The use of Nevada corporate entities as an asset protection vehicle has gained ground in the last several years. The selling point of this strategy has been twofold: (1) by using a Nevada entity you somehow import Nevada’s allegedly protective laws into the jurisdiction you are doing business or holding an asset in; and (2) the Nevada entities are often companies that were formed by a promoter months or years in advance before they were sold to you, and that the age somehow provides more protection. The first point is debunked by the internal affairs doctrine (which I will write more on later). The second point was recently debunked by none other than the Nevada Secretary of State.

In early September the Secretary’s Securities Division ordered a Wyoming company to stop selling shell Nevada corporations. The Securities Division stated that selling an existing corporation was the sale of a security by an unlicensed broker or dealer. However, the Chief Administrator of the Securities Division went on to say that they were also concerned about fraudulent and misleading claims regarding the value of shell companies, stating: “Many times when these corporations or LLC’s are sold, the buyer is told that simply because the entity was formed and registered a few years ago, it has more value because it’s an ‘aged’ corporation. Buyers are sometimes told that the aged nature of the entity makes it more valuable for things like getting a line of credit, or just general credibility. It does not, and so that’s a serious misrepresentation.”

The lesson here is something that I’ve told people time and again. It’s not that there is never value to using a corporate entity or trust that is formed outside the state or other jurisdiction you are in. The lesson is that you have to be doing it for the right reason. Out of state and offshore entities and trusts can have a lot of value in an asset protection plan, but if you are inclined to consider using one consult with someone that knows about asset protection and that can help you create a plan that will most effectively address your specific situation.

What is estate planning, and what documents and agreements should an estate plan include?

Estate planning is the process of planning for likely or inevitable events in our lives and presently determining how we should address those events. A proper estate plan considers not only obvious events like death, but should also encompass issues such as retirement, disability, mental incapacity, guardianship of minors and asset protection (both for ourselves and our beneficiaries).

This outline presents several basic concepts and strategies that should be considered during the estate planning process. It is not intended to be a comprehensive guide that will allow you to independently plan your estate absent input and assistance from an attorney. It will, however, give you sufficient background information so as to be able to intelligently discuss your personal situation and alternatives when you do meet with an attorney.

I strongly recommend that you seek the advice and assistance of a qualified attorney when you prepare and estate plan. There are many unscrupulous non-attorneys that sell purported estate plan documents to the unwitting consumer. Often they are alleged to be “reviewed” by an attorney. These documents are usually prepared in a trust mill by non-attorneys and their assistants without any oversight or input from an attorney. They are rarely customized to actually fit your personal situation. Estate plans in a box (software) and from online companies are no better.  As Justice Painter (of the Ohio Court of Appeals) said:

To me, this case exemplifies the problems inherent in having assets pass by sloppily drafted instruments. The public should realize the danger in attempting to have a substantial portion of their wealth pass to their heirs or beneficiaries by IRA accounts, brokerage accounts, insurance policies, bank-deposit accounts, and the like. Often, as here, these documents are not prepared by a lawyer, not subject to the legal formalities of a will, and not artfully completed. For someone with the substantial assets involved here, an estate plan would have been advisable, so an attorney could have reviewed all documents such as this, avoiding ambiguity and its attendant costs, and ensuring that the decedent’s wishes were followed.

Tip! While the initial cost may be more, you’re much more likely to get an estate plan that meets your specific situation and accomplishes your goals if you work with an experienced estate planning attorney. Trust mills, online services and software kits are likely to produce documents that don’t accomplish your goals, create ambiguity and confusion and end up costing you and your heirs more in the long run!

The Basic Estate Plan Documents

Most estate plans include a last will and testament (often just referred to as a “will”), general durable power of attorney, health care power of attorney and health care directive to physicians (also known as a living will). Trusts are extremely powerful and also flexible agreements that are also often used in estate planning.  Common estate planning trusts include testamentary trusts (created when you pass away under the terms of the will), living trusts (created by you while you are still alive) and special purpose trusts that carry out a particular function (such as irrevocable living insurance trusts, also known as “ILITs”, that are intended just to hold life insurance policies). In some states (including Washington) community property agreements are also commonly used.

