Asset Protection

Introduction

Asset Protection is an important part of any financial or tax planning discussion.

A Crisis Averted

A new client came to our CPA Firm last week after settling a frightening lawsuit. The possibility that they could have lost several million dollars in assets was very real; it was close!

Increasingly people and “for profit” and “not-for-profit” businesses face the routine threat of litigation.  The “Assets Protection” concepts discussed in this newsletter apply equally to commercial businesses just as well as it does to “not-for-profit” businesses.

What follows is, in large part, extracted from the “Asset Protection” letter that I drafted to help my new client avoid the future possibility of losing substantial assets due to litigation.

Social Welfare Services, Inc.

The name that I have arbitrarily assigned to this entity for confidentiality reasons is: Social Welfare Services, Inc.

A Consulting engagement

Not-for-profit organizations, such as Social Welfare Services, Inc., face complex and often dangerous tax situations and legal situations. Our CPA firm has (and has had) many hundreds of §501(c)(3) clients over the years; we have clients who are not-for-profit organizations in 35 states and 25 foreign countries. We have seen non-profits accomplish remarkable and positive things; on rare occasions, these accomplishments had powerful, worldwide impact. We have also seen the opposite; situations so bad that they are beyond belief or comprehension.

Catastrophe

The first rule of managing a catastrophe is this: avoid it!

A “Tax Opinion” Letter

This is a “tax opinion” letter. This letter is subject to strict ethical and legal standards governed by my Code of Conduct, IRS Circular 230 and the Internal Revenue Code.

IRS Circular 230, Section 10.37, sets the required standard to which I must comply when providing a tax opinion in any written communications.

A summary of the rules to which I must comply are:

• Base the written advice on reasonable factual and legal assumptions, including assumptions as to future events;
• Reasonably consider all relevant facts the practitioner knows or reasonably should know;
• Use reasonable efforts to identify and ascertain the facts relevant to written advice on each federal tax matter;
• Not rely on representations, statements, findings, or agreements (including projections, financial forecasts, or appraisals) of the taxpayer or any other person if reliance on them would be unreasonable;
• Relate applicable law and authorities to facts; and
• In evaluating a federal tax matter, not take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.

I am required to include in the opinion a recitation of the relevant facts, apply the law to those facts, and state the conclusions from applying the law to the facts. The sanctions for a CPA who fail to meet these well understood ethical and legal obligations are harsh.

My Team

I will outline a tax plan that has positive tax and legal consequences. I’m not a lawyer; I rely heavily on outside legal counsel in designing and implementing this sort of plan.

The legal work that will be required to implement this plan will need to be done by competent legal counsel. Some of the law that I will discuss is relatively new. Inexperienced or uninformed attorneys (or accountants) could make mistakes of profound implications.

The “New” Law (2006)

In late 2006 (December 8, 2006), the IRS established a new concept in tax law called a “disregarded entity”. Early on, Alabama allowed for what was at the time a unique corporation called a “Single Member LLC”. Since then, all states now allow this special type of entity.

A “Single Member LLC”, which I will hereinafter refer to as a SMLLC, is a deceptively simple organization with hidden super powers. Two of these “super powers” are that a SMLLC can “disappear” for all purposes of federal income tax law and it can offer strong liability protections under Alabama law.

But, there are other super powers in addition to these two.

Confidence

Early in 2007, prior to clarifying IRS Regulations, I started to explore the use of SMLLCs in connection with §501(c)(3) and other entities to good effect.

Each time I employed a SMLLC ahead of IRS Regulations, the IRS and the Regs ultimately endorsed my actions. I think my forays into this, at the time, obscure branch of tax planning, encouraged my own attorney to be a bit more aggressive in his study of and use of SMLLCs in tax and legal planning.

Thus far, our plans have been effective in accomplishing the intended purposes.

The “Single Member LLC”

The SMLLC is a unique tax entity. A SMLLC has, as you might expect, a single member. That single member could be any legally existing tax entity. For example, a SMLLC could be owned by:

• An Individual
• A partnership
• A corporation
• A trust, or, as will be the case in this tax plan, or,
• A §501(c)(3) entity.

A SMLLC has the same limited liability as a Corporation

A SMLLC offers the same limited liability to its owners as corporations for all purposes of state law. Alabama has good, well crafted, laws that support LLCs in general and SMLLC in our particular case.

In fact, LLCs and SMLLCs have, in my opinion, better limited liabilities than a regular (old fashioned) corporation because the old fashioned corporations could have the limited liability shield broken by a long list of accidental or inadvertent oversights such as a failure to have required annual meetings, etc. These meetings are not required for LLCs.

A SMLLC is a Disregarded Entity

Although the SMLLC has some of the more desirable corporate characteristics under Alabama law, it is, for all purposes of federal income tax law, a “disregarded entity”.

As a “disregarded entity” for federal income tax law, a SMLLC then becomes the “same” taxpayer as the owner. If, for example, a SMLLC is owned by a §501(c)(3), then, as far as the IRS is concerned, the SMLLC is a §501(c)(3).

