Hot and Cold Assets: Should Your Revocable Living Trust Hold Business or Real Estate Interests?
What’s a “hot asset,” anyway? Is it the newest meme stock on Reddit? Good guess, but no. In the estate planning world, the notion of “hot assets” and “cold assets” relates to whether a particular asset may give rise to liability exposure (i.e., exposure to a lawsuit). Commercial real estate is an example of a “hot asset” (i.e., the residential house or apartment you rent out to another family or the building from which you run your autobody repair shop or dental practice). In general, in many cases, there may be a good argument for keeping hot with hot, and cold with cold: if you separate your assets, you separate your liability.
At least that’s the general principle. Let’s explore the principle a bit further. Again, we’re talking about the basic concept of segregating, on the one hand, commercial or business property, and on the other hand, personal assets, such as your primary residence and brokerage account.
Some of the biggest factors for business owners to consider when thinking about or engaging in estate planning include: (1) tax implications; (2) business succession; and (3) asset protection. Each of these three factors can be a “world” unto itself; each of these concepts can become incredibly complex and thorny. Here, we’re scratching the surface to get you started.
Tax Considerations
How do you currently hold your business property and personal assets? Do you own your commercial building in your own name (jointly with your spouse, perhaps), along with your primary residence? How do you want to own this property, and how should you?
Property that we own in our own names makes sense to us: we’re the owner. It’s ours. There’s no “separate entity” for us to consider. But in some cases, having an “entity” own property may make sense, for one reason or another. Corporations, limited liability companies (LLCs), and partnerships (such as a limited liability partnership or limited liability limited partnership, as there is little to no reason to continue to use a general partnership anymore) are common “forms” of entity “structures.” The LLC, though, is quickly becoming by far the favorite and most popular entity choice, and for good reason.
From a tax standpoint, one important point to talk to your estate planning attorney about is the concept of the “pass through entity,” or the “disregarded entity.” If a C corporation files with the Internal Revenue Service (IRS) the appropriate paperwork to make an “S election” for federal income tax purposes, the C corporation becomes an S corporation, a pass through entity. LLCs and partnerships that likewise file with the IRS the appropriate paperwork to be treated as pass through entities are indeed pass through entities. Sole proprietorships, too, are pass through entities.
One of the biggest advantages of being a pass through entity is avoiding double taxation. Whereas a C corporation pays to the IRS income tax at both the corporate level and the individual level (shareholder level), with an S corporation (or an LLC that has elected to be treated as a disregarded entity), only the S corporation shareholders (or LLC members) are subject to income tax (the entity’s income and expenses “flows through” to the S corporation shareholders or LLC members, as the case may be).
However, care must be given in determining which entity structure is appropriate to particular circumstances and to achieve particular goals. Income tax may be only one part of a complicated equation. For instance, in many instances, having an S corporation own real estate may achieve a very poor result from an income tax standpoint. While avoiding double taxation during the shareholder’s lifetime may be advantageous (such as an S corporation with a sole shareholder), the “basis” consequences at the death of the shareholder can be complicated and surprising. Likewise, distributions of stock or assets from either a C corporation or an S corporation may cause unfavorable tax consequences (i.e., recognition of gain, capital gains tax, depreciation recapture, etc.) at the corporate and/or individual/shareholder level. While these consequences are beyond the scope of this article, the point is that avoiding double taxation should not be the only goal. As we say in the estate planning world, “Don’t let the tax tail wag the estate planning dog.”
Attorney Ryan J. Casson can help you undertake a holistic analysis of your personal situation and goals, which very well may involve a revocable living trust.
Now, let’s briefly look at a couple of points about transferring business property to a revocable living trust.
Electing Small Business Trusts and Qualified Subchapter S Trusts
In short, yes, corporate shares can be transferred or assigned to a shareholder’s revocable living trust. The corporation’s secretary can reissue new share certificates to confirm that the revocable living trust owns the shares. Remember, a shareholder owns shares in a corporation, and an owner of an LLC interest is a member owning membership interests in the LLC. In either case, shares of stock in a C corporation or S corporation and membership interests in an LLC can be held by a revocable living trust.
However, under the Internal Revenue Code (i.e., Section 1361), only trusts of a particular type are permitted to own shares in an S corporation. The two types of trusts that are permitted to own shares of an S corporation are electing small business trusts (ESBTs) and qualified Subchapter S trusts (QSSTs). If S corporation shares are transferred to the shareholder’s revocable living trust, at the shareholder’s death, the the trustee will need to make a QSST/ESBT election on time with the IRS to maintain S corporation treatment and the income tax benefits associated with S corporation status. If after the shareholder’s death the QSST/ESBT election timing requirements and other Internal Revenue Code requirements are met, the trust is treated as the owner of the S corporation stock that was transferred to the revocable living trust during the shareholder’s lifetime. (In addition to the requirement that the trustee elect QSST/ESBT treatment on time, Section 1361 requires that the terms of the trust satisfy certain criteria, and these rules are beyond the scope of this article.) If a trust does not qualify as a QSST/ESBT, the corporation’s “S" status (and attendant potential income tax benefits) is lost!
