Level 2: Lifetime Gifts
If not fraudulently conveyed (see below), assets that were irrevocably gifted to family members are beyond the reach of a debtor's creditors. A gifting program also serves estate planning objectives since the gifted assets (and the income and appreciation thereon) are removed from the debtor's estate and, therefore, will not be subject to estate taxes at the debtor's death. To avoid the federal gift tax, a gifting program typically uses the debtor's $12,000 ($24,000 for married couples) annual per donee gift tax exclusion, and $1 million ($2 million for married couples) lifetime gift tax exemption.
Under Michigan's Fraudulent Conveyances Act, transfers for less than full consideration can be set aside by the courts if the transfer was made with the "actual intent to hinder, delay or defraud any creditor of the debtor". Therefore, irrevocable lifetime gifts must be made well in advance of any financial troubles of the debtor. The following gifting strategies all assume no fraudulent conveyance occurs.
Outright Gifts. Outright irrevocable gifts to family members remove the gifted assets from the reach of the debtor's creditors. A problem, however, with outright gifts is that the donee is not protected from his/her inability, disability, creditors and predators, including divorced spouses. Another problem with outright gifts is that the debtor loses total control over the gifted property. Accordingly, consideration should be given to making gifts to irrevocable trusts (see below).
Assets transferred to the debtor's spouse are not subject to gift taxes. However, proper planning is critical to prevent the transferred assets from returning to the debtor-spouse should the donee-spouse die first. Therefore, the donee spouse should transfer the gifted assets to a revocable living trust designed to provide income and principal for the benefit of the debtor-spouse, but in a manner that protects the trust property from the debtor-spouse's creditors.
Irrevocable Trusts. By making gifts to an irrevocable trust, the debtor can protect his/her beneficiaries from their creditors, including divorced spouses. The debtor cannot be a beneficiary or trustee of the trust. However, if properly designed, the debtor can retain the right to remove and replace trustees (with someone who is not related or subordinate to the debtor). In addition, the trust can give the trustee the power to use trust income or principal for the benefit of the debtor's spouse. Thus, the debtor will have "indirect" access to trust property.
Leveraging the gifts with life insurance within an irrevocable trust allows the death proceeds to escape estate taxation at the debtor-insured's death, and possibly at the death of the beneficiaries as well. The trust can be designed as a "grantor" trust so that the debtor (as opposed to the trust or its beneficiaries) is taxed on the trust's income. The debtor's payment of the trust's income taxes is the equivalent of a tax-free gift to the beneficiaries of the trust. Moreover, the funds used to pay those income taxes are removed from the reach of creditors.
Family Limited Liability Companies. The principal advantages to making gifts of membership interests in a family limited liability company ("FLLC") are control and flexibility. The debtor transfers to the FLLC those assets to be gifted and then makes gifts of non-voting membership interests to family members (or to trusts for their benefit). As the manager of the FLLC, the debtor has complete power and authority to manage the FLLC's assets. The non-voting members have no voice in the management of the FLLC, and cannot withdraw their share of the FLLC's assets without the manager's consent. Another benefit of making gifts of FLLC membership interests is that they may be subject to "valuation discounts" for lack of control and marketability, thereby "leveraging" the debtor's $12,000 annual gift tax exclusion and $1,000,000 gift tax exemption.
Under Michigan law, the creditors of a member cannot reach the FLLC's assets. Instead, a creditor's sole remedy is a "charging order" which entitles the creditor to any distributions made to the indebted member. However, if the FLLC's operating agreement is properly designed, the manager has the power to withhold distributions by retaining profits within the FLLC. In such event, the creditor might end up with a tax liability without the cash distributions for paying the tax. Because of this potential for "phantom income", the creditor may be willing to settle the claim on a favorable basis for the indebted member.