Probate

Before discussing what most lay people regard as the foundational estate plan document (the will), it is worthwhile to discuss the probate process. Probate is the judicially supervised process of administering your affairs and assets after you pass away. It includes marshaling your assets, ascertaining and paying your debts and finally distributing your assets. The process is necessitated by the fact that after you have passed away we need some means of transferring title to the assets that you owned. Since you are no longer available to transfer assets yourself, the court will order that someone can act in your place (your “personal representative,” also called your “executor”).

Among perceived problems with the probate process are its cost, the time it takes and the fact that it is a public proceeding. For example, I recently reviewed a probate file at the Pierce County, Washington Superior Court Clerk’s Office. I randomly selected a probate file that had been opened in 2005, read the decedent’s will, discovered that from beginning to end the probate took nearly eleven months and cost almost $5,000 (in court costs as well as fees paid to attorneys and accountants). In my experience, this was a very typical probate.

Because of the time, expense and public nature of probate, many people will desire an estate plan that will avoid the probate process.

Intestacy

Intestacy simply means dying without a will or other legal estate plan document that directs distribution of your assets. A person dying without a will is “intestate”. Each state has laws that direct the distribution of an intestate estate. For example, in Washington if you are married and all of your property is community property your surviving spouse will receive all of the property. However, if you are single your parents would receive the property and if your parents do not survive you then your brothers and sisters would receive it, unless you are single and have children, in which case your children would receive the property.

As you can imagine there are many alternatives as to where your property will go in the event you are intestate. Applicable statutes are simply the legislative best-guess at what most people would want in any given situation.

When someone dies intestate probate is not avoided. As mentioned above, the crux of probate is transferring title to assets. The same issue exists without respect to someone that is intestate.  The only difference is that the law, instead of your will, determines where your property is going to go. A court must still specify a personal representative (technically an “administrator” in an intestate probate) who will then have the court’s authority to transfer assets according to the statutory scheme.

Last Will and Testament

A will is a legal document that usually includes the following: (a) a description of your family members; (b) direction as to who will benefit from your estate; (c) limitations on how the beneficiaries will receive distributions (such as trusts for minor children, etc.) (d) nomination of your personal representative; and (e) nomination of your guardian if you have minor children. One significant advantage to a will over intestacy is the opportunity to make these determinations rather than accept decisions made by the legislature and courts.

The formalities that must be adhered to in preparing and executing a will are dictated by the laws of the state you reside in when you prepare the will. For example, in some states you might need two people witness the will, while in others you must have three witnesses.

Contrary to common belief, a will does not avoid probate. As stated above, probate is largely about transferring title to assets. While a will does give you the opportunity to state who will receive assets, under what circumstances and who will make the transfers for you, a court must still enter an order in a probate proceeding affirming that the person you nominated as your personal representative has legal authority to transfer assets.

Alternatives to Probate

As discussed, probate is often necessitated by the fact that we need a mechanism for transferring title to assets upon a person’s death. There are several other mechanisms that serve as probate alternatives. Each of these provides for a transfer of assets upon death by some means outside of intestacy or a will. These mechanisms include community property agreements, titling assets as joint tenancy with right of survivorship and using a revocable living trust.

Community Property Agreement

Community property agreements are agreements that allow a husband and wife to (a) establish that all of the property owned between them is community property, and (b) agree that upon the death of the first spouse to die, all of that spouse’s interest in the community property will vest in the survivor.

The feature that allows property to pass is a specific provision of Washington law. While community property agreements might allow probate to be avoided when the first spouse passes, a probate will still be required when the second spouse passes (and for that reason a community property agreement can be a supplement to, but is never a substitute for, a will or revocable living trust). Additionally, “no probate” does not mean “no process”. It is usually preferable to clear the first deceased spouse’s name from title at the time the spouse passes, which usually requires filing the community property agreement with the county recorder and then preparation and filing of various affidavits to remove the deceased spouse’s name from real property and vehicle titles, bank accounts, etc. While some process is therefore required, it is usually much less burdensome than the probate process.

