rate. Then, the corporation distributes what money is left to shareholders who also pay tax on the money (so-called “double taxation”).

S-Corporations
Because the corporation pays taxes separately before it declares a dividend, there is a risk of “double taxation” – i.e., the corporation pays income tax on its profit, then pays a dividend to shareholders, and then the shareholders must also pay income tax on the dividend.

To avoid double taxation, the Internal Revenue Code allows for an “S” Corporation which allows a corporation with few shareholders to be treated the same as a partnership. This means that the corporation’s profit is not taxed, but rather all of the profit is divided among the shareholders who must declare it as their personal income. Note, however, that this is not creating any new advantage; rather, it is only relieving the disadvantage of double taxation.

Please note that to qualify for “S” Corporation treatment you must first file an election with the IRS. No election, no “S” treatment.

Because of the equally favorable tax treatment for LLCs, which are a more flexible, very few “S” corporations are being formed.

Limited Liability Companies (“LLC”)
Limited Liability Companies are business entities which are hybrids of corporations and partnerships. L.L.C.s which do not issue shares, but rather each owner is entitled to a percentage interest in the company which is equal to the net of his total contributions.

For example, assume that Fred and Ethel form an L.L.C. Fred and Ethel each immediately contribute $1 million to the company. At this point in time they are each 50% owners of the company. Later, Ethel contributes an additional $2 million to the company. Fred is now only a 25% owner, and Ethel is a 75% owner.

Further, the income received from an L.L.C. is treated like partnership income – i.e., all income is distributed to the owners who individually pay tax on the income. Another way to think of an L.L.C. is that it is an S-corporation without stock. L.L.C. serve an important purpose by streamlining the accounting for small businesses.

No doubt, these are neat entities, but the law is just too new and we don’t know how well they will stand up to creditors, if at all. There is quite a bit of theory about LLCs, but very little case law relating to how easily one may be penetrated.

Delaware and several other states have recently extended “charging order” protection to the holders of Limited Liability Company (LLC) interests. “Charging order” protection means that even though your creditor get a judgment against you, the creditor cannot actually take your LLC shares — the most the creditor can do is “charge” the shares IF any distribution is made to the LLC shares. Probably, all the other states will follow and also extend charging order protection to LLCs, at least to some degree. Because of this, many promoters — and even some very good tax and estate planners — have been using LLCs for asset protection, with the claim that LLCs now afford the same level of relief as the so-called Family Limited Partnerships (FLPs).

This can be true IF the LLCs are formed in the same fashion as FLPs; it is not true if they are formed as simple LLCs or, worse, as single-member LLCs (that is, an LLC with only one interest holder). What made FLPs valuable as asset protection tools is that you had two components. First, you had the limited partnership shares, which you held. Second, you had a general partner corporation which was either owned or controlled by someone else, or was set up in a way where you would control the FLP irrespective of who owned the general partner corporation (such as a director for life). If a creditor obtained a charging order against the limited partnership interest, the general partner would simply not distribute anything to those limited partnership interests, and the creditor was stuck.

LLCs are the same way. Even though there is now charging order protection, you can’t simply stand behind an LLC alone for asset protection, but must use a structure where you form another company to act as the “Managing Company” for the LLC which will actually hold the assets. In the best circumstance, this Managing Company will be an offshore corporation which will not be subject to the jurisdiction of U.S. courts, and will hold 1% or 2% of the domestic LLC interests. Thus, in the event of a creditor attack, the Managing Company will simply not make a distribution to the LLC. But it will of course be necessary for the LLC Operating Agreement to carefully specify the powers of the Managing Company, and the limited rights of the majority LLC member.

The other thing to look out for is whether the charging order protection is the EXCLUSIVE remedy in the state where the LLC is formed or where it protects assets. If the LLC laws provide that the charging order is only one form of relief against the LLC, or that other remedies will exist, the LLC will not afford much protection.

But if you can clear these hurdles, an LLC with an offshore corporation as the Managing Company ought to provide domestic asset protection comparable to that of a Family Limited Partnership – which is to say that it should provide a decent “first-line” level of defense which will keep assets from being frozen and allow time to move assets offshore (where the only dependable asset protection can occur, since the assets are removed from the whims of U.S. judges).

Professional Corporations (“PC”)
Professional Corporations are corporate entities, the stock of which may only be owned by a certain class of professional persons, such as doctors, lawyers, etc. The purpose of a Professional Corporation is to avoid ownership by a non-professional. For instance, if I am in medical practice firm and I don’t want my partner’s spouse to own a portion of the business when my partner dies or they are divorced (which co-ownership is also probably ethically improper), I would form a P.C. so that the spouse would be prohibited by law from owning the shares.

