September 13, 2012 – What You Need to Know About 529 College Savings Plans, Florida LLC Charging Order Myths and an Offshore Trust Issue

Providing updates and comments on Florida estate planning and creditor protection developments and insight for lawyers, CPAs, and other planning professionals

1. 529 Questions About 529 Plans

2. Florida LLC Charging Order Myth

3. How Can the IRS Conclude That a Transfer to an Asset Protection Trust is a Completed Gift When the Grantor Has Retained the Right to Direct How the Assets Will Pass on His or Her Death?

Welcome to this week’s Thursday Report, which profiles the benefits of Florida 529 College Savings Plans, common misconceptions regarding charging order protection for Florida LLCs, and an offshore trust issue.

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529 Questions About 529 Plans

“The best math lesson we can teach college students this year is to subtract a tuition increase and benefit from the dividends of higher education.” – Jodi Rell

Many clients are unaware of the benefits offered by Florida 529 College Savings Plans. In addition to helping clients fund higher education opportunities for their children and other family members, these plans also provide creditor protection and tax benefits. Under Florida Statute Section 222.22, money paid into or out of, the income of, and the assets of any qualified tuition program are protected from the creditors of the account owner, contributor, or beneficiary. Additionally, the plan’s earnings are not subject to federal income tax, so long as the earnings are used for qualified educational expenses, including tuition, fees, books, and room and board.

To read our chapter on 529 Plans from the Florida Physician’s Guide to Creditor Protection, please click here.

The Tricks

The recent economic downturn may have caused some clients who currently own 529 Plans to suffer losses in value in these investments. However, clients who have 529 Plans that are worth less than what they invested may find it advantageous to start new 529 Plans. The old 529 Plans can be viewed as a tax shelter for the client, and once it reaches the original investment amount, the client might want to cash it in without paying tax. The gain on the new plan will also not be subject to income tax. This principle is best illustrated by an example.

For example, John Smith opens a 529 Plan for his son and invests $50,000, which is now worth $30,000.

If he simply waits until the Plan is worth $50,000 again and then his son spends these funds on college, there will be no income tax savings.

However, if he starts a new 529 Plan with $30,000 and then both 529 Plans grow to $50,000, he can use the newer one for college tax free, and can cash in the older one without paying taxes. This saves the taxes on $20,000 worth of growth that would have otherwise been taxable if the funds were not invested in a 529 Plan.

Section 529 plans are named after Section 529 of the Internal Revenue Code, which provides generous gift and income tax provisions for qualified tuition programs.

The state of Florida offers two types of 529 Plans: prepaid plans and savings plans. The Florida Prepaid College Plan is the largest prepaid program in the nation and offers various tuition fees and packages, including a dormitory option, which is not offered by many states. In order to qualify for the Florida Prepaid College Plan, you must be a Florida Resident. This plan allows you to prepay the cost of tuition, required fees, and dormitory housing so that your child’s education costs will be paid for by the time he or she is ready for college.

The Florida College Investment Plan is a board-managed 529 college savings program available to residents of any state that hires outside investment managers to separately manage the program’s portfolios. This plan does not have a Florida residency requirement and allows you to choose from different investment options that have different levels of risk.

The plans described above are offered by the state of Florida, but you can also invest in other 529 Plans. There are many different investment programs available and you can compare 529 plans from various states by visiting the website Savingforcollege.com. To buy a 529 Plan, you can enroll directly or buy through an investment broker. Although 529 Plans purchased through a broker or a financial advisor are more expensive and typically have higher annuals costs, advisors can help you sort through the hundreds of plans that are available, understand your savings goals, actively manage your investment, and avoid tax consequences in certain states.

529 Plans do not have to be owned individually. Clients who have investments held under family limited partnerships, LLCs, and/or irrevocable trusts for descendants can have these entities purchase 529 Plan investments and pay college-related expenses.

One of the most obvious benefits of these plans is the ability to secure your children’s (or other designated beneficiary’s) financial ability to obtain a college education. With the costs of undergraduate and graduate tuition steadily rising, it is wise for families to begin preparing for their children’s education and help their children avoid huge amounts on student loan debt, which often burdens college graduates for many years after graduation.

