Do You Need A Gznto Chart?

0 Comments

September 1996
Vol 20 No 1

Once upon a time I worked in an assembly plant producing circuit boards under contract with the government. To be able to price contract bids competitively, we had to figure out how many of which parts went into each sub-assembly and how many sub-assemblies it took to make the final product. A GZNTO chart explodes the entire product into each of its parts down to the very last component and depicts exactly how many of each goes into a widget, then how many widgets goes into a whatsit, and how many whatsits into the next assembly, etc., etc. Thus, GZNTO stands for ‘goes into’.

By being able to see how each part fit into each other, the GZNTO chart made it easier to calculate not only the costs of the components, but also to estimate the difficulty of assembly and the costs of labor to assemble them all as well. In the GZNTO chart was a useful tool to train the assembly line workers in how and when to use each component part to make the next higher assembly. By seeing everything all laid out in an exploded view, they could understand what was required of them and how best to do their respective jobs.

It occurs to me that some sort of explanation of the various components of an asset protection plan might be useful for those who’ve become confused by the plethora of Trusts, Limited Liability Companies, S corporations, and C corporations. There’s a tendency to lump everything together, or to combine them haphazardly, causing more problems than they cure. Hopefully, in this letter, I’ll be able to explain how each might be used, the benefits each confer and the strategies associated with each. In short, I want to see if I can’t help you to construct some sort of GZNTO chart of your own to put each organization in its place in your overall strategic planning. Let’s begin with Trusts.

A Trust is nothing more or less than a contract between two or more parties. The trust contract creates a fiduciary between Trustee, Grantor and Beneficiary. The party who creates the Trust is called Trustor, Grantor, Settler, Creator, Donor, or Contributor. The Grantor turns over title to assets and/or assigned responsibilities to the other party. He would be identified as Trustee, Donee, Grantee. He holds, manages or performs some duty with regard to property or persons entrusted to his care. He would do this for the benefit of one or more third parties, called Beneficiaries. All of the legal entities described in the foregoing paragraph can be named as Beneficiaries of any kind of Trust.

Generally speaking, while there are endless varieties of Trusts, for convenience, we can divide them up into two main categories. In the first category, we’ll include trusts that are distinguished by their legal vulnerability. These can be divided into REVOCABLE Trusts, and IRREVOCABLE Trusts. In the second category, we might include two kinds of trusts distinguished by their IRS classification. Trusts are taxed according to whether they are GRANTOR or NON-GRANTOR. To further complicate matters, in certain combinations, one kind of trust can affect the other. In an effort to sort all this out, let’s look at them one at a time.

REVOCABLE TRUSTS: Anytime that a trust agreement can be legally revoked or amended, it’s a revocable trust. Living Trusts, Title-Holding Trusts, Land Trusts, and Personal Property Trusts are usually revocable trusts. Because all revocable trusts are also deemed to be GRANTOR trusts by the tax code, they normally won’t have a separate tax I.D. number. Nor do they file any special tax returns. Revocable trusts serve a useful purpose in providing privacy, avoiding probate, protecting against legal liability as well as rights in divorce. A revocable Living Trust becomes irrevocable upon a Grantor’s death. Usually, irrevocable trusts offer better asset protection when drafted to achieve that end. Let’s take a closer look.

IRREVOCABLE TRUSTS: Grantors and Trustees can contractually agree that their arrangement cannot be legally terminated or amended. So long as their agreement is not in conflict with applicable State laws, they’ve got an irrevocable trust agreement which both must adhere to. ‘Irrevocable’ could mean ‘revocable’ from time to time depending on the intent of the parties. Within the agreement, there might be included special circumstances, the occurrence of which, would cause the trust to be terminated. Everything hinges on the contractual trust agreement.

Business Trusts, Testamentary Trusts, qualified Charitable Trusts and Foundation Trusts, Qualified Personal Residence Trusts, Crummey Trusts, Foreign Trusts, Generation-Skipping Trusts, Trusts set up to provide for Minor children and incompetent people, Insurance Trusts, and most Trusts designed to pass on major estates are usually irrevocable.
While all revocable trusts are taxed as Grantor Trusts, depending on how it was formed, the parties to it, and how they interact; an irrevocable trust may or may not be a Grantor Trust. It can still be treated as a GRANTOR trust under IRC Sections 671-678 if the creator retains any control over assets contributed to it, exerts undue influence on the Trustee, has administrative powers over it, or deals with it other than at ‘arms length’. If it is the desire of the Grantor that the trust be treated as a NON-GRANTOR trust, this is easily done through careful drafting of the Declaration of Trust contract, and responsible administration.

