Trusts and LLCs: Mind the details

When it comes to wealth management, the devil is in the details — the minutiae in plans and strategies that may be overlooked or disregarded, only to cause serious problems later on. The challenge, of course, is discerning the details before they create havoc.

When it comes to the growing use of sophisticated wealth transfer mechanisms, like trusts and limited liability companies, by individuals, the details include complicated insurance considerations that must be expeditiously addressed. If not, the devil — in this case, a potentially catastrophic loss of coverage — might make an unexpected visit.

Here's the backdrop: All insurance policies, including those covering homes, boats, automobiles, fine art and other collectibles, are underwritten to provide coverage to the owner or titleholder of the asset. In other words, the owner's name is stated on the policy.

Simple enough. Now here is where the aforementioned fiasco can occur. Say a homeowner has been advised to create a trust or LLC for estate planning, tax, creditor protection or other reasons. The owner agrees with the strategy, and the house is transferred to the trust or LLC. The homeowners insurance policy must now be altered to reflect this change in ownership, i.e., state the name of the trust or LLC as an insured party.

If this change is not made and the house burns down to the ground or is otherwise damaged, the insurance company could question the change in ownership.

Practical insights from a wealth manager

This extraordinary risk became clearer to me following a recent discussion with Bob Bensman. Bob is the CEO and founder of The Bensman Group, a Chicago-based insurance and financial advisory firm specializing in serving the needs of an ultra-high-net-worth clientele. While Bob has not encountered the aforementioned situation with his clients — he's too smart for that — he says it is not uncommon, particularly in cases where the former owner of a home still resides in it, even though the actual ownership has been transferred. The same is true for scenarios involving a yacht, Ferrari or Giacometti sculpture, still in the "possession" of the former owner. "When it does occur, needless to say, everyone is in shock," Bob said.

There are many intelligent reasons behind the transfer of high-value assets to a trust or LLC. "Say you have two homes and are advised by tax or legal counsel to transfer the vacation home to a trust for your son for estate tax planning reasons," Bob explained. "You're 75 years old and not ready to actually give the home away today, but want to do that in 10 years. Under IRS regulations, the gift of the house to your son is not its market value today (from a gift tax perspective), since he's not getting it for 10 years, but the present value of the gift in 10 years.

Thus, a $5 million house, based on the market value, may be discounted to $2.5 million, yet, 10 years from now, might actually be worth $10 million. When you anticipate the future value to be more than the present discounted value, there is an incredible tax savings."

This explains, in part, the growing popularity of such sophisticated wealth transfer strategies. But what about the insurance ramifications?

"Here's the deal," Bob said. "Typically, when you transfer title of a home to a trust, the house no longer belongs to John Doe. It now belongs to the trust. Now say John Doe has a party at the house and a friend becomes inebriated, suffers a terrible accident and becomes a quadriplegic. The attorney representing the friend sues the owner of the home, which is the trust. You must make sure the insurance program provides coverage to both the owner (the trust) and the occupant (John Doe) to make sure there are no gaps in coverage. In effect, the trust has no insurance coverage. John is now potentially liable for millions of dollars in damage."

What's the solution? Certainly, proper wealth planning should include input not just from tax and legal professionals, but from insurance agents and brokers specializing in the risk transfer and risk management needs of families and individuals — people like Bob Bensman. It's a straightforward solution, of course. But frequently in the discussions on the merits and challenges of wealth transfer strategies among financial planners, attorneys, CPAs and owners, the subject of insurance may not come up, in part because the insurance agent or broker may not be privy to these deliberations or has not requested to become involved.

How can such potentially dire complications be avoided? "If advice has been provided to transfer an asset to a trust or LLC, it is incumbent that the insurance agent or broker be notified immediately," Bob says. "Otherwise, if a claim arises down the road, it's important that all parties have appropriate coverage to avoid everyone from pointing fingers at everyone else."

It's smart advice, given the possibility of devastating financial loss. Obviously, the goal of all financial advisors and wealth managers, including insurance agents, should be to ensure their clients are properly and fully protected — with no devils lurking around the corner.

For more on estate planning, see:

The prospecting power of the new estate tax

The new estate tax: What producers really think

The $5.25 million question