Construction Accounting and taxation

R. Wesley Sierk III
November 4, 2008 — 1,935 views  

For contractors and developers, a declining real estate market is a double whammy. Most conspicuous, of course, is the resultant decrease in new construction that ensues when the market slides. But more alarming is the correlation between a dipping market and the regularity of lawsuits against developers and contractors. Contractors Studies of dozens of insurance company filing s show a direct inverse correlation between the robustness of the real estate market and the number of insurance claims filed against developer and contractor's insurance policies. Indeed, when Southern California's real estate market peaked in 2006, 36 claims were filed against 1,800 liability policies. But the past year it has seen interest rate s increase and home values slide. In turn, claims against these policies have increased 200 percent. Aggravating matters are the widespread exclusions that provide little in the way of actual coverage for contractors and developers. One story making the rounds: A mass grader was required by the hiring city to carry a $5 million general liability policy with products and completed operations coverage. After being declined by more than a few insurers, the developer was finally able to purchase a policy from a non-admitted carrier with a price tag of $3.4 million in annual premiums. The policy, delivered eight months into the contract term, listed "subsidence, soils, and any soil related complaints" as the first in a long list of exclusions, making the policy almost useless for a contractor responsible for moving large plots of soil. Indeed, the mass grader's policy would likely not cover any claim that would ever be le vied against him!

One might hope that this example is the exception, but loopholes and exclusions are commonplace, some making policies almost entirely worthless for the insured. Aggravating matters, runaway jury verdicts can be catastrophic and threaten to wipe clean a contractor or developer's life savings. The days of good sense fair treatment by a jury of one's peers are long gone. In the event a client goes to trial, there is little chance of having a single juror of his peers. Most likely it will consist of people unsympathetic to business owners who will be champions of the less affluent To protect their assets, therefore, many high-risk professionals, including con tractors and developers, simply transfer all assets into the spouse's name. Though this strategy" might provide a token layer of protection so long as the marriage remains stable, it assumes the spouse will never be in a car accident, or any other situation in which a law suit might be initiated. For contractors and developers, a deeper level of ingenuity must be explored to mitigate risk. But let's make this clear: You should stand behind your work; skirting accountability by protecting 100 percent of assets from creditors is irresponsible and imprudent. But with lawsuits and insurance claims on the rise, contractors and developers would be equally irresponsible and imprudent to ignore risk management entirely.

Proper entity structuring

The first layer of protection requires forethought as to the entity in which business investments are held. Limited Partnerships (LPs) and Limited Liability Companies (LLCs),' of course, offer "pass through" tax protection. They also provide an opportunity to separate control from ownership, an important concept in risk management. In most cases, Limited Partnerships offer the most protection when controlled by a small - percentage general partner (1-2%) and the remainder owned by a limited partner. In this case, the general partner (the contractor or developer) would have 100 -percent control of the decisions being made, but would only own a small percent of the assets (In the case of an LLC the managing member controls the LLC).This might not sound favorable, but imagine now that the limited partner is a foreign privacy trust (also known as a wealth protection trust) in which the general partner is a trustee Wealth protection track. Using this arrangement, the trustee is disenfranchised and would have no real power because it does not have direct control over the assets held by the partnership. Because the limited partner has 100-percent control, the contractor or developer makes all decisions as to when and to whom distributions will be made. If a creditor sues the LLCILP successfully, a court will issue a "charging order," which instructs the LLC/L P to pay the debtor's share of distributions to the creditor directly. Because of LLC/LP structure, the courts may decide not to allow creditors to seize assets directly. Instead, the partner being sued, the one- percent general partner (or managing member in the case of a LLC), will have hi s distributions paid directly to the creditor But the charging order does not provide the creditor with any leverage to force distributions , which means the general partner can simply withhold distributions. In the meantime, the charging order forces the creditor to step into the economic shoes of the general partner, and because LLCs and Limited Partnerships generally offer pass through tax protection, the LLC/LP does not pay taxes: Its owners do. The income is taxable, regardless of whether distributions are made, which means the creditor, who has stepped into the economic shoes of the general partner or managing member is responsible for paying the tax bill on this phantom in come. This partnership between the general partner (contractor or developer) and the limited partner (wealth protection trust) offers yet another layer of protection. If the general partner hears a grumbling or suspects a creditor attack might be imminent, it can terminate the LLC or Limited Partnership and transfer the assets directly to the account of the limited partner in the foreign domicile outside of the reach of U.S. creditors. Then, the partnership between the contractor and privacy trust can be terminated, with assets distributed accordingly. This provides two benefits: First, it makes the assets in the offshore trust virtually impossible to reach. It will also liquidate the general partner's small percentage of assets, making them immediately available to the creditor. To make use of this protection, however, contractors and developers must begin risk management procedures now, before the threat of liability. Assets that have been placed behind legal moats prior to lawsuits are largely safe. Assets sequestered after a lawsuit begins can still be seized, regardless of ingenuity or complexity of the structure. Once a claim arise s, any transfer of wealth can be undone, and the court can rule any such reallocation to be a fraudulent transfer. Furthermore, offshore privacy trusts provide almost unlimited protection. . .......Cont. ......

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About the Author

R. Wesley Sierk, III is the President and Lead Strategist for Risk Management Advisors, Inc. He is an expert in executive compensation, corporate benefit planning, alternative risk transfer, and captive insurance formation and management.

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R. Wesley Sierk III