ELITE ADVISOR BEST PRACTICES
The missing chapter from the family office manual
By Alexander A. Bove, Jr.
- High-net-worth families—and oftentimes their advisors—tend to overlook the importance of asset protection planning.
- Well-crafted asset protection plans must remain flexible and be periodically monitored in light of family developments, changing objectives and updates to the law.
- Without proper asset protection provisions in place, creditors can override a restriction on the transfer of shares of a family business, especially in the event of a forced bankruptcy or other large judgment.
- FLPs and LLCs do not provide as much protection as many advisors believe—they generally delay, rather than prevent, a day of reckoning with aggressive creditors.
- More and more states are allowing self-settled asset protection trusts to be created. Such trusts enable the trust creator to retain the right to vote shares of company stock that are held in the trust.
Family offices are attracting more and more attention from the advisor community, and there is no shortage of resources describing the many facets of managing a family office. Virtually all of the prominent family office manuals cover, in carefully detailed chapters, every component of the family office, from its foundation to entity options, investment management, governance and succession issues, and almost everything in between. But there is one problem—every one of the several manuals I reviewed is missing a very important chapter: Asset Protection.
Why is that? Is it the thought that these families have so many assets that losing $10 million or $50 million in a lawsuit won’t really matter? The fact is that under the right, or I should say the wrong, circumstances, it may not be only money that is lost, but even control of the family business. Consider the following case.
A case study
Many years ago, Andrew Parker took over Park Corporation, the family business, from his father and continued to grow it into a hugely successful company. Having bought out his siblings along the way, his intentions have been to transfer ownership to his son and daughter, Edward and Evelyn, and their children. He also intends that, to the extent tax laws allow, his family should enjoy the rest of his “empire.” Over the years, Andrew transferred some of the Park Corp. shares to Edward and Evelyn, and also to trusts for the grandchildren, but Andrew retained control. At last count, Edward and Evelyn each owned 20 percent of Park Corp., and the grandchildren’s trust owned 9 percent. Of course, there are the usual restrictions on ownership and transfer of shares. Meanwhile, Andrew, with the help and recommendation of advisors, established the Parker Family Office, which advises the family about all aspects of management and operations of the family empire, as most family offices do.
Disaster can strike at any time
While driving to the office one day, Andrew, in deep thought about a business matter, drifted into another lane, causing a van carrying a couple and their four young children to run off the road and crash into an abutment. The couple and one of their children were killed; the other three children were left handicapped for life. Of course, lawsuits followed, resulting in a huge judgment against Andrew that was far in excess of his insurance coverage, his available cash and his non-company assets. But, Andrew did have his shares of Park Corp., and in such a case, to Andrew’s astonishment, his new creditors could reach Andrew’s shares, which represented a controlling interest in the company.
What would that do to the company? The creditors could take control, drain the company of cash and assets or even sell the company outright, to recover on their judgment. A similar situation could result, though not a sale or loss of control of the company but still the interference of new unwanted shareholders, if Edward or Evelyn’s creditors reached their shares in the company. Where satisfaction of a judgment is involved, the restriction on transfers of shares can be overridden, particularly if a forced bankruptcy results, and family shareholders could find themselves with new partners.
Would an LLC or FLP offer protection?
Speaking of partners, many advisors believe that a family limited partnership or limited liability company (“LLC”) can prevent the disastrous result illustrated above. While a limited partnership, and especially a limited liability company, will certainly be better than outright ownership, depending to some extent on the jurisdiction of its formation, these entities generally offer only a postponement of the day of reckoning with a creditor, and definitely not an avoidance of the claims. So, what does the family office do with this knowledge if they have it? Unfortunately, not much, as evidenced by the total lack of it in the family office manuals.
Building a protective plan
The missing chapter—which most family office manuals neglect—could explain that there are ways to retain control over a company without exposing ownership of the company to creditors; there are ways of protecting children’s and grandchildren’s assets and company interests from creditors; and there are ways of passing the baton without passing the exposure. To accomplish such objectives, however, requires not only a careful and expert structuring of the underlying entities, but having in mind the family’s immediate, intermediate and long-term objectives. Further, even the best current plan can be subsequently handicapped by unforeseen changes, unless flexibility is built into the plan as well as provisions for a periodic monitoring of the plan to consider family developments, objectives and changes in the law.
Taking advantage of legal trends
For example, 17 years ago, there was no such thing in the United States as a “self-settled” asset protection trust. Now, 14 states have adopted such legislation and more are considering it each year. A self-settled asset protection trust is one in which a person establishes a trust for their own benefit, and after a period of time ranging from 18 months to four years, depending on the state in which the trust is established, their creditors cannot reach the assets in the trust. One of the features of such a trust is that the person establishing the trust may retain the right to direct investments, but more relevant to our discussion, the person may also retain the right to vote shares of company stock held in the trust. Thus, in our illustration above, Andrew could have retained not only control but also the benefits of his shares of Park Corp., while his creditors would have been unable to reach them. Similar results could be arranged for Edward and Evelyn, but the self-settled trust is only one of many options that may be worth considering.
Tailor the plan to the family
As suggested above, asset protection planning for the family must be designed around the particular family and the family’s particular assets. A family with large holdings of real estate, for example, would undoubtedly have a different plan than the one for a family like the Parkers, whose assets are largely “intangibles” (securities, cash, etc.). Real estate invites special considerations because it is immovable. (Here is a related article I wrote about protecting real estate from creditors.)
At the very least, real estate might be held in one or more LLCs, but it is generally not a good idea for LLC membership interests to be held directly in a family member’s name. Although, unlike corporate stock, creditors cannot take ownership of the LLC interest, they can obtain a “charging order,” which is a lien against the LLC interest, so that the individual owner gets nothing from the LLC until the creditor is paid. Once again, you will seldom find these details in the family office manual, although if the objective is to protect the family and its interests, those details should be there.
Another consideration may apply when the family has global interests. In this case, the establishment of entities in the several jurisdictions must be considered. The problem is that this situation also requires an expertise outside the typical family office manual, particularly if the foreign entities and the domestic entities are to be coordinated into a single overall plan. Further, in some cases, the foreign entities may take on a totally different form than we see here in the United States. For instance, the United States is a common law jurisdiction, while most of the rest of the world is governed by “civil” law, a system that does not recognize trusts. In many of these jurisdictions, a family foundation is used instead of a trust. Generally, the family foundation benefits a particular family (not a charity), is run by a board and is an extremely protective entity from creditors of the family. In some respects, it is like a corporation without shareholders, though like a trust, it has beneficiaries. And just as trusts in many jurisdictions are allowed to continue without a time limit, so are family foundations. Thus family foundations may continue to manage assets, including a family business, for many generations. One of the more significant benefits of the foreign family foundation as well as the foreign trust is the extraordinary creditor protection they provide, largely because many of the choice offshore jurisdictions do not recognize foreign (e.g., United States) judgments, meaning that even if a creditor obtained a U.S. judgment, it could not be enforced in the foreign jurisdiction.
In light of these and the numerous additional asset protection planning options where a family office is concerned, and acknowledging that properly implemented options can protect the family interests from interference and loss, it’s hard to understand why family office manuals do not take the opportunity to advise families on those issues. Unfortunately it appears most are missing that opportunity—and that chapter.ï»¿