There are potentially significant drawbacks to community property agreements. First, one of the spouses might have a separate property asset that they want to continue to regard as separate property. Second, in situations where the spouses are in a second marriage and each has children from a prior relationship, a community property agreement can essentially disinherit one of the spouse’s children. And finally, transfers of property under a community property agreement will waste the first deceased spouse’s estate tax credit because the property will be deemed to be subject to the marital deduction (discussed more fully below).

Joint Tenancy with Right of Survivorship

Titling assets as joint tenants with right of survivorship (or “JTROS”) means presently transferring title to your proposed beneficiaries as your joint tenants. Upon the death of any joint tenant, ownership of the property transfers to the surviving joint tenants (that is the survivorship feature).

To be blunt, titling assets as JTROS and calling it estate planning is such a bad idea it borders on being a dumb idea. This is true for many reasons. First, the asset is now subject to the claims of the new joint tenant’s creditors. Second, if the joint tenant dies before you then your “estate plan” has also died. Third, significant income tax benefits the beneficiary would otherwise enjoy will be lost. Fourth, amending the estate plan means re-titling all of the JTROS assets (which the joint tenants may or may not agree to).

I mention JTROS not as a legitimate alternative estate planning strategy but rather as a warning. While there may be non-estate planning reasons for titling assets as JTROS, from an estate planning perspective it is typically a terrible idea.

Revocable Living Trust

A revocable living trust is in many respects a will substitute. Like a will, it specifies who your family members are, who will receive property from your estate, under what circumstances, and who will manage the property and distributions for you. One significant difference between the will and revocable living trust is that the revocable living trust requires that you presently transfer your assets to the trust.

A revocable living trust is a three-party document. It is created by you (and often your spouse, if married) as the grantors or trustors of the trust. As grantor, you are the person specifying the trust terms and signing the trust agreement. You will also be the beneficiary of the trust for the remainder of your life. The trust also requires a trustee to manage the trust property pursuant to the terms of the trust agreement. During your lifetime (and as long as you have the capacity and desire to do so), you will usually also be the trustee of the trust.

Once the trust agreement has been signed you can formally transfer title to your assets to it (by way of deed, vehicle title transfer, etc.). Thereafter, you can manage the assets as you previously had; now you are legally doing it as the trustee of the trust.

Upon your death the revocable living trust avoids probate because it does not die. Recall above that I mentioned probate is necessitated by the fact that you had your name on title to assets at the time you die.  With a revocable living trust in pace you will ideally pass away owning nothing, in which case there is no reason to undergo the probate process. Your successor trustee (who you named when you executed the trust agreement) steps forward to manage and distribute the trust property according to the terms of the trust agreement. While the successor trustee acts much as a personal representative would, the fact that the property is owned by the trust and is subject to distribution under the trust rather than a will means that the successor trustee does not need to perform his or her duties in the context of a probate proceeding.

The following chart summarizes the differences between using a last will and testament or a revocable living trust as the central document regarding asset management and distribution in the estate plan.

Comparison of Will and Revocable Living Trust

As the above comparison indicates, the primary advantages of the revocable living trust over the will are the following:

Estate Tax Issues

Both Washington and the federal government have an estate tax. While the following is an oversimplification, you can see that the estate tax is calculated much like the individual income tax.

Gross estate

- Allowed deductions

= Adjusted gross estate

X Tax rates

= Tax payable

- Estate tax credits

= Estate tax due

For most people, three points are particularly relevant. One, the gross estate includes all property that you own or have an interest in at the time of your death. “Have an interest in” is an incredibly broad concept. It includes, for example, the proceeds of life insurance if you hold the “incidents of ownership” over the policy (the right to change beneficiaries, cancel the policy, etc.), even if the proceeds are not payable to your estate.

Two, every individual is allowed a dollar for dollar deduction for any property that transfers to a surviving spouse. This is often called the “unlimited marital deduction”.

