Whoever Ends with the Most "Toy Trusts" Wins!
A person's life goals generally follow some natural progression including family, security, success, and finally lots of toys. Toys are the resultant dreams that tell the world, and ourselves that we played the game and won. Toys can be anything of tangible value that is not a necessity of life. It seems that each of us has a personalized definition of what we would do with "money to burn" and if that money is used to buy a depreciating toy, then this article is for you.
What is a depreciating toy? If the item decreases in value with use and could create a liability for your estate, then it is a depreciating toy. A few general examples could be: cars, motorhomes, boats, airplanes, helicopters, pets, jet skies, snowmobiles, and horses. It should be expensive and imply a high probability of a lawsuit for any minor infraction involving a third party. To be more specific, if you retired and purchased a dream-type motorhome and chased rainbows, the motorhome would eventually lose value while the odds of an accident increase dramatically just due to the fact that a huge hunk of metal is roaming down the highway. It is unlike a stationary retirement home in that the latter should increase in value and it is very unlikely that your stationary home could run over some third party. The distinction is usually the liability issue and decreasing value. The more you use your toys the greater the liability risk and the faster the depreciation. Of course, insurance should take care of this problem, so why worry?
Let's talk about insurance. Most prudent people insure for third party liability even though the law may not require it. Unfortunately, this insurance is the incentive for a lawsuit. At best they will be awarded a percentage of everything you have - or will have - and in the process make your life miserable at worst your opponent loses his or here filing fee. It has been said that the best guarantee against a law suit is having no insurance and nothing to lose.
Liability is not the only problem associated with toys however. If you've worked your entire life to own and enjoy that dream machine, it seems that preserving it for your spouse or children might be a priority goal. Unfortunately, toys are the first to go in a financial or family crisis. For example, you may have traded everything for a motorhome so you could spend your remaining years travelling down the highway. It is entirely possible that some time in the future you could become medically disabled and end up in a nursing home costing your estate little less than $5,000 per month. Maybe your insurance will pay for this but I suspect that most will not. This means that your estate may become depleted before the government will step in and help out. Your spouse now has essentially nothing and your toys were the first things to go. If you are thinking that your living trust has provisions for this, you're correct except that some portion of your estate must be sold off and your toys are still the first to go. There are other problems brought on with this visual affluence such as a preponderance of scam artists, persistent gold diggers, x-spouses looking for alimony adjustments, creditors, and even children's needs. Privacy of ownership (provided by toy trusts) may not solve these problems, but should shorten the duration of the abuse as well as provide liability protection and several other unique benefits.
In order to understand how toy and other asset protection works it is important to visualize yourself as a target and then provide model solutions that weigh relative risk against the cost/benefit of providing the appropriate protection. The attached flow charts (Steps 1, 2, and 3) should provide a guide to understanding the basic concepts of asset protection as well as an expansion on toys and the special attention required to protect these visual law suit invitations. First let's talk about you as a target. There are primarily two ways that a lawsuit may attack your assets. The first is asset ownership and control. The second is personal involvement such as driving the motorhome. A toy trust is designed to protect you against the first implication by removing the asset from legal ownership and explicit control. This works very well if someone other than you is using the toy; but the real trick is to limit you personally. Enter step #1 (protecting all assets in general - please review).
Step #1 is an overview of a popular asset protection plan overlaid on a risk scale. The scale is from (0) to (10) with ten being the most exposed to asset loss. You can equate this scale with the earthquake scale in that if you become involve in a lawsuit and are at a level (10), you will most certainly be shaking for fear of losing everything. A good asset protection plan segregates and reduces the risk level of losing the segregated assets as portrayed in this example. It doesn't mean that you won't lose assets, but it does provide a lower level of risk for groups of assets and limits losses to the individual groups.
In viewing step #1, note that magnitude 10 shows a man and woman debarking for their individual living trusts. This magnitude 10 risk in joint ownership is typical for people with nothing to lose; however, as assets are obtained in equity and quantity, this position is extremely dangerous for these people to be oblivious to legal predators. The first move to asset protection is usually the revocable living trust. Although the revocable living trust provides worthwhile probate protection, it doesn't generally provide much in asset protection, consequently the risk magnitude for this entity creation is a level 9. The next move is to form family limited partnerships (FLP) and segregate your assets into FLPs.
