There are many forms of asset protection. There is no silver bullet and often multiple techniques are used.
One of the best types of asset protection is purchasing insurance. If your home burns to the ground, insurance protects you. If you get in a car accident and injure someone, insurance protects you. Insurance, however, has limitations on coverage - both on the amount that will be covered and on the type of activity covered. Therefore, insurance is not always sufficient to protect your assets.
Limited Liability Companies
Another type of asset protection is operating your business activities through a company with limited liability - such as a corporation or a limited liability company. If formalities are complied with and if business and personal assets are not commingled, a company with limited liability can be an effective means of asset protection for the shareholders of the company. If the company is sued, the shareholders generally cannot be held liable for the debts of the company.
Divesting of Assets
If one member of a family is more likely to be sued than another, it may be helpful to have family assets held by other members of the family. For instance, if one spouse engages in a high risk profession, it may be prudent to have the family home and other assets held by the other spouse. It is important to note, however, that this approach merely shifts risk from one spouse to another. If the low risk spouse is held liable for an action, the assets can still be lost.
Domestic asset protection trusts (“DAPT”) and offshore asset protection trusts (“OAPT”) are also included in this category. Trusts can be created for the benefit of family members and property can be transferred to the trusts so that the property is beyond the reach of creditors. In several U.S. states it is now even possible to create “self-settled” trusts, where the trust benefits the creator of the trust and may protect the property from creditors.
Obfuscation (Hiding Assets)
Making it difficult for creditors to find assets and/or to gain control of those assets is another technique of asset protection. There are an unlimited number of techniques that can be used to hide assets. This rationale is often one of the major selling points of offshore asset protection advisors.
One approach to hiding assets is to set up bank or other accounts in countries with bank secrecy laws. Another approach is to set up foreign corporations, foreign trusts, foreign foundations, or other types of foreign entities where the owners or beneficiaries of those entities are kept secret. This secrecy might be achieved by having the title to the shares held by one person, but the shares beneficially owned by another. Sometimes, instead of keeping the owners or beneficiaries secret, the beneficiaries or owners are simply not yet determined (shares not officially issued for corporations, contingent beneficiaries for trusts, etc.).
U.S. Tax Issues With Obfuscation
The problem with obfuscation is that Congress has created numerous U.S. tax reporting requirements for offshore activities. The penalties for failing to comply with the U.S. tax reporting requirements can be enormous. For instance, if a U.S. citizen transfers $100,000 to a foreign trust and simply fails to tell the I.R.S. about the transfer, the penalty starts at 35% ($35,000) and goes up from there. Code § 6677(a). The comparable penalty for failing to disclose transfers to foreign corporations is 10%. Code § 6038B(c).
To learn more about U.S. tax reporting requirements (and the penalties) for offshore activities, speak with a qualified U.S. tax professional.
Obfuscation Increases U.S. Tax Advisor Fees
Even without obfuscation, it can cost thousands of dollars to hire a tax professional to help you prepare the necessary U.S. tax forms related to the offshore activities. Many tax professionals don’t regularly deal with offshore tax reporting, and the ones that do may be hesitant to prepare the tax returns due to the potential for penalties.
Where there has been obfuscation, it can cost even more. In the typical case, the U.S. citizen that has created the offshore asset protection structure may initially be tight-lipped about the details. The conversation might go as:
Client: "I don’t own the shares of the foreign corporation (to which I transferred assets)."
U.S. Tax Advisor: "Who owns the shares?"
Client: "My foreign attorney’s secretary holds title to the shares."
U.S. Tax Advisor: "Can you have the shares transferred into your name at any time?"
Client: "Well . . . "
U.S. tax law looks to the substance of the transaction. If shares or assets are nominally owned by one person, but beneficially owned by another, U.S. tax law would treat the beneficial owner as the true owner. Therefore, the beneficial owner would be required to report the ownership of the shares or assets.
Obfuscation techniques intentionally make transactions overly complex and unclear. To meet the U.S. tax filing requirements, the complexity and uncertainty must be sorted through to determine the proper filings. The time it takes the U.S. tax advisor to sort through the “mess” costs the client in additional fees.
U.S. Tax Reporting Undercuts Obfuscation
A properly prepared U.S. tax return will be a road map to where the assets went and to who controls the assets. It is not recommended that the U.S. tax filings have any misleading information. On the contrary, it is important that the U.S. tax filings be as complete and as accurate as possible. The I.R.S. often has discretion in determining whether they will assert penalties. If an I.R.S. agent perceives that the information provided is not complete or accurate, they may be more likely to impose penalties.
In essence, the obfuscation must be unwound for purposes of preparing the U.S. tax return. Therefore, the complexity and uncertainty intended for asset protection purposes may not serve its purpose.
In summary, it is important for U.S. citizens and U.S. residents to understand all of the U.S. tax implications of setting up offshore asset protection structures, preferably prior to entering into such a structure. However, if such a structure has already been set up and the U.S. tax reporting requirements for earlier years have not been complied with, it is important to get up to date with those filings. While the I.R.S. generally waives penalties for reasonable cause, they are much less likely to find reasonable cause when they are the ones who discover the existence of the offshore structure.
Andrew Mitchel is an international tax attorney who advises businesses and individuals with cross-border activities.