Three, currently the federal estate tax exemption is on an adjusted gross estate of $3,500,000.  The Washington state estate tax laws, however, provides a credit that gives an individual exemption on an adjusted gross estate of $2,000,000. This is not an exceptionally high amount. Many people have life insurance policies that total $1,000,000, putting them halfway to the point of a taxable estate before any other assets are considered.

Note that as of the date of this article there is a further complicating factor in the federal estate tax.  Under current law the $3,500,000 exemption will automatically expire on December 31, 2012.  At that time, we will return to the estate tax as it existed in 2001, which is a mere $1,000,000 exemption.  The uncertainty surrounding whether Congress will actually fix the broken federal estate tax means that people who don’t have taxable estates today but would under the 2001 version of the law should provide flexibility in their estate plan to address a return to the $1,000,000 exemption.

While the effects of the estate tax and uncertainty surrounding it is a significant problem, another significant issue exists with a common planning tool and it’s effect on estate tax planning.  The issue is the unwitting use of community property agreements or a will or trust that leaves everything to the surviving spouse. For example, assume Husband and Wife have a joint $4,000,000 estate, all of which is community property, and a community property agreement, will or trust that specifies everything will go to the surviving spouse when the first spouse passes. If Husband dies in 2012, his $2,000,000 share of the estate would have been completely shielded by his state and federal estate tax credit. However, the estate tax calculation must be done in the order set forth above. His estate will receive a dollar for dollar deduction for everything that passes to his surviving spouse, leaving a $0 estate subject to estate taxes (and therefore no use whatsoever of his estate tax credit). When Wife dies with what is now her $4,000,000 estate, the combined state and federal estate taxes will be imposed on her now $4,000,000 estate.

The effect of this may be somewhat mitigated by a newer provision of the federal estate tax that does allow for some portability of an unused estate tax credit from one spouse to another, but portability is not automatic and does not apply with respect to the Washington state estate tax (and may not apply in other states).

This problem can be avoided by using what is commonly known as an AB Trust (also called a Credit Shelter Trust). An estate plan that includes an AB Trust will specify that upon the death of the first spouse, a trust is established for the benefit of the surviving spouse. The trust will receive assets from the deceased spouse’s estate up to the maximum amount that can pass free of tax and use all of the deceased spouse’s credit. The surviving spouse will continue to have access to the assets as the beneficiary of the trust. However, because the surviving spouse will not receive the assets outright, they will not be included in his or her estate upon death. In our example above, had an AB Trust been used as a receptacle for the Husband’s share of the community estate, the entire $4,000,000 estate could have passed free of estate taxes as the spouses successively passed away.

AB Trust provisions can be included in a will or revocable living trust. While the provisions are not terribly difficult to draft, if you are in a position where they should be included (that is, you have a taxable estate), you should consult with an attorney that is well versed in federal and state estate tax law. The two tax regimes are not always consistent and an AB Trust must be carefully structured to ensure that the maximum benefit of the estate tax credits is achieved.  This is not an area that you should leave to an inexperienced attorney, and it is definitely not an area that you should attempt to “go it alone” in by using an online document preparation service, software or estate planning kit.

Other Common Estate Plan Documents

General Durable Power of Attorney

A general durable power of attorney is a simple, inexpensive and reliable way to arrange for someone to make your financial decisions should you become unable to do so yourself. When you create and sign a power of attorney, you give another person legal authority to act on your behalf. This person is called your “attorney-in-fact” or, sometimes, your “agent” (while the term is properly “attorney-in-fact”, the person you name obviously need not be an attorney).

Commonly, people give an attorney-in-fact broad power to handle all of their finances. But you can give your attorney-in-fact as much or as little power as you wish. You may want to give your attorney-in-fact authority to do some or all of the following:

The attorney-in-fact must always act in your best interests, maintain accurate records, keep your property separate from his or hers and avoid conflicts of interest.

