Offshore Structuring

 

Using Offshore LLCs for Advanced Structuring of Management Companies

 

Of all the considerations that must be made when formulating an asset protection program, one of the often overlooked and arguably most critical factors (aside from fraudulent transfer considerations) is management structure. Although a properly structured onshore management entity can certainly enhance any asset protection program, using an offshore company offers some unique benefits that cannot be achieved any other way.

 

If one is to enhance their asset protection program with an offshore component, it is far more important and desirable to use offshore entities to manage assets than to actually hold assets offshore. This is because actually holding assets offshore will likely trigger a requirement to report such holdings to the federal government (and possibly generate a fair amount of suspicion in our post-9/11 environment), however reporting requirements for an offshore management company may be minimized or even eliminated if the offshore management company’s structuring is done properly.

 

Furthermore, charging order protection makes it extremely unlikely that a properly structured domestic LLC or LP1 will be dissolved in order to satisfy a judgment creditor.²

 

However, there are two threats to a domestic management entity that can be avoided by using an offshore LLC or other offshore limited liability entity. This first threat is that, if the entity is sued, the entity’s manager can be added as a co-defendant on the lawsuit, if the plaintiff’s attorney alleges that the manager acted in bad faith or was guilty of gross negligence (which most attorneys will do, if they can.) This is the exact reason why insurance companies now offer director’s insurance to corporate officers and other upper level management personnel. The second threat is that if the manager is within the jurisdiction of a U.S. judge, the judge may order the manager to do something that would compromise the debtor’s asset protection program. For example, a judge could order the manager of an LLC to make distributions of profit to the LLC members, so that a creditor who is assigned a charging order interest may collect the profit that would normally go to a member-debtor.

 

Using a domestic LLC or corporation to manage the entity that holds assets provides an extra layer of protection. This is because, if an entity is sued, then the entity manager, if it is named as a co-defendant on the suit, will be another limited liability entity. The managers of the managing entity will only be named on the lawsuit if the limited liability veil of the managing entity is pierced. However, if the limited liability entity is pierced, then the people who manage that entity may be personally pursued for the judgment debt if the lawsuit is successful. Furthermore, if the managing entity is domestic, then it will fall within the jurisdiction of a federal or state judge. The worst case scenario is that the judge will order the dissolution of the domestic management entity if it fails to comply with a court order that would be detrimental to the debtor. Although such an event would be extremely rare, unfortunately the bottom line is no amount of domestic structuring can completely insulate the management entity from the risk of court-ordered dissolution, or from an order to do something detrimental to the debtor.

 

A properly structured offshore management company would avoid both of the aforementioned dilemmas. The author specifically recommends the Nevis LLC as a management company. Among other things, the Nevis Limited Liability Company Act is based upon the corresponding Delaware Act. Therefore, Nevis law integrates very well with U.S. law, which means its laws will be more familiar to a U.S. judge, and thus we can predict with greater accuracy how a U.S. judge would interpret such law as opposed to the law governing some bizarre offshore hybrid entity that would be completely alien to him. Furthermore, although some may think that using an offshore LLC would make management more difficult, this is not true. Although many offshore entities face complex and sometimes very punishing international tax laws (for example, an offshore partnership subject to U.S. taxation must withhold 30% of its income at the source and turn it over to the U.S. government3), an offshore LLC may elect to be taxed as an entity disregarded from its owner.4 This means that the LLC has no requirement to file any entity level tax return. Rather, its taxable activity is treated as that of its owner, and reported on the owner’s tax return.5 Therefore a Nevis LLC may be structured so as to completely sidestep any tax return filing requirements altogether. Furthermore, even though the LLC is domiciled offshore, this LLC in turn may be managed by an onshore individual while the creditor seas are calm. When creditor threat arises, the Nevis LLC’s onshore manager should be fired and replaced with an offshore manager. As long as the LLC’s operating agreement is drafted correctly (which is absolutely critical), all managing parties will now be outside of U.S. jurisdiction and thus not subject to a U.S. court order.

 

Using an Offshore Trust to Hold Offshore LLC Membership Interests

 

Although management is now wholly located outside U.S. jurisdiction, a clever creditor may convince a judge to order the onshore members of the offshore LLC to vote out the offshore manager and replace him with an onshore manager, who would be subject to the court. We can counter this problem by having the LLC’s membership interest wholly owned by an irrevocable offshore grantor trust. If the trustee has discretionary power to vote as the LLC’s member and is also located offshore, then he would not be required to obey a U.S. judge’s order, thus preventing replacement of the manager. By using a grantor trust, the trust is ignored for tax purposes, thus sidestepping tax law regarding offshore entities, and it will have no 1041 or other filing requirement.  Instead, taxable trust activities are treated as that of the grantor’s, and reported on his income tax returns.

 

In light of the Anderson case6 and other landmark court decisions regarding offshore trusts, the author feels that an offshore trust should not be structured in a manner that might be frowned upon by a U.S. judge. In other words, it is preferable that the trust not be self-settled7. An ideal offshore trust could be, for example, a trust with the grantor’s children as the beneficiaries. Because the offshore LLC need have no more than a 1% interest in the entity it manages, its member distributions would be minimal. These distributions could be reduced or even effectively eliminated if the onshore manager charged the offshore LLC a management fee for its services.