529 Plans also provide significant creditor protection. Under Florida Statute Section 222.22(1), money paid into or out of, the income of, and the assets of qualified tuition programs authorized by Section 529 of the Internal Revenue Code are protected from creditors of the plan’s owner, contributor, or beneficiary. Some other states that provide creditor protection for qualified tuition programs include Colorado, Oklahoma, Oregon, Mississippi, and Kentucky. To view a chart of 529 program costs and creditor protection status for select states, please click here.

These plans also offer significant tax benefits. The plan’s earnings are not subject to federal income tax, so long as the earnings are used for qualified educational expenses, which can include tuition, required fees, books, supplies, and room and board. 529 Plans can be used to absorb otherwise taxable gains, to act as a tax shelter for the contributor, or as a vehicle for the gift tax annual exclusion when funding 529 plans for descendants. Our 2010 Bloomberg BNA quarterly article, “Unconventional Uses of 529 Plans Should Not Be Ignored by Taxpayers and Their Advisors,” provides further 529 Plan strategies and can be accessed by clicking here.

The Traps

The main traps regarding 529 Plans are the underuse of these plans or the mistaken belief that 529 investments cannot be made under family limited partnerships, irrevocable trusts, or other similar arrangements. As mentioned above, contributions to 529 Plans are not limited to individuals and can be made by entities such as trusts, LLCs, and family limited partnerships.

While these plans are highly advantageous, they do come with some disadvantages. Notably, 529 Investment Plans can depreciate in value, which creates some amount of risk. Additionally, these plans typically require annual fees and minimum contribution amounts, and establish maximum account balances to prevent a person from shielding more money than is necessary for the purpose of paying for educational expenses. However, these disadvantages seem minor when reminded that monies paid into or out of, assets contained in, and the income of any validly existing qualified tuition program (including Florida Pre-Paid Post-Secondary Education Expense Trust Fund as well as out-of-state plans) are not subject to attachment, garnishment, or legal process, and that the income earned from a 529 Plan will not be taxed.

Although Florida Statute Section 222.22 provides that 529 Plans are exempt from the claims of creditors, some creditors might attempt to claim that 529 Plans purchased by Floridians but are sponsored by states other than Florida that do not have creditor protection laws may not be protected. However, the Florida Legislature’s intention to make all 529 Plans protected from Floridians’ creditors seems clear, as evidenced by the fact that the requirement that the plan must be in Florida was removed from the statute.

Florida LLC Charging Order Myths

Many clients and advisors are aware that the sole remedy of a judgment creditor with respect to a debtor’s ownership in a Florida multiple-member LLC is a charging order. Nevertheless, there are many points of confusion and misconceptions that need to be understood by planners and clients, who could face drastic consequences based on how the LLC is formed and how LLC planning is handled.

The Tricks

A charging order is a remedy that a creditor of a member in an LLC (or of a partner in a limited partnership) can receive from a court that instructs the entity to give the creditor any distributions that would otherwise be paid to the partner or member from the entity. Generally, a creditor who receives a charging order with respect to a member’s (or partner’s) interest in the entity does not have any authority to mandate distributions from the entity or to participate in the management and affairs of the entity.

In 2011, Florida Statute Section 608.433 was amended to clarify and somewhat change charging order protection for multiple-member LCCs. The revised statute now provides that “a charging order is the sole and exclusive remedy by which a judgment creditor of a member or member’s assignee may satisfy a judgment from the judgment debtor’s interest in a limited liability company or rights to distributions from the limited liability company.” The state also specifically provides for protection for multiple-member LLCs, stating that “In the case of a limited liability company having more than one member, the remedy of foreclosure on a judgment debtor’s interest in such limited liability company or against rights to distribution from such limited liability company is not available to a judgment creditor attempting to satisfy the judgment and may not be ordered by a court.”

This amendment was designed to “fix” the uncertainty and confusion created by the Florida Supreme Court’s ruling in Olmstead v. Federal Trade Commission, 44 So.3d 76 (Fla. 2010) with respect to charging order protection for multiple-member LLCs. In this case, the Florida Supreme Court found that statutory charging order protection was not available to single-member LLCs, reasoning the statute did not explicitly provide that a charging order was the “sole and exclusive remedy.” This reasoning concerned many practitioners and LLC members because the same reasoning could have been applied to multiple-member LLCs, which would have deprived multiple-member LLCs of charging order protection. Fortunately, after Olmstead, the Legislature amended the statute in 2011 to provide the missing “sole and exclusive remedy” language.

It is now clear that multiple-member LLCs will receive statutory charging order protection under Florida law.