FLPs are nothing more then limited partnerships designed to spread your equity to family or friends while maintaining complete control over your assets. They provide a unique barrier against judgement creditors and also provide an acceptable means of substantially reducing your estate tax through minority and marketability discounting. It's quite surprising that these FLPs are not more frequently used. Please note in step #1 that FLPs are designated as five separate entities with assets grouped according to similar character. Toys are on top of the list with a magnitude 8 level of risk with business running a close second with magnitude 7. It may seem that this is reversed from a logical inference associated with business since business has a high level of risk, but it can easily be explained by understanding the judgement creditor's rights against the FLP.
In forming an FLP, you or your spouse will be designated a general partner and share an equity interest that you annually gift to relatives or friends. With this partnership interest, you will maintain complete control and have discretionary power to distribute earnings, as you desire. If you were sued personally, a judgement creditor would be given a "charging order" that essentially puts that creditor in your shoes for any distribution from the FLP. However, it doesn't give the right to the creditor to force you to make the distribution. The benefit to you comes from the tax reporting responsibility in that the general creditor also has to pay taxes on your income without getting a distribution. This actually becomes a major deterrent for any judgement creditor because it seems unlikely that any creditor would step into a tax paying situation that is uncontrollable. Toys, on the other hand, generally don't pay taxes because they mostly lose value and are sold as personal losses that are non-deductible. A judgement creditor really has no obstacle in exercising their charging order and can wait until the toy is sold and take their claimed distribution. This is the reason toy assets are at a higher level of risk than business assets and need additional protection.
In proceeding on with step #1, please note that business can also limit liability with other entities designed specifically for liability protection (i.e. corporations and limited liability companies). It also shows business asset transfers to offshore or children's trust for further protection of the assets. It might be noted that an offshore trust doesn't necessarily provide (0) risk due to what is commonly called "fraudulent conveyance". In other words, there should be a good reason to transfer asset ownership offshore other than to avoid creditors or the courts may disregard the ownership issue. In any case, step #1 shows a good asset protection design and the relative magnitude of risk for different kinds of assets with toys being the least protected. Enter step #2, toy trusts (the trust that makes Subchapter S Corporations difficult to sue).
"Toy trust" is a term I've used to more appropriately describe the special use of an Electing Small Business Trust (ESBT) authorized by the Small Business Job Protection Act of 1996. This trust was established to provide flexibility in solving some difficult inheritance problems with Subchapter S Corporation stock. A complete dissertation on the bill and the evolution of the ESBT is not necessary; however, it is important to point out a few pertinent congressional intentions that provide the foundation for our toy application:
It appears that congress actually provided the stockholders of Subchapter S Stock some major flexibility with the passage of this law; however, as always there is a catch. The catch is the highest marginal tax rate (currently 39.6%) must be paid by the trust on income of the Subchapter S Corporation. So most applications of the trust are simply not worth the tax rate and it seems that the use of these trusts are limited to the highest marginal rate taxpayers; or, Subchapter S Corporations that have no income. The no income position is something that congress did not consider but it is perfect for toy trusts because toys generally have no income or the definition of a toy would not apply.
In viewing Step #2, please note that this is an expansion of the toy FLP in step 1. In order to provide the additional required protection for toys the toy asset protection plan (a toy model) was developed that consists of the following:
The following is a possible scenario on the use of this model. Suppose you loan money to an Subchapter S Corporation on the condition that the corporation purchase a toy of your choice and at the same time donate 100% of its stock to an irrevocable trust that makes an ESBT election. Of course, you will have a rental agreement that essentially gives you a life estate in the toy and unlimited use. The loan (your receivable) is placed in a FLP (Toy FLP). Your toy FLP is now the major creditor with a security interest in your toy. Consequently, the judgment creditor will first have to overcome your claim on the asset and if successful, will then have to face the limitations of a "charging order" as discussed previously. Wouldn't it be interesting to increase the interest rate of the loan and make an annual payment to the toy FLP without giving a distribution to the partners and judgement creditor. This would strictly limit any creditor's adverse intentions since we could control the income tax ramifications at the toy FLP level.