Nevada Corporations
Why go offshore when a Nevada corporation offers all, if not more, of the protections of an offshore corporation? After all, you get nominees, you get secrecy, you get bearer shares, you get – well, you get what you usually get in Nevada, which is something which feels really good for a couple of days but you wonder why in the world you did it when you get home.

There are many groups which harp Nevada corporations as the end-all, and there are even a few practitioners who rely on Nevada corporations. These days, its hard to look in the newspapers and not see some fringe group or sleazy attorneys hawking Nevada corporations as a “judgment proofing” structure.

Unfortunately, the reality is that Nevada corporations suffer from the same basic problems as the Alaska Trust. In summary, these are as follows:

Federal Law
Federal judges don’t give a hoot about Nevada law, so don’t expect these things to give you any protection if you are sued in federal court. [Don't believe us? Then just tell the federal judge that you are refusing to answer questions because of the Nevada secrecy laws. Oh, and bring your toothbrush to that hearing.]

Full Faith & Credit
The U.S. Constitution requires Nevada courts to recognize judgments of other states. So, if you get sued in another state, Nevada will still have to recognize the judgment irrespective of Nevada corporation law. But this doesn’t mean that other states have to respect Nevada corporation law. If a Nevada corporation gets sued in Texas, for instance, Texas procedure will apply and not Nevada procedure.

Still in the U.S. of A.
Assets held inside a Nevada corporation are subject to seizure, attachment and/or garnishment in the U.S.

State Taxes
About the only real reason that you would want to use a Nevada corporation is to try to avoid state tax law. California residents attempt this a lot; unfortunately, California isn’t so big on it and regularly audits businesses which are doing business in Nevada.

Summary of Benefits
About the only people that the “extraordinary” Nevada statutes benefit are Nevada residents who have formed Nevada corporations who are being sued on a Nevada cause of action in a Nevada state court. Everybody else is out of luck if they expect any real benefits above those of any other state.

Higher Chance of Audit
The IRS reads the newspaper ads like everyone else, and know that many people are trying to use Nevada corporations to avoid federal income tax – and not surprisingly, Nevada has a higher audit rate than most states.

The Bottom Line
Avoid Nevada corporations, and planners who use Nevada corporations as any regular planning technique. The protection you receive from Nevada corporations will only rarely be worth the incorporation cost…about $99 if you do it yourself.

OFFSHORE CORPORATIONS (IBCs)

Here’s the bad before we go into the good…

Over the years, alot of folks have used offshore corporations to avoid billions, if not trillions, of dollars of taxes. But Congress and the IRS have wised up to these strategies, and there now are a bunch of harsh rules and civil and criminal penalties for abusively using offshore corporations to avoid taxes. So, before we tell you some of the legitimate ways to use offshore structures, we’re going to give you some warnings.

First, you must understand the CFC rules. If an offshore corporation has any US shareholders who own 10% or more of the company’s stock (or if U.S. shareholders in the aggregate own 50% or more of the stock), then it is considered under U.S. law to be a “Controlled Foreign Corporation,” or “CFC”, and the person who owns the stock must file an informational return as to the company and report (and depending on how it is set up, paytax on) the company’s income, etc., pretty much as if it were a US S-corporation. Additionally, there are “attribution” rules which has the effect of greatly expanding this basic rule.

For this reason, at least for US citizens there are absolutely no income tax advantages, and very few other tax advantages, to using an offshore corporation. Offshore corporations are great for facilitating international trade and for protection against creditors, but they are more or less “tax neutral.”

Anybody who tells you differently is probably lying – send us their documentation and we’ll take a look at it for free! If it works we’d love to see it, but chances are it will do little more than amuse us. If we do find something that works to save taxes, you can bet it will be plastered all over this web page within 24 hours, but we’re not holding our breath.

Until only a couple of years ago, you could set up an offshore trust, which you controlled through a protector agreement, and then the trust formed an IBC. You could then honestly say that you did not control the IBC, and the IBC could invest abroad and accumulate assets and income tax-free. But not anymore, after the 1996 Small Business Act, which essentially states that if you have anything at all to do with a foreign trust you must file tax reports for that trust, and if such a trust owns shares in an IBC the IBC is considered to be a Controlled Foreign Corporation (CFC).