A durable power of attorney can be drafted so that it goes into effect as soon as you sign it. Alternatively, you can specify that the durable power of attorney does not go into effect unless a doctor certifies that you have become incapacitated, or until you sign a separate certificate announcing that powers are then effective. This is called a “springing” durable power of attorney. It allows you to keep control over your affairs unless and until you become incapacitated or sign a certification, when it then springs into effect.

Your durable power of attorney automatically ends at your death. That means that you can’t give your attorney-in-fact authority to handle things after your death, such as paying your debts, making funeral or burial arrangements or transferring your property to the people who inherit it (although your attorney-in-fact can also be your personal representative or successor trustee).

Your durable power of attorney also ends if:

Power of Attorney for Health Care

A power of attorney for health care is much like a general durable power of attorney in that you are naming a person to act on your behalf because you are unable. As the name implies, however, this power of attorney grants only the power to make health care decisions.

Health Care Directive to Physicians

A health care directive to physicians (commonly just called a health care directive, but also known as a living will or advance medical directive) is a statement that you can make as to whether or not you want certain medical treatment in certain circumstances.

In Washington, the health care directive is not only allowed for by statute, but a sample form is set forth in the statute. Essentially, the Washington health care directive statute allows you to specify whether you would or would not want artificially provided nutrition and hydration if you are permanently unconscious and terminally ill.

The decision that you make is not nearly as significant to your loved ones as the fact that you made a decision at all. We need only look to the case of Terry Schiavo to understand how important it is that we sign a health care directive.

Other Estate Planning Issues

There are many other issues that should be considered during the estate planning process. Among others, they include planning for special needs beneficiaries, charitable planning and asset protection. While it is beyond the scope of this short article to fully address all of these areas, you should consider how each of them might fit into your estate plan and consult with legal counsel that can assist your exploration of these areas and how they fit into your estate plan.

As if intending to rub salt into what could turn into a significant tax wound for many people, the Washington legislature is proposing to increase estate tax rates. House Bill 3184 would increase Washington State estate tax rates from the current range of 10% – 19% to 20% to 38%.

This is particularly troubling in light of Congress’s failure to act on the federal estate tax before the end of 2009. For the remainder of 2010 there is no federal estate tax, but under current law the federal estate tax will be automatically reinstated beginning in 2011. When it returns it will do so at 2001 levels, which mean a $1 million dollar exemption and rates that top out at 55%.

The combined effect of HB3184 and the 2001 version of the federal estate tax is nothing short of government confiscation of wealth. Under those tax regimes a Washington resident with a $3 million taxable estate would pay combined estate taxes of $980,000, or nearly one-third of the total estate. Someone with a $5 million taxable estate would pay combined estate taxes of $2,620,000, or over one-half of the total estate.

What to do? First of all, don’t delay planning. Don’t think that Congress or any state legislature is going to keep itself from trying to grab whatever they can get. If you don’t have an estate plan contact a good attorney that knows something about estate tax planning. If you do have an estate plan contact a good attorney anyway. Dust off your old plan and have an attorney take a look at it. Chances are it does not adequately address the current state and federal estate tax structures. Many plans drafted since 2001 (and all plans prior to that date) were not drafted to take into account the very unusual estate tax regimes that we have today.

Second, if you are a resident of Washington contact your representative today and tell them to vote no on HB3184. Then contact your representative or senator in Washington D.C. and ask them to put meaningful efforts into resolving the federal estate tax mess.

Don’t put off creating or reviewing your estate plan! The estate tax environment is fluid and your plan needs to address a variety of possible estate tax circumstances.

So your home or condo has lost a lot of value? Maybe it’s lost so much value that you just don’t see the point any more and you are considering walking away and turning it over to the bank. Beware that in so doing you may get to keep paying a debt for a home you no longer own.

The New York Times reported on the growing number of people that walk away from underwater homes (underwater generally meaning any home with debts that exceed value). You can find the article here. The short version is that an many people with the ability to keep on paying their mortgages are abandoning underwater homes anyway, apparently not seeing that it makes any sense to keep paying for something that will take perhaps decades to recover its value (if ever).