 

The figure below illustrates the structure we’ve discussed.

 

FIGURE 1: A STANDARD OFFSHORE MANAGEMENT STRUCTURE

 

Because the offshore trust and LLC in Figure 1 is structured so as to be tax neutral, reporting requirements are reduced. However, some reporting requirements still exist.

• To elect disregarded entity tax treatment, the offshore LLC must file IRS form 8832. Failure to file form 8832 will subject all LLC income to a 30% withholding requirement, so it is very important to make a timely election. This form will require the disclosure of the LLC’s owner for tax purposes. Also, any person liable for income derived from LLC profits should report their income on their 1040 schedule C return. If the offshore LLC does not receive taxable income, however, then there need be no return filed for the LLC, and there are no other reporting requirements for the LLC.

• Notwithstanding the above, any U.S. citizen who is a signer on or holds an interest in an offshore financial account(s) that holds $10,000 or more in the aggregate should mark “YES” on line 7a of your 1040 Schedule B return, and you should also file form TD F 90-22.1.

• Any U.S. citizen who receives a distribution from, or is either a grantor of or transferor to a foreign trust should mark “YES” on line 8 of your 1040 Schedule B return, and you should also file IRS form 3520.

• A common misconception is that if a U.S. citizen has earnings offshore, then it is not taxable. The truth is that whether earnings are onshore or offshore does not alter one’s tax liability. If you would have tax liability from onshore earnings, then these same earnings would be taxable if they were earned offshore as well.

Critical Considerations When Drafting the Operating Agreements

Immaculate drafting of the entities’ operating and trustee agreements is essential to the effectiveness of an offshore management structure. There is much more to drafting an effective operating agreement than can be discussed in this article. However, there are several considerations that are critical when drafting operating agreements for both the onshore company and its offshore management company.

• The onshore company should not give any member the right to a return of capital, unless the management and all members unanimously agree. 

• Companies of perpetual duration are preferable to those with a specified termination date. 

• The offshore managing LLC should be the sole and exclusive manager until replaced.

  • It should not be replaceable unless all members unanimously consent.

  • t should have at least 1% membership interest in the onshore entity, so that it also has to consent in order to effect its replacement.

• The offshore LLC’s operating agreement should specify the same provisions for management replacement, rights to return of capital, and duration as the onshore entity.

• The offshore LLC’s operating agreement should stipulate that its manager be paid a fee, unless you have an offshore individual who would be willing to manage the entity for free under times of duress. Even then, the operating agreement should at least allow for a management fee.

• If the offshore LLC has a grantor trust as a member, make sure the trust document is irrevocable, and also gives the trustee the power to vote as an LLC member.

• Operating agreements of onshore and offshore LLCs should both allow for member distributions to be withheld, in the manager’s sole discretion, and converted to operating capital for the betterment of the company.

• Operating agreements of both LLCs should reinforce the charging order protection found in statutory law, and stipulate that it is the exclusive remedy of a member-debtor’s creditor. Assignment of LLC interests should be likewise addressed.

• It is always a good idea for an operating agreement to have a buy-sell provision.

• The operating agreement could also stipulate that no member, manager, or other person or entity may have the right to disclose the contents of the operating agreement to a non-member or non-manager without unanimous consent of the members and the managers. In some states, such as Florida, this provision will actually be honored by a judge.

  • Note however that it is not always a good idea to keep the operating agreement private. Sometimes the operating agreement may need to be examined by a court in order to save your skin. It is nice to have this option if you need it, though!

  • Placing the operating agreement in the hands of an offshore manager will give another layer of protection if you wish to keep it from falling into the wrong hands. Keep in mind that most states require the operating agreement and other company documents to be kept at the LLC’s principle place of business. However, most states allow this place of business to be located anywhere in the world.

Other tips for drafting a solid operating agreement may be found in the articles Entanglement Theory® and Laying a Trap to Make Your Creditors Cry “Uncle!”

 

Footnotes

1 Occasionally the use of an LP is preferable to that of an LLC as a domestic holding company in order to reduce or minimize state franchise taxes. Because of the similarities between the two entities, however, any mention of a domestic holding LLC should be considered to also mean an LP.

2 On very rare occasion creditors have been able to circumvent an LLC or LP’s charging order protection. However, charging order protection may be reinforced against such an event by utilizing Entanglement Theory®. For more information , see the author’s article Entanglement Theory®.

3 See Title 26 U.S.C. §1441(a).

4 This is accomplished by filing IRS form 8832.

5 In the case of a natural person, the LLC’s income would be reported on the owner’s 1040 schedule C return.

6 FTC v. Affordable Media, LLC, 179 F.3d 1228 (9th Cir. 1999.)

7 A self-settled trust is a trust wherein the grantor is also a trust beneficiary. Currently, 46 of the 50 states allow that, to the extent a grantor is also a beneficiary, his beneficial interest shall be freely attachable by creditors. This usually means a creditor may also directly invade the trust’s corpus (property), spendthrift provision notwithstanding.