Despite these changes, there are still a few offshore practitioners fumbling around and telling their clients that they can form offshore trust with IBCs under them and pay no taxes, which is wrong — but the practitioners have been doing it so long that they know of no other way to make a living. Beware of these people, especially when they are offshore as it will be you going to Club Fed and not them. Controlled Foreign Corporations are now at best tax-neutral, period the end.

The Three Most Popular Ways to Commit Tax Evasion Using an Offshore Corporation

We get calls from concerned businessmen, who have either implemented a questionable offshore structure, have been counseled to implement such a structure, or were thinking about doing it themselves. Based on our experience, here are the three most popular ways that people (unwisely) use offshore corporations to commit tax evasion:

Bearer Shares – Shares which are owned by whoever holds them at any particular moment. These can trigger several horrible tax consequences.
Non-CFCs – These are foreign corporations which you control, but which your tax attorney or CPA argues you don’t own should you get audited or have to go to court.
Reinvoicing / Transfer Pricing – Establishing an intermediary company offshore to divert profits. The IRS has some of its strongest powers to fight these structures.

Introduction to Offshore Corporations
Offshore corporations are similar to domestic corporations, but they are incorporated in an offshore jurisdiction and are subject to the offshore jurisdiction’s laws. The offshore corporations which we are concerned about typically cannot do business within the jurisdiction of their incorporation, except for investment purposes, etc. Such corporations are often referred to as “exempt companies” or more commonly “International Business Companies” or “IBCs”.

Nominees
Nominees are local folks the company formation companies and trust companies hire to act as the officers, directors, and shareholders of a corporation, or as the trustee, protector, and in some cases beneficiaries of a trust.

A couple of years ago, the CBS program “60 Minutes” did a segment on the Isle of Sark (one of the Channel Islands), which detailed the nominee services being offered by the residents of that island – most of which were the nominee directors and shareholder for hundreds of companies, including some of the largest companies in the world.

Typically, at the time that a nominee is appointed the nominee will simultaneously execute a “blank” resignation – i.e., a resignation with the date left blank – so that the Client can terminate the nominee at any time, even retroactively if the Client has disagreed with some act of the nominee.

Concern that the nominees will somehow make off with the assets of the company can be mitigated in a number of ways, such as having the assets titled in the name of the corporation and in the name of the Client or a trusted friend, requiring that the nominees put up a bond, or by simply utilizing a well-respected offshore trust company as an additional protector of the company’s assets.

Nominees are paid annually, and fees for their services generally run from as low as US$100 per year to act as a shareholder, to as high as US$500 per year to act as a corporate secretary.

Please keep in mind that nominees are your agents. Thus, you can’t hire a nominee and then claim that the nominee is not you for purposes of determining whether the company is a Controlled Foreign Corporation. Nominees are good for your average collection attorney, who simply doesn’t understand these issues.

Exotic Corporations
Just as the offshore jurisdictions have created a bunch of weird trust structures – almost always to get around U.S. and U.K. tax laws, these jurisdictions have also created a bunch of weird corporate structures, sometimes by digging deep into the history of the common law for things which haven’t been used for hundreds of years, but just as often by making stuff up as they go along. We’ll focus on one here by way of example: Companies Limited by Guarantee.

Companies Limited by Guarantee
This is a form of corporation which has existed for hundreds of years, but has only recently resurfaced because in theory it avoids the U.S. controlled foreign corporation rules. A company limited by guarantee is a company which does not issue shares. Instead, you “pledge” that if the company gets sued that you will then contribute (this is the “guarantee”) X dollars to the corporation. The amount of your guarantee relative to all guarantees determines the percentage of your equity, and the return you willl receive.

For instance, assume that a company limited by guarantee is formed, and Joe guarantees the company for $300 and Fred guarantees the company for $700. If the company makes $20,000 dollars in a give year, Joe will receive $6,000 and Fred will receive $14,000. But, let’s say the company gets sued for $15,000. In that case, Joe will be liable to the company for $300 (the full amount of his guarantee) and Fred for $700 — and the creditor is out of luck for the other $14,000 (assuming the creditor doesn’t sue Joe and Fred in their individual capacities).

Now, from an asset protection standpoint, these companies raise some interesting possibilities since the creditor is at least theoretically limited to the amount of the guarantee. So, we’ll throw them in our toolbox and await an opportunity to use them.

Where people try to use these is in relation to taxes are essentially arguing that since no shares are issued, the CFC rules are not implicated. Unfortunately, this overlooks the attribution rules, and it is very likely that that a court will say that Joe owns 30% of the stock and Fred owns 70% of the stock.