Step #2 also shows several Subchapter S Corporations controlled by a parent corporation. This is made possible by a wonderful provision in the IRS regulations that allow a parent Subchapter S Corporation to establish Qualifying Subsidiary Subchapter S Corporations (QSSS) that all file one tax return. This can be used to establish a Corporation for each major toy with little increase in the administrative reporting requirements but a major increase in the protection of the toys. For example, if you had individual corporations for your yacht, racecar, and airplane and the airplane was involved in an accident; the yacht and racecar would be outside the scope of any lawsuit, as they are not reported within the legal corporate entity that owns the airplane. The extra inconvenience of several corporations is minimized with the ability to establish subsidiary corporations, but the protection is potentially greatly enhanced.
The toy trust provides the ultimate barrier to any predator by owning the stock of the parent Subchapter S Corporation. This trust has an independent trustee (preferably a fiduciary corporation) that has instructions to distribute to the named beneficiaries any cash flow from the corporations at the discretion of the trustee. If all else fails, the trustee can order the corporations liquidated, notes paid, and can accumulate the equity result for ultimate distribution to the specified beneficiaries. In closely examining this situation, there appears to be a choice as to beneficiaries -- either the limited partners (in the toy FLP) or the named beneficiaries in the toy trust. It would even be possible to split the proceeds depending on lawsuit or tax positions. This provides great versatility in accomplishing your goals depending on the circumstances as they change and it also provides a way of using the irrevocable trust provisions only if they are needed.
This toy model certainly should protect your toy assets; except that, the legal system will generally not allow you to convey assets to a legal form for the sole purpose of avoiding your legal responsibilities. While it may appear that asset protection is the only benefit, but there is much more. The toy FLP is a great estate-planning tool. The reason is that after the loans are placed in the FLP, the annual gift tax exclusion can be used to gift a percentage of your equity to your family or friends (see step #3). It is also possible that you may be allowed a discount on gifting a minority interest that would qualify for a larger annual exclusion and more rapid depletion of your taxable estate. This benefit, however, requires minority interest appraisals that are becoming more easily obtainable as this method becomes more popular.
This is not all, however. Another good reason for this scenario might be the favorable treatment received by establishing this model in another state. Not only does it provide additional legal protection by providing a state line obstacle to attorneys; it would also eliminate the partnership minimum tax and might provide an avenue for legally not paying use tax. In this scenario the toy is owned by an out-of-state corporation (a corporation established in a state that has no sales or use tax, i.e. Oregon) and is purchased for its intended use in this particular state. It is important to note that most sales and use tax states have a time requirement that effectively establishes that the intended use is in other states if the toy's physical presence has not entered the taxable state for a certain number of days. This must be verified and proven to the state in which it will ultimately be licensed. This can certainly be arranged when purchasing a toy, but the officers of the Subchapter S Corporation will enforce strict compliance with state tax and licensing requirements. The potential tax savings on expensive assets would provide a substantial bonus in addition to paying for this entire process. This is more than enough reason to establish a toy trust.
How is the IRS going to perceive this model? Most of these types of trusts and corporations have some sort of current tax benefit to the user and promoted as being completely legal and safe. Substance over form, however, usually defeats this type of representation with drastic consequences to the taxpayer. It is relative easy to see that this toy model is nothing more than a positioning of the toys for legal and estate planning purposes and should be disclosed as such on the respective tax returns when filed. This puts the IRS on notice that these assets are personal in nature and will be taxed accordingly. Let's look at the entities:
Owner of the Toy Corporation with FLP general partner designating beneficiaries. Files loss tax returns on the pass through activity of the Toy Corporation. Corporate fiduciary signs tax return.
It would be difficult to determine that you have any ownership of the toy under this arrangement. After all, the corporation is owned by a trust that has other beneficiaries and the note receivable (loans) makes you and your limited partners a major creditor. In unwinding this arrangement however, all we have is a personal asset owned and controlled by you. This is typically what the IRS will try to enforce with substance over form reasoning. So why not agree to this position and maintain a tax neutral position. After all, the estates tax savings should be more than enough benefit not even considering the asset protection benefits.
In conclusion, it should not be necessary to relate the horror stories involving legal liability for innocent affluent people. It seems that more often than not the legal system is fueled by money more than justice. Toy trusts and corporations in conjunction with family limited partnerships are an effective road block to these abusive attacks on people that have generally done nothing wrong other then having a visual source of attachable equity. The new provisions for Subchapter S Corporations and related trusts provide a unique opportunity to enjoy your toys without the underlying concern about being sued. Used in conjunction with estate planning, toy trusts can be a lucrative solution in toy asset protection.
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