The article misses a crucial asset protection point. The bank may not be happy with just taking the home and dinging your credit. Loans typically have two documents underlying them. The homeowners personal promise to pay the debt is the promissory note. The promise is secured by a security instrument (often a deed of trust). If the homeowner doesn’t pay on the note the security instrument gives the bank the right to foreclose. Upon foreclosure and eventually the sale of the property, the sale proceeds are applied toward the promissory note debt.

The significant point missed in the article is that the bank doesn’t necessarily take whatever it gets out of the foreclosure sale in full satisfaction of the promissory note. At the outset of the foreclosure process the bank will assess what it is likely to get at a foreclosure sale. If the bank believes that it will get something less (or perhaps “much less”) than the full amount due then the bank can take steps to get the deficiency from the homeowner.

How does the bank do that? In some states (including Washington), the bank’s security instrument is often a deed of trust. A deed of trust typically includes a provision that allows the trustee to foreclose non-judically and sell the property at a trustee’s sale. If the bank uses this non-judicial foreclosure alternative then the bank is often not allowed to get a deficiency judgment. (NOTE: I say “often not allowed” because I’m trying to be general. Non-judicial foreclosure does mean that the bank can’t get a deficiency judgment in Washington but I’m not going to address every state out there – you need to look into the result in your own state.) However, the bank is not required to use the non-judicial alternative and can instead elect to judicially foreclose upon the security and then get its deficiency judgment.

So what’s the risk to the walk-away strategy? If you’re thinking about walking away because of decline in value but you do have the capacity to keep paying, you ought to expect that the bank is going to elect to foreclose judicially and get the deficiency judgment against you. You will have rid yourself of the home, but if the bank doesn’t get the full amount of the note out of the foreclosure process you will get to keep paying until the deficiency judgment is satisfied.

In the previous post I discussed statutory protections that apply to IRAs.  One obvious point is that an account is only protected as long is it actually is an IRA.  This post discusses what can happen when the IRA owner engages in certain conduct known as “prohibited transactions.”

What is a prohibited transaction?  It’s a tax rule.  It’s all in Sections 408 and 4975 of the Internal Revenue Code, but I’m going to try to save you some of the pain of reading code citations and give this to you in English.  Here we go ….

• Certain transactions with an IRA account are prohibited if a “disqualified person” is involved in the transaction.
• Disqualified persons include the IRA owner, certain family members any other fiduciary and certain service providers (among others).
• Prohibited transactions include the following:
  • a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person;
  • any act of a fiduciary by which plan income or assets are used for his or her own interest;
  • the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets;
  • the sale, exchange, or lease of property between a plan and a disqualified person;
  • lending money or extending credit between a plan and a disqualified person; and
  • furnishing goods, services, or facilities between a plan and a disqualified person.
• If a prohibited transaction occurs, the IRA ceases to be an IRA as of the first day of the tax year in which the transaction took place.

We often see the potential for prohibited transactions with self-directed IRAs investing in real estate or closely held entities.  However, it is possible to create a prohibited transaction with traditional IRA accounts invested in stocks, bonds and mutual funds.

TIP!  Prohibited transactions can occur with any kind of IRA account owning any category of investment.

In a recent bankruptcy case, In re Ernest W. Willis, Debtor, Case No. 07-11010-BKC-PGH, a creditor argued that the debtor’s IRAs should not be exempt and should be part of the bankruptcy estate available for distribution to creditors.  The creditors assertion was based on transactions that had taken place over ten years before the bankruptcy case was filed.  In the first transaction (in 1993) the debtor withdrew funds from IRA #1, used the funds to acquire an investment and returned the funds to IRA #1 64 days later.  In the second series of transactions (in 1997) the debtor swapped checks between IRA #1 and his regular brokerage account.  The debtor also had separate IRAs #2 and #3, both of which contained funds deposited in rollover transfers from IRA #1.

The court noted that the debtor (as the account owner) was a disqualified person.  Analyzing the two transactions, the court first concluded that the first transaction amounted to transferring funds from IRA #1 to the debtor, which was a prohibited transaction and the IRA therefore ceased to be an IRA in 1993.  The court also said that the transaction could also be viewed as borrowing from IRA #1, which was also a prohibited transaction.