For federal income tax purposes, a qualifying non-grantor irrevocable trust is a separate taxpayer. It has its own federal I.D. number, pays more taxes on undistributed income. It files its own tax return on Form 1041 and various supplemental forms thereto. It issues a K-1 form to its beneficiaries for any distributions of property that it passes on to them.

GRANTOR TRUSTS: This category is a creation of the Internal Revenue Code which denotes that all trust income or loss is recognized as having been received by the Grantor rather than the Beneficiary. This isn’t necessarily bad. For instance, when setting up an irrevocable foreign trust, it’s desirable to deliberately structure the trust as a Grantor trust in order to avoid the high taxes levied on Non-Grantor foreign trusts. Similarly, those who want to pass on the maximum estate to their heirs often create Grantor trusts in order to be able to pay taxes at their level, thereby keeping their assets compounding tax free at their heirs’ level. Since Grantor trusts don’t file any special tax forms, they enjoy an almost invisible existence from an income tax standpoint.

NON-GRANTOR TRUSTS: According to the tax code, any trust that’s deemed not to be a Grantor trusts is automatically a Non-Grantor Trust. Assuming that the Grantor designs his trust to avoid being classified as a Grantor trust, these trusts can be used for myriad purposes. The income and losses can be netted out at the Trust level. Only net numbers will appear on the financial statements or tax returns of the Grantor. As you might imagine, this makes for a very low personal financial profile. If a person were engaged in a hazardous business, fraught with high liability, operating out of an irrevocable, non-grantor, business trust would insulate business risks from personal assets, or vice versa.

LIMITED LIABILITY COMPANIES: The oldest limited liability company in America is just barely old enough to vote. Based upon unincorporated organizations that came into existence in the Pennsylvania oil fields in 1874, LLCs as we know them were started in Germany over 100 years ago. They finally reached our shores only in the mid-70s where they were created by statute law in Wyoming. LLCs can be described as Partnerships in which the partners have no liability. Or Limited Partnerships in which the LPs can take control without liability. Or S-corporations which can be formed by any number of legal entities or foreign citizens. Or Trusts in which title is vested in the entity rather than in the Trustee.

The LLC is the Swiss Army Knife of legal entities. It’s an extremely versatile form of business organization which allows disparate members, domestic or foreign, of almost every description, to join together to hold property and to engage in business. LLCs can be confusing when one considers State laws. Some States tax them as C-corporations. Others don’t tax them at all. In some States, one person can form an LLC with himself. The jury is still out as to how federal taxes might be determined. The IRS has issued rulings that allow LLCs to be taxed as C-corporations in some States, and as Partnerships in others.

LLCs are so new that very little case law has been created in civil, criminal, or tax courts. With a paucity of regulations or statutes, they represent a tempting form of organization, especially when they can be formed with all kinds of Trusts or Corporations as members. Under ideal circumstances, when an LLC in one State is owned by a Trust in another State whose beneficiary is a Corporation in yet another State, virtually all liability risk can be eliminated effectively, except for tax liability. Taxes liability could be reduced if an LLC were structured so that taxable income would pass through to the trust, then to the corporation where it could be held as retained earnings in a State where Corporations aren’t taxed.

Within reasonable limits, the various owners of LLCs that qualify to be taxed as Partnerships enjoy being able to add the LLC’s debt in varying proportions to the basis of their shares. Done properly, it’s conceivable that an owner could reduce taxes on low basis property by placing it into an LLC, then sell his high basis shares to another member of the LLC. Perhaps a corporation. Best of all, where State law permits it, professionals can obtain high levels of liability protection and tax shelter without the constraints of Personal Service Corporations and their high tax rates.

S-CORPORATIONS: Once hailed as the wunderkind of corporate tax strategy, S-Corporations are beginning to out-live their usefulness when compared to LLCs. Each year, a few more S-corporation benefits are taken away. Today, owners of more than 2% are taxed on most fringe benefits. Without special permission, they must adhere to calendar year tax accounting. Some States require them to pay taxes as C-Corporations. Nonetheless, they’re backed by considerable case and statute law.

In States which refuse to allow professionals to use LLCs, S-Corporations can provide court-tested liability protection. At the federal level, S-Corporations pass all their profits and losses through to their owners. Therefore, they’re a good tax shelter vehicle for a new business which will sustain operating losses for the first few years. And when they’re liquidated, built-up gains are only taxed once, to the extent they exceed the basis in the shares.