Transferring S corporation shares to a revocable living trust can help avoid probate and ensure that the shares pass to the shareholder’s intended beneficiaries, but the trustee will need to make sure to be prompt in following IRS timing and other guidelines and make the appropriate election on time to maintain the S corporation status. Shares should not be transferred to an irrevocable trust during the owner’s lifetime unless appropriate tax counsel is obtained first. Whether it is appropriate to make the election to treat the trust as a QSST versus an ESBT is an important question that estate planning attorney Ryan J. Casson can discuss with you.
As we have touched on above, and as will touch on briefly below, it must be remembered that entity interests, such as shares in a corporation or membership interests in an LLC, may need to be segregated from personal assets (property not used in a trade or business and much less prone to liability exposure), titled separately in a separate legal entity or trust.
The Law Office of Ryan J. Casson can draft a California revocable living trust or other trust that contains flexible QSST/ESBT language that will permit your trustee to make an appropriate election on time.
In some circumstances, it may be appropriate for the operating entity to “lease back” real estate, equipment, or other assets titled to a LLC, trust, or other entity holding title to only “hot” assets. If you are a California business owner, there are numerous factors and possibilities that Ryan can discuss with you!
Business Succession
Once you determine whether your business assets should be owned separate from your personal assets (or perhaps you do not own any such “hot” assets), and how your assets should be titled (in your own name, with your spouse, in a sole-member LLC, in a multi-member LLC, etc.), you must also consider what you wish to happen with your real estate or business property upon your incapacity and death.
In some cases, commercial real estate, rental real estate, or other business property may be distributed to one or more family members or heirs, and the remaining property to other family members or heirs. This may make sense if you know who you want to take the reins of the family business or if one family member wants to manage rental real estate (such as if one heir lives nearby and the other heirs live far away or out of state, or where one heir has special training).
Sometimes, as in the case of an LLC owning real estate, multiple heirs can own as members membership interests in the LLC, with a particular heir being a manager of the LLC. Whether an LLC should be member-managed or manager-managed is an important consideration that, along with many other considerations, California business succession planning attorney Ryan J. Casson can help you navigate.
Much of these decisions, including determining whether real estate should be transferred to your revocable living trust, involves analyzing and, potentially, amending or redrafting LLC operating agreements or partnership agreements, drafting and implementing buy-sell agreements, and considering tax goals. These documents should be reviewed every few years in any event, as tax laws change and “Life Happens!”
Asset Protection
As we have observed, in some circumstances, separating hot assets and cold assets makes sense. Titling your personal residence separately from your commercial real estate should help segregate any potential liability. While this potential protection is nice, there is a complexity and cost component (such as the $800/year fee to the State of California for a business entity to continue to enjoy the privilege of doing business in California, which can add up where multiple entities are needed). With multiple parcels of real estate, multiple, separate LLCs may be an appropriate approach, with the above-noted additional levels of complexity and costs.
Camarillo Attorney Ryan J. Casson can discuss with you the concept of “outside-in” liability and “inside-out” liability, the related concepts of veil-piercing and reverse veil-piercing, and charging orders (a remedy that judgment creditors use to attach or lien LLC and partnership interests). Separating commercial real estate or other hot assets from your cold assets may mean not transferring your commercial real estate and your personal residence to the same trust; perhaps your personal residence can be transferred to your revocable living trust, along with your other personal assets, while your commercial real estate is transferred to an LLC. In that scenario, it should generally be much more challenging for a judgment creditor of your commercial or business property to come after your other, separate property.
Community property aspects of estate planning must also be considered, as well as often overlooked forms of simpler asset protection, such as statutory exemption planning. Statutory exemption planning involves a Californian using California and federal statutes to “maximize” the amounts that these statutes identify as being exempt from creditors. Two excellent forms of California statutory exemption planning include maximizing contributions to your 401k and paying down the mortgage on your primary residence (in California). For individuals who, for whatever reason, or not ready or able to utilize irrevocable planning or entity planning, it may be appropriate to consider longstanding and well established forms of statutory exemption planning.
Finally, we should note that a revocable living trust is known as a “self-settled trust,” as is an irrevocable trust of which the trustmaker (or settlor) is or may become a beneficiary. Many states, including California, provide no asset protection to self-settled trusts (Nevada is a notable exception, for example). As such, a California revocable living trust is not meant to be an asset protection tool. Also, in California, in many instances, “support creditors” (a spousal support or child support judgment holder) can petition the court to pierce and lien the support judgment debtor’s trust share. As such, transferring real estate to your revocable living trust will not protect the trust property from a beneficiary’s potential, future divorce where the beneficiary becomes support judgment debtor.
Working to try to protect your real estate, whether or not it is your primary residence, rental real estate, or other commercial property, means not proceeding on your own. Procced with caution, understand the potential pros and cons as you see them, and use a competent estate planning attorney who understands not only how to create a revocable living trust but also how to interweave tax planning, business succession, and other potential objectives into your comprehensive California estate plan. Contact Attorney Ryan J. Casson to identify the approach that you are most comfortable with.