As to the second transaction in 1997, the court found that the check swapping scheme also amounted to borrowing from IRA #1 and that the IRA therefore ceased to be an IRA as of the beginning of 1997 (which would only make a difference if the court was incorrect about the transactions in 1993).

Having concluded that the prohibited transactions occurred and that IRA #1 was not an exempt asset, the court also found that a certain portion of IRAs #2 and #3 were not exempt because those accounts held amounts rolled over from IRA #1.

I doubt that the IRS would agree that the 1993 transactions were actually prohibited transactions, but they were clearly in violation of the 60 day rollover rules and therefore subject to an excise tax.  I think, however, that the court was correct in its conclusion as to the 1997 transactions.

So what does this mean to you?  Simply this.  Creditors are becoming more aggressive when it comes to exemptions.  They will not hesitate to dig up any available information to attempt to convince a court that exemption claims should be set aside.  While self-directed IRAs are a more likely arena for prohibited transactions, they can occur in any circumstance.  If you are considering any kind of transaction with your IRA other than buying and selling in traditional stocks, bonds and mutual funds you need to consider consulting with counsel experienced and knowledgeable in this area.

Debtors have the right to claim certain property as exempt and therefore not available to be used in satisfaction of debts in the bankruptcy proceeding.  Debtors generally have the choice of exemptions set forth in federal statutes (section 522 of the bankruptcy code) or under state law.  For example, you can review the list of federal and Washington state exemptions here.

Generally, almost all “retirement funds” are exempt assets in bankruptcy.  This is very broad protection that applies to all types of plans including 401(k) plans and 403(b) plans.  IRAs and Roth IRAs are regarded as retirement funds, but there is an exception to the exemption.  They are only exempt in the maximum amount of $1,000,000.  To add another twist, there is as exception to the exception, which is that amounts in an IRA or Roth IRA that were originally in another type of retirement account (like a 401(k) plan) and transferred to an IRA in a rollover are not subject to the $1,000,000 cap.  This creates an interesting problem if an IRA account is over $1,000,000 and contains both contributory and non-contributory amounts.

Planning Tip!  Keep rollover IRAs and Roth IRAs separate from contributory IRAs and Roth IRAs to ensure the $1,000,000 cap does not apply to the rollovers!

In the next post in this series we’ll discuss prohibited transactions and how they can expose your IRA to claims of creditors, both in and out of bankruptcy.

This is an introduction to a multi-part post on asset protection for individual retirement accounts (or “IRAs”).  Many people believe that their IRA is an extremely secure asset, held inviolate against claims of creditors and fully protected by bankruptcy laws.  As we will discuss, there is a certain level of asset protection for IRAs in both state and federal exemption statutes, but the protection is not as absolute as it would seem.

Many of the comments in each part of this series of posts will likely apply to other types of retirement accounts, such as 401(k) and 403(b) accounts.  Unless noted, however, the information provided is specifically with reference to IRAs.  The comments in this series (and anywhere else on this blog) are intended to be general in nature and should not be regarded as legal advice specific to your personal situation.  You should consult an attorney with experience and expertise in asset protection and retirement accounts.

The series will progress in the following parts:

• Part I: IRAs and Bankruptcy – Statutory Protection
• Part II: IRAs, Bankruptcy and Creditor Claims – Prohibited Transactions
• Part III: IRAs, Bankruptcy and Creditor Claims – Inherited IRAs
• Part IV: Asset Protection for IRAs Post Death – Protection From Your Creditors
• Part V: Asset Protection for IRAs Post Death – Protection From Your Family
• Part VI: The Importance of Beneficiary Designation Forms

We have no particular timeline for posting each of these parts.  Please check back often or subscribe to our feed for update notification.

As reported by the Wall Street Journal (http://online.wsj.com/article/SB126098351451293981.html) Congress has failed to pass a vote to extend estate taxes.  This means that the federal estate tax will effectively (but temporarily) cease to exist on January 1, 2010.