A recent Nevada Supreme Court case strengthened charging order protection for multiple-member LLCs under Nevada law. In Weddell v. H20, Inc., 271 P.3d 743 (Nev. 2012), the Court found that a charging order only entitles a judgment creditor to the debtor’s share of the profit and distributions from a multiple-member LLC.

In this case, two men had a business relationship concerning numerous projects, including co-ownership of an LLC. Their relationship later collapsed, and the two men commenced litigation against each other, resulting in one obtaining a judgment against the other. To satisfy this judgment, the district court issued a charging order entitling the prevailing member to all rights of the debtor member’s interest in an LLC that was co-owned by both men.

The Nevada Supreme Court overruled this decision and held that a charging order does not grant the creditor any interest in the LLC’s assets and does not entitle the creditor to participate in management or administration of the business. The Court further determined that after the entry of a charging order, the debtor no longer has the right to receive future distributions, but the debtor retains all other rights previously held, including managerial rights.

The Traps

It is important to note that single-member LLC ownership offers very little, if any, protection from a charging order standpoint. Under Florida Statute Section 608.433(6), a charging order is not the “sole and exclusive remedy” available to judgment creditors of a single-member LLC. Under this Section, a court may order the sale of a single member’s interest in an LLC if the creditor shows that the distributions made under a charging order would not satisfy the judgment within a reasonable time.

The issue of whether charging order protection is available for a multiple-member LLC when a creditor has a judgment against all members is unclear. If the same creditor obtains a judgment against all members of an LLC, it is possible that the creditor will be able to seize ownership of the LLC based upon the premise that none of the members have an “economic interest” in the LLC. Florida Statute Section 608.402(21) imposes a requirement that a “member” must have an “economic interest” in the LLC. Because the judgment creditor could obtain the right to receive all distributions from the LLC, it seems that the individual members may no longer have an “economic interest” in the LLC. Thus, it is possible that the individuals would no longer meet the statutory definition of a “member” and could lose charging order protection.

Although this issue currently remains unclear, the Business Law Section of the Florida Bar plans to remedy this problem in the proposed LLC Act, which should be finalized in the near future. The Business Law Section has created the Chapter 608 LLC Drafting Task Force to evaluate the current statute and draft a replacement statute, which should clarify much of the uncertainty and confusion associated with the current LLC Act. In the Latest Draft posted on the Business Law Section’s website, the definition of the term “member” no longer requires an “economic interest.”

We would like to thank attorney Thomas O. Wells, of Coral Gables for providing us with valuable information about charging order protection for multiple-member Florida LLCs.

Thomas O. Wells
540 Biltmore Way
Coral Gables, FL 33134
Tom@twellslaw.com

Although multiple-member LLCs typically receive charging order protection when a judgment is against one of the members, it is important for the other (non-debtor) members to acquire ownership before a creditor situation arises so as not to constitute a fraudulent transfer. It is also best that the other members contribute material monies or assets to the LLC in exchange for issuance of a membership interest.

Under certain circumstances, LLCs may not receive significant protection in bankruptcy proceedings. If an LLC member ends up in bankruptcy, the bankruptcy trustee may be able to seize the ownership interest of the member unless there is a legitimate “executory operating agreement” in place. Under bankruptcy law, an “executory contract” is a contract where both sides have unperformed obligations and must execute certain duties in order to receive a benefit. Thus, if the debtor-member has affirmative duties, the operating agreement will likely be deemed an “executory agreement.” On the other hand, if the debtor-member does not have affirmative duties and merely receives distributions, the agreement could be deemed “non-executory” and would not be binding on the trustee, which could allow the bankruptcy trustee to seize the member’s ownership interest.

Click here for Miami Lawyer, Thomas Wells’ 2012 ACTEC (American College of Trust and Estate Counsel) paper entitled “Effects of Bankruptcy Filing By Members and Shareholders and Executory Contracts.”

To see our article entitled “Pass-Through Entities Have Charging Order Law,” which was published in the April 2012 edition of Thomson Reuters Business Entities Magazine, please click here.

Click here for our Leimberg newsletter entitled “8 Common LLC Planning Errors.”

How can the IRS conclude that a transfer to an asset protection trust is a completed gift when the Grantor has retained the right to direct how the assets will pass on his or her death?