There is no need to seek an IRS determination letter; if the SMLLC is owned by a §501(c)(3), then the SMLLC is automatically a §501(c)(3). (There is a bit more to this in terms of organization and operations in a manner consistent with the exempt purposes of the §501(c)(3), but, not much.)

The Plan

Recent Alabama law related to LLCs and SMLLC has been substantially improved to allow for creative restricting of all business entities including §501(c)(3) organizations.

What I recommend is as follows: Social Welfare Services, Inc. should form the following entities.

1. Operations and Management, SMLLC
2. Real Estate, SMLLC
3. Equipment, SMLLC
4. Thrift Store #1, SMLLC
5. RBC Thrift Store #2, SMLLC
6. Development Funds and Endowment, SMLLC

This structure is seven entities:

• The parent entity, Social Welfare Services, Inc., an approved §501(c)(3), and:
  • Operations and Management, SMLLC
  • Real Estate, SMLLC
  • Equipment, SMLLC
  • Thrift Store #1, SMLLC
  • RBC Thrift Store #2, SMLLC
  • Development Funds and Endowment, SMLLC

I have tried to apply hypothetical names to these various entities to make the purpose and function obvious; when selecting actual names, I suggest you try to accomplish the same goal.

Operations and Management, SMLLC

This first SMLLC from our list above, Operations and Management, SMLLC, will be the entity that provides facilities, personnel and financial management.

Operations and Management SMLLC is an entity with no tangible assets. Its function is to manage the operations of Social Welfare Services, Inc. in a manner consistent with the organization’s exempt purposes. It will be responsible for all bookkeeping, accounting, personnel and payroll activities for all the entities.

Operations and Management SMLLC should keep minimal cash in the bank balances for operational purposes only. Savings accounts and other cash assets need to be move to the Development Funds and Endowment, SMLLC.

Did I mention other “super powers”?

A SMLLC is a disregarded entity for all purposes of federal income tax law. It is, however, not a disregarded entity for all purposes of federal payroll tax law. Interesting!

One of the more common catastrophes of the not-for-profit world are payroll tax mismanagement. Catastrophic is the appropriate word. The Directors, members of the board, secretaries and payroll clerks and, in some cases, even banks, can be held responsible for unpaid payroll taxes and penalties. Harsh!

SMLLCs, Payroll and payroll tax functions

By placing all payroll and payroll tax functions into Operations and Management, SMLLC, and by crafting operating agreements and employee job descriptions carefully, it is possible that any payroll tax issues can be confined to that entity and to only a few designated (or perhaps, only one) individual who could be a designated “responsible party” for IRS purposes.

This could offer asset protection for the other related entities in the group and quickly move any payroll tax dispute onto the shoulders of the responsible party. This is not necessarily a bad outcome. Having agreements in place to indemnify any responsible party for payroll tax liabilities could quickly reduce payroll tax assessments to one-third (¹/₃) of the original assessment and thereby offer the consolidated entities a clear pathway to full financial recovery.

I have successfully worked this odd twist in payroll tax law three or four times in the past but never with a §501(c)(3) in the mix. I see no reason why it would not work just as well in the not-for-profit area of law.

Real Estate, SMLLC

The second entity from the above list is Real Estate, SMLLC. The function of this entity is to own land and buildings.

The management and maintenance of this real estate will be accomplished by Operations and Management, SMLLC. This second entity, Real Estate, SMLLC, is merely a real estate holding entity with no management or operational functions.

Equipment, SMLLC

The fourth and final entity from our list shown above is Equipment, SMLLC. This entity is for the sole purpose of owning all tangible property and equipment that is not land or buildings. This entity will have no management or operational functions for this entity.

Thrift Store #1, SMLLC and RBC Thrift Store #2, SMLLC

Even in the commercial world, separating retail operations by location is a common use of SMLLCs. The liabilities unique to retail are then confined to that location by the SMLLC. For example, a disastrous sales tax audit at the Attalla store can be confined to that store; the assets of the organization are protected. Likewise, a slip fall injury; etc.

Development Funds and Endowment, SMLLC

Each SMLLC can receive donations that are tax deductible. By using a SMLLC to hold and manage development and endowment funds, you isolate these funds from operations and create an additional layer of protection from the organization’s potential liabilities.

This organizational structure is helpful for special fund raising events, such as a capital fund campaign or to develop an endowment fund.

I have recently used this to avoid imminent litigation with profoundly positive results. Because an endowment fund can be its own SMLLC, it can have its own board of directors and the needed additional layer of liability protection.

In the recent case, successfully navigated by good entity and tax planning, I had to deal with potential litigants who were actually members of the board of directors of the parent organization! We caused a substantial (multimillion) contribution to be made to a new SMLLC for that purpose thus isolating these funds from the direct control of the renegade board members to a SMLLC (who had their own unique board) and accomplished two positive things:

• Assets were protected and
• The renegade board members regained perspective and fulfilled their board obligations admirably.

