Trusts Are Not Suitable Replacements for LLCs
February 10, 2017
Revocable Living Trusts (RLTs) vs. LLCs
In my practice, entrepreneurs sometimes ask me about trusts. They’ll ask things like, “Isn’t it easier to just set up a trust [instead of an LLC or corporation],” or “Can’t I get the same [legal] protection from a trust without all the cost and hassle [of an LLC]?” The quick answer is a definite, “No.”
I was recently asked: Well, aren’t LLCs still, like, part of the person, whereas trusts are completely separate? I boggled. From a layperson’s perspective, this was probably a reasonable question to ask. As a lawyer, however, I momentarily struggled to understand how that conclusion had been reached.
Ultimately, I decided non-lawyers probably have trouble understanding that a Limited Liability Company (“LLC”) is very much a separate entity from its members, even if the LLC is disregarded for tax purposes (if it has elected to be treated as a disregarded entity). I think non-lawyers often feel that there is an inappropriately intimate connection between an LLC and its members. Add to this that non-lawyers really don’t understand the differences between Revocable Living Trusts (RLTs) and Irrevocable Trusts, and you get even more confusion.
Trust law can be baffling, especially for non-lawyers. At the end of the day, what non-lawyers should do is tell their attorney exactly what they want to do–and, usually, why–and then listen to their lawyer’s advice about how to accomplish that goal. The worst thing a non-lawyer can do is go into a meeting with a lawyer with preconceived notions about what they want, and then insist on having the lawyer give them what they think they want, whether or not it’s actually an effective or efficient means to the intended end.
The reasons people form RLTs and the reasons they form LLCs are completely different. While RLTs and LLCs have a few features in common, they have more differences than similarities. The bottom line is that RLTs are a great tool for avoiding probate; whereas LLCs (or other business organizations), not RLTs, should be used to manage ongoing business concerns.
RLTs DO NOT PROTECT ASSETS FROM CREDITORS
If there are people who have legal claims against you (“creditors”), putting assets into a Revocable Living Trust will not protect them from creditors. The grantor of a Revocable Living Trust, the creator of the trust, is, for legal purposes, still treated as the owner of the trust’s assets.
One of the reasons the law treats the grantor (“creator”) of the trust as the legal owner of the trust assets is because the trust can be revoked at any time; if this happened, the assets would be transferred back to the grantor.
Also, practically speaking, the assets really do belong to the grantor, because grantors can retain total control over the assets after they’re transferred into the trust. Grantors can put in, take out, sell, or give away trust assets at any time, with no restrictions.
Even for income tax purposes, trust assets are considered your personal assets. While assets are in the trust, the grantor must pay income taxes on any income the assets generated. As long as the grantor is alive, the trust is not considered a separate, tax-paying legal entity.
LLCs CAN PROTECT ASSETS FROM CREDITORS
There are trusts that can protect your assets, like irrevocable trusts. Irrevocable Trusts are trusts the grantor cannot control and cannot revoke. Because the assets in an Irrevocable Trust are out of the grantor’s control, in most cases, the assets in the Irrevocable Trust are not considered to be the property of the grantor; therefore, these assets are protected from creditors.
If you are wealthy and worried about lawsuits, you might set up one or more (potentially quite complicated) trusts to shield your certain from your creditors. A simpler solution is to use one or more LLCs or even Family Limited Partnerships to manage certain ongoing concerns, such as investment properties or asset portfolios.
In my opinion, for protecting assets from creditors, an LLC is usually a better solution than a trust scheme, because one can maintain a reasonable amount of control over the assets, but still protect the assets from [potential] creditors.
Other Ways to Shield Your Assets
There may even be simpler methods of protecting some of your wealth (particularly when it comes to protecting large sums of money). Among these are purchasing assets in states that protect certain kinds of assets from creditors.
This is why OJ Simpson bought a huge mansion in Florida. Simpson “was acquitted of the double slaying in the mega-publicized, “crime-of-the-century” criminal trial, but was later found liable for the deaths in a civil trial and was ordered to cough up $33.5 million in damages.”1 Florida’s unlimited homestead exemption ensured his wealth would be tied up in a high-value asset that was exempt, under state law, from his creditors (the families of Nicole Brown Simpson and Ron Goldman). Since OJ exploited Florida’s unlimited homestead exemption, and the state got a lot of bad press over it, Florida “modified the law to prevent new residents such as O.J. to pull the same trick.”2
“In states like Florida and Texas, citizens enjoy an unlimited homestead exemption and it’s very difficult for creditors to ever get a debtor’s home. O.J. Simpson exploited this law and since then they modified the law to prevent new residents such as O.J. to pull the same trick. However, it can be a powerful tool for citizens in several States.
This tool is generally available in 44 states and is a law specifically designed to protect a certain amount of equity in a person’s residence from a variety of creditors. Not only do the amounts of the homestead exemption vary from state to state, there are also different rules on how to qualify for and satisfy the particular requirements of the homestead exemption based on the jurisdiction. Approximately, twenty-one states even require that a home owner file appropriate paperwork to qualify for the exemption.”2
Whether you are trying to use a homestead exemption or another kind of asset protection strategy–and there are whole industries devoted to asset protection–the best thing you can do is obtain ongoing legal services from an attorney who can guide you through the process and give you sound legal advice.
Oh, and actually listen to the advice; that should go without saying, but it doesn’t. You might be surprised at how many people hire lawyers, and then, to their detriment, ignore what their lawyers tell them to do.
Most lawyers want to make their clients wealthier, protect their clients’ assets, and make their clients happy. Lawyers aren’t just leeches who want to draw up documents and charge a big fee. Lawyers are people who know how to structure complex legal arrangements and entities for the benefit of their clients.
A smart client will hire a lawyer and then let them do their job with the understanding that the fee they pay, the cost of the services, is commensurate with the value they can expect to receive. In other words, you get what you pay for.
1. Burke, C. (2000, September 24). O.J. SPENDS BIG BUCKS ON FLORIDA HOME. Retrieved February 10, 2017, from http://nypost.com/2000/09/24/o-j-spends-big-bucks-on-florida-home/
2. Kohler, M. J., M.Pr.A, C.P.A., J.D. (2014, December 2). 6 Ways to Protect Your Home from a Lawsuit. Retrieved February 10, 2017, from http://markjkohler.com/6-ways-to-protect-your-home-from-a-lawsuit/
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