In an IRS CCA (Chief Counsel Advice) Memorandum issued in February an IRS lawyer reached the above conclusion, and we that that it was wrong. Our article on this was published on Tuesday, September 11, 2012 on the Leimberg Information Services Network and can be reviewed by clicking here.

The Leimberg Information Services Network can be accessed by clicking here.

As the result of this decision creditor protection trusts that can benefit the grantor are not intended to be treated as completed gifts will also provide one of the following provisions:

(a) no distributions can be made to or for the benefit of any individual or entity other than the Grantor during the Grantors lifetime except with the Grantor’s written permission; or

(b) that the Grantor has the right to designate how the assets will pass to individuals other than the Grantor at any time, while alive or by instructions that become binding on death.

NEWS AND UPCOMING EVENTS

• Renowned author and speaker, Dr. Srikumar Rao will be in Clearwater working with us and we have arranged for him to provide a free lecture at 10:30 am on Saturday, September 22, 2012 at the Hilton Carillon Park in St. Petersburg on the topic of Good Thing – Bad Thing – Who Knows? Changing Your Immediate and Long-Term Responses to Events and Challenges. All Thursday Report recipients, friends and colleagues are invited. Dr. Rao will also be providing an afternoon workshop as described in the attachment. Click here for more information.
• September 27, 2012, 4:00 p.m. – 4:50 p.m. Please join us for The 4-4-4 Show, a monthly Clearwater Bar Association continuing education webinar series that qualifies for 1 hour of continuing education credit and is moderated by Alan S. Gassman, Esq. This month’s topic is “Florida LLC and Limited Partnership Law and Strategies Update” with well known expert Tom Wells, Esquire of Coral Gables, Florida. To register please visit: www.clearwaterbar.org

FREE CONTINUING EDUCATION CREDIT

Alan Gassman and nationally known author and business coach Dan Sullivan will be presenting a free webinar beginning at 5:00 p.m. on Tuesday, October 2, 2012 on “Why 20% of the Doctors Make 80% of the Money (and Enjoy What They Are Doing!)”. This 1-hour program qualifies for continuing education credit for Florida lawyers and CPAs, and will include live discussions with successful physicians who will share what they have done in their practices to enhance income and their enjoyment of practicing medicine. Complimentary replays and audio downloads will also be available. To register for this event please email agassman@gassmanpa.com

Christopher Denicolo, J.D., LL.M. is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law. He has co-authored several handbooks that have been featured in Bloomberg BNA Tax & Accounting, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters and the Florida Bar Journal. He is also the author of the Federal Income Taxation of the Business Entity Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition. Mr. Denicolo received his B.A. and B.S. degrees from Florida State University, his J.D. from Stetson University College of Law and his LL.M. (Estate Planning) from the University of Miami. His email address is christopher@gassmanpa.com.

Kenneth J. Crotty, J.D., LL.M., is a partner at the Clearwater, Florida law firm of Gassman, Crotty & Denicolo, P.A., where he practices in the areas of estate tax and trust planning, taxation, physician representation, and corporate and business law. Mr. Crotty has co-authored several handbooks that have been published in BNA Tax & Accounting, Estate Planning, Steve Leimberg’s Estate Planning and Asset Protection Planning Newsletters, Estate Planning magazine, and Practial Tax Strategies. Mr. Crotty is also the author of the Limited Liability Company Chapter of the Florida Bar’s Florida Small Business Practice, Seventh Edition. He, Alan Gassman and Christopher Denicolo are the co-authors of the BNA book Estate Tax Planning in 2011 & 2012. His email address is ken@gassmanpa.com.

Thank you to our law clerks who assisted us in preparing this report:

Kacie Hohnadell is a third-year law student at Stetson University College of Law and is considering pursuing an LL.M. in taxation upon graduation. Kacie is also the Executive Editor of Stetson Law Review and is actively involved in Stetson’s chapter of the Student Animal Legal Defense Fund. In 2010, she received her B.A. from the University of Central Florida in Advertising and Public Relations with a minor in Marketing, and moved to St. Petersburg shortly after graduation to pursue her Juris Doctor. Her email address is Kacie@gassmanpa.com.

Alexandra Fugate earned her B.A. in English from the University of Florida in 2008, and J.D. from Stetson University College of Law in 2012. She has been a Guardian ad Litem for the past two years, a judicial intern for the Twelfth Circuit in Bradenton, and is currently seeking admission to the Florida Bar. She wants to pursue a career in Business, Employment, and Property law.