This is not necessarily good news.  In the place of an estate tax certain income tax amendments will become effective.  Significantly, as of January 1, 2010, estate beneficiaries will not get a step-up in basis of assets they receive from estates.  This likely will mean that we’ve replaced a tax on a few thousand estates with an income tax on tens of thousands of individuals when they someday sell their low basis assets.  Even more troubling is the notion that the estate tax will be automatically reinstated on January 1, 2011, but at 2001 levels (a mere $1,000,000 exclusion and 55% top marginal rates).

This also significantly complicates planning.  As reported in the linked article, Congress will probably address the matter next year and hopefully at least extend the 2009 exclusion amount of $3,500,000.  We have, however, spent every year since 2001 hoping that Congress was going to address the issue and it failed to do so for eight years.  That leaves persons with potentially taxable estates (anything over $1,000,000 come 2011) left deciding whether to plan for a $1,000,000 exclusion or to instead plan for a $3,500,000 exclusion and hope that Congress finally acts.

If you have an estate over $1,000,000 you should consult with an attorney well qualified in estate tax planning … but how you decide to plan is not going to be a clear, easy decision.

We’ve had this blog up for a few years but have to admit it has gotten a bit stale.  That’s unfortunate, but we’re going to try to be more proactive in the future with new posts, commentary, links to other sites and articles of interest and discussion with our visitors.

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The IRS released a memorandum in Oct 2008 discussing a particular retirement plan investment strategy whereby retirement plan assets (usually 401(k) assets) are invested in stock of a start up company. The idea behind the strategy is to use your retirement assets to capitalize a start-up business without having to cash out the retirement plan (and pay taxes and early distribution penalties). The memorandum raises significant concerns with the strategy and makes clear the IRS’s position that implementing the strategy could be very problematic for the taxpayer.

Upon reviewing the memorandum, I didn’t get past the first page before it was clear that the IRS was going to express a very dim view on the strategy. They describe the arrangement as Rollovers as Business Startups, or “ROBS”. You don’t have to know the IRS well to know that if they are describing your transaction as ROBS, the result is probably not going to be good.

The basic operation of this strategy is the formation of a new business entity (usually a corporation) and the immediate formation of a qualified retirement plan. The client then directs a rollover transfer of his or her existing retirement plan assets (most often a 401(k) plan or something similar from a prior employer) into the new plan. The new plan contains a provision allowing the plan to invest in the employer company’s securities (that is, the stock of the newly formed corporation). Voila, the plan purchases the stock and the company gets the money, and then the client uses the money to pursue his or her new business opportunity. (The IRS points out that this strategy is often marketed as a way to obtain use of retirement funds to purchase a franchise.)

Using retirement account assets as business start-up capital is risky! You may be engaging in a prohibited transaction!

The IRS describes two primary issues raised by the strategy. First, the transaction often only benefits the principal setting up the business. Typically after the corporate stock is acquired by the plan, the plan document is then amended to bar further investments in employer stock. In this regard, the strategy may violate ERISA non-discrimination requirements. Second, the plan usually acquires the stock for all of the available assets in the plan. That is, the value of the stock is set at the amount of plan assets. If an appraisal is prepared at all, it is often a flimsy single page statement with no real substantiation of the value of the stock. Absent a legitimate valuation and acquisition of stock for an appropriate price (based on the valuation), the principal has likely engaged in a prohibited transaction.

Another prohibited transaction may exist where the promoter’s fees are paid by the corporation (out of what were previously plan assets).

The IRS memorandum raises several other issues and problems that may exist with the “ROBS” transaction. Based on the release of the memorandum at least one of the larger companies that promote this strategy have stopped offering it, but others appear to take the memorandum as guidance as to how they should be implementing the strategy, not that there are significant issues that they should probably stop implementing the strategy.

The bottom line is that this strategy is very risky in light of the IRS guidance set forth in the memorandum. If you were considering it you should consult with independent legal counsel that is experienced in retirement plans, and if you have implemented the strategy you should probably do the same and determine whether you need to take remedial measures.