I am very fond of isolating development and endowment funds by use of SMLLC!

Management Issues

The organization delivers services as it always has; from the point of view of the children and the donors, nothing will appear to have changed. Internal management will change. These changes are not onerous.

• Each SMLLC becomes what the law refers to as a fully integrated auxiliary of the parent organization. As such, each SMLLC is obligated to:
  • Make regular and routine financial reports to the management of the parent organization, in this case, Social Welfare Services, Inc.
    • This may require that Operations and Management, SMLLC make modest modifications to how the bookkeeping is accomplished.
    • Financial reports should be unique to the operations and function of the SMLLC to which they relate.
      • We can help set these up.
    • Also, each SMLLC is required to make operational and management reports to the parent organization.
      • Each SMLLC should have a report unique to the function of that SMLLC, for example, Real Estate, SMLLC should include two items, one for maintenance and the other for needed but deferred maintenance.
        • We can help set these up.
      • Each SMLLC can have a unique board of directors. Even with a unique board of directors, each SMLLC must report to the parent organization.

More Super Powers!

SMLLCs have a large variety of attributes and abilities that, in the right context, become super powers. The §501(c)(3) world offers a rich context to apply these abilities. A full list of these abilities are beyond the scope of this letter and, frankly, beyond my skill level and competence. That’s why I rely on outside legal counsel. By brain storming together, we and I have often discovered hidden applications for LLCs and SMLLCs that evolved into super powers.

A small list follows; each SMLLC can:

• Have a unique EIN Number
  • This does not change how the IRS Form 990 is filed.
• Have a separate bank account
  • Keeping money away from Social Welfare Services, Inc. is a good idea for reasons I will discuss in the next section of this letter.
• Have a unique and separate board of directors.
  • This can be a good idea for a number of reasons; marketing is only one good reason.
  • A unique “junior” board of directors can groom the next generations of donors and management.

I promised a short list of alleged super powers; I have delivered. This list is too short by a large factor. Discovering new super powers that apply to your organization are where an ongoing relationship with a CPA Firm and an Attorney with deep skill sets in this area become important. None of us can anticipate all future situations. The attributes of LLCs and SMLLCs only become “super” with the right situation and timing. Going forward, that is our real job.

Liability Protection

The point of this proposed reorganization is asset protection. Each entity, including the parent entity, Social Welfare Services, Inc., enjoys a layer of liability protection.

Any meaningful discussion of liability protection through entity selection and management structure is the strict domain of attorneys. For that reason, I will ask our own attorney to review this letter and will allow him to make suggestions and, if he chooses to, make changes or add comments.

Social Welfare Services, Inc. is the provider of services to the children. If a child is hurt or killed in delivering these services, Social Welfare Services, Inc. will likely be a primary party in any legal action. Social Welfare Services, Inc. has no assets other than the limited funds in the operating bank account.

In the event that Social Welfare Services, Inc. is a party to a legal action, it is very likely that Operations and Management, SMLLC will also be named as a party to that legal action because it provides financial and personal management. To this point, the additional layer of protection from legal liability is thin. From the point of view of managing legal liability, it offers some but minimal additional protect. The mere fact that it is another legal entity complicates any potential plaintiff’s case.

For that reason, both Social Welfare Services, Inc. and Operations and Management, SMLLC should maintain minimal cash balances. All cash, not essential to day-by-day operations, should be held by Development Funds and Endowment, SMLLC.

Because Social Welfare Services, Inc. and Operations and Management, SMLLC does not own land, buildings or equipment, or the assets held by the Development Funds and Endowment, SMLLC they actually become a less attractive target for litigation.

The following entities:

• Real Estate, SMLLC
• Equipment, SMLLC
• Thrift Store #1, SMLLC
• RBC Thrift Store #2, SMLLC
• Development Funds and Endowment, SMLLC

Because they are owned by a §501(c)(3), each of these entities will be important in achieving the goal of asset protection.

The purpose of LLC laws nationwide

LLC laws are now an important part of legal environment for businesses and not-for-profits in all fifty states. These laws were created were to offer liability protection to business owners and operations.

At the heart of the laws relating to LLC is the desire to accomplish liability protection for businesses and §501(c)(3), business owners, directors and employees.

This letter is not a radical or new interpretation of the law; this letter addresses the heart and purpose of LLC laws. State LLC laws and federal tax laws have made in clear that LLCs and SMLLC apply to not-for-profit organizations; again, I am not bending or twisting the law.

My letter is a mainstream application of the law. This is not risky or pioneering legal or tax work, this is simply an application of the law!

Conclusion

I enjoy working with §501(c)(3) organizations. Our CPA Firm has more than a few such organizations. In general, these organization have deep convictions that their work is essential. In your case, caring for children, especially boys, is essential!

Your need to protect assets is 100% driven by your desire to see that these children receive essential services in the future.

I am 100% committed to helping you accomplish that task!

Sincerely,

Steve Richardson, CPA

For the Firm