C-CORPORATIONS: When it comes to tax shelter, ability to raise capital, and liability protection, a C-Corporation is the true Rolls Royce of business. Most of the States tax them about the same way, although Washington, Nevada, Wyoming and South Dakota don’t tax them at all. Delaware doesn’t tax corporations doing business outside the State. Properly run C-Corporations are legal strongholds which insulate their owners from corporate misadventures. We hear about billion dollar awards levied against giant corporations, but nothing against their shareholders.

In States where they aren’t taxed, C-Corporations comprise the most favored of tax-paying entities. Officers and employees can be provided pension plans, education, healthcare, life insurance, day care for parents or children, maternity leaves, golden parachutes; plus a host of other benefits that no other type of organization can match. C-Corporations can elect to be taxed on a fiscal rather than a calendar year. When they are taxed, they pay less taxes than any other taxpayer. It just gets better and better, especially with real estate.

The passive activity loss rules for rental real estate don’t apply to small C-Corporations. They can deduct 100% of their rental real estate losses against operating income. They can make officers zero interest rate loans. And they can retain up to $250,000 in earnings without paying it out in dividends. If they should go out of business, each owner can deduct up to $50,000 in losses per year against all other income. That’s the good news. The bad news is that when any profits are paid out, they’re taxed against at the shareholder level.

Let’s see if we can’t put this all together. Where people go wrong is in buying a neat new tool before having a job for it to do. Fess up. How many hand tools, computer programs, calculators, or LLCs, Trusts and Corporations have you bought that you haven’t gotten around to using? Maybe if we approached the whole thing from the standpoint of need, we’d be able to get more use out of the various entities discussed in this month’s letter. What are some problems and solutions?

 

PRIVACY: Trusts provide more privacy at lower cost than any other business form mainly because they can be set up in a State that doesn’t require them to have a resident agent, file any forms, or request permission to exist. Illinois type land trusts with a 3rd party trustee can be used to hold real estate. Personal property of all kinds can be held in Trust with no public record of ownership. But, when formed as Grantor trusts, any income would flow onto your tax return, and be subject to discovery proceedings and tax in your State of domicile. There’s a solution:

C-Corporations can be formed in Nevada with no record of ownership. When the shares of a trust are held by a Nevada corporation, neither ownership nor income will be traceable to you. When the corporation pays its officers, payment can be made on contract to an LLC that provides family members as employees. The LLC will withhold income and payroll taxes and pass on its earnings via a low profile K-1. This is a fairly simple way to maintain privacy. In other States, C-Corporation shares could be held by irrevocable non-grantor trusts to conceal ownership.

PROTECTION: LLCs are designed specifically to provide liability protection to those who manage or own them. Suppose two irrevocable trusts were to form an LLC and be taxed as a Grantor trust. This would create a high degree of liability protection. Income would flow through to the trust Grantors in their own tax brackets. If the Grantors were C-Corporations, all the fringe benefits and lower C-Corporation tax rates would apply. A case could be made that the income received was from active conduct of business, and thus not personal holding company income. If these entities were domiciled in different States, just determining the legal jurisdiction would discourage spurious lawsuits, filed by predators.

TAXES: What about State and Federal franchise, income, capital gains, inheritance, and estate taxes? My best advice is to domicile in a favorable tax environment to escape State taxes. Nevada has none of these taxes at the State level. If you don’t want to move, at least use a basic business trust to do business at the State level, providing that it isn’t taxes as an entity. Let it be owned by a C-Corporation. The Trust should divide its income by paying some salary in the lower brackets, retaining as much earnings as possible in the 15% and 28% brackets, and distributing the remainder to the C-Corporation in an untaxed State.

By creatively combining the basic building blocks discussed in this letter, you can materially reduce liability risks and taxes at reasonable cost. Holding assets in a variety of entities, and building an estate plan around them, you’ll be able to pass on gifts and bequests. These can be discounted when they represent minority and unmarketable interests in complicated structures.

Just for fun, take a pencil and draw some squares on a sheet of paper. Each should denote a C-Corporation, Trust, LLC or S-corporation. Next, make a rough list of your personal and business assets and their approximate value. Using this letter as a guide, start plugging in specific entities, names of trustees and beneficiaries, locations, and activities. Let your diagram reflect the flows of income and tax liabilities of each entity and ‘player’. You’re going to have a whale of a time once you see the possibilities.

 

Copyright Sunjon Trust  All Rights Reserved
Quotation not permitted. Material may not be reproduced in whole or in part in any form whatsoever.
1-888-282-1882 www.CashFlowDepot.com

Tags The CommonWealth Letters

Leave a Reply

Your email address will not be published. Required fields are marked *

Fill in your details below or click an icon to log in:

*

You Don't Have to Spend a Fortune to Learn How to Make One!

Join the CashFlowDepot Community today and learn how to make cash and cash flow with real estate.