We all work hard to accumulate wealth over our working years. Now, imagine the unthinkable ... losing your life savings.
To some, this is a very real concern. After all, we live in a litigious society. Doctors and other professionals are engaged in rewarding, but high-risk jobs. Landlords face lawsuits from tenants, lenders or visitors to their property. Even an everyday event like driving a car can give rise to liability. In today's legal environment, even meritless lawsuits are risky because no one can guarantee how a case will be decided. This means that if you go to court, even if you are "in the right" you have a risk of losing.
Without some form of asset protection planning in place, a person's life savings or nest egg could be at risk. The purpose of this issue of e-Counsel is to provide an overview of asset protection planning and what people do to insulate property from potential creditors. This newsletter is only intended to be educational and informative in nature and is not intended to give legal or other advice regarding any person's particular situation. If you have any questions regarding the contents of this newsletter, please do not hesitate to contact us.
What is Asset Protection Planning?
Asset protection planning is but one component of wealth management planning. Wealth management planning is generally defined as the process of acquiring, growing, protecting and ultimately distributing wealth in a cost effective and efficient manner.
The component of wealth management planning that involves growing wealth is called "financial planning;" the component of wealth management planning that involves disposing of wealth is called "estate planning;" and the component of wealth management planning that involves protecting wealth is called "asset protection planning."
With asset protection planning, a person organizes his or her assets and affairs in advance to guard against risks to which that person's assets might otherwise be subject. Like any component of wealth management planning, this involves analyzing many things, including a person's short and long-term goals and objectives, risk tolerance, net worth, the type of assets which are owned and who might be potential future creditors.
Just like there are different investments a person can utilize in a financial plan and different ways a person can dispose of assets in an estate plan, there are also many different tools and strategies that can be utilized to protect assets. Which tools or strategies that are utilized is dependent on a person's particular situation and his or her goals and objectives.
Usually asset protection involves transferring assets from an unprotected form of ownership to a different type of protected ownership. For example, if a person owns assets in his or her individual name, those assets are generally subject to creditors' claims. Depending on the circumstances, it could make sense to transfer ownership of those assets to certain types of trusts, a retirement plan, a partnership, a limited liability company, or a corporation to shield and protect those assets.
What Asset Protection Planning is Not
As important as it is to know what asset protection planning is, it is also important to know what asset protection is not. Asset protection planning is not about hiding assets. A hidden asset can be found. A protected asset is more secure. Asset protection planning is also not about defrauding creditors. Rather, it is a process of using existing law to legally protect assets.
Who Are Potential Creditors?
Asset protection planning is designed to insulate assets from future creditors. Who are these potential future creditors? Well, you do not have to look hard to find people who think you owe them money. Some possible creditors include:
- Tax-collecting agencies, including the Internal Revenue Service, for all types of taxes imposed upon you, a business you own, or a trust for which you are the trustee;
- Car accident victims, even if you believe they were at fault;
- Other accident victims, including victims whose injuries were caused by the actions of minor children or employees;
- Tenants who rent property you own;
- Visitors to any property you own;
- Banks or other financial institutions or lenders who have loaned you money;
- Clients, patients or others you provide services for who think you did something "wrong" even if you believe you were not at fault;
- Doctors, hospitals, nursing homes, and other health-care providers;
- Credit card issuers;
- Business creditors, including employees, suppliers, partners, etc.;
- Creditors of others, where you have cosigned or guaranteed their obligations.
The list can go on and on.
Asset Protection Planning and Fraudulent Conveyances
One of the keys to formulating an effective asset protection plan is to plan in advance. In fact, if a person waits to implement a plan until creditors' claims already exist, it is probably to late. This is because of the law of fraudulent conveyances. A fraudulent conveyance is the transfer of an asset when it is already at risk to a lawsuit or claim. For example, a person gets sued and wants to move his or her property to a spouse or children so a creditor cannot attach it. Almost any time a person conveys an asset in order to defraud or delay a legitimate creditor's claim, a fraudulent conveyance has probably been made. If a court finds that a property transfer is a fraudulent conveyance, it can, among other things, set aside the transfer as if it had never been made. Therefore, a meaningful asset protecton plan has to be established before a claim arises.
Asset Protection Planning Tools and Strategies
There is no one asset protection tool that universally safeguards all of a person's assets or that is an ideal match for every person. Some tools are rather easy to implement. Others are more complicated. Some asset protection tools provide more insulation than others. The benefits of any planning tool also needs to be weighed against any potential negatives associated with it.
We have found that one of the most logical places to start when thinking about asset protection is to review the kind of assets you own. Are your assets risky or hot assets that could generate liability or are your assets relatively safe? A hot or risky asset could be rental property which by its very nature can give rise to liability from claims by tenants, lenders, visitors and the like. A safe investment from an asset protection standpoint could be an investment account or mutual fund which is unlikely to cause a lawsuit.
Most of the time, you do not want to mix risky or hot assets with non-risky or safe assets. In other words, if rental property is owned and a lawsuit arises from a slip and fall, you obviously do not want all of your other personal investments to also be at risk.
Once you review the type of assets you own, look at how those assets are owned. Do you own assets in your individual name, in a retirement account, jointly with a spouse, in a trust, or in some type of entity? Is the manner in which your assets are owned appropriate from an asset protection standpoint or is there a "better" or "safer" way to own those assets?
In determining whether there is a "better" or "safer" way to own assets, consideration should be given to various ways people can protect assets. For most people, one or more of the following will be utilized or considered as part of an asset protection plan:
- Joint ownership;
- Exemption planning;
- Domestic irrevocable or asset protection trusts;
- Domestic family limited partnerships;
- Domestic limited liability companies; and/or
- Offshore planning.
Each of these planning tools or strategies is analyzed in more detail below.
1. Insurance. Ensuring that a person or business has proper and adequate insurance is one of the basic tenets of developing a sound financial and asset protection plan. When it works, insurance can be a godsend. Analyze the insurance you currently have. Consider purchasing or increasing "umbrella" coverage on your homeowners insurance policy. Since these policies rarely cover business-related liability, for any business activities, consider purchasing or increasing liability coverage under your business insurance policy.
It is important to understand that insurance will not eliminate all risks. If you review your coverage, you will probably find that it does not cover all possible claims. For example, intentional wrongdoing or punitive damages are typically excluded. In addition, the scope of coverage seems to continually decrease and a claim can always be made which exceeds your coverage. Finally, with the ongoing crisis in the insurance industry, the financial stability of insurance companies is never certain. Prudent planning usually dictates a combination of other asset protection strategies instead of relying on insurance coverage alone.
2. Joint Ownership and Division of Assets Between Spouses. Although the law differs from state to state, property owned by a husband and wife as tenants by the entirety ("TBE") offers some limited asset protection benefits. TBE ownership is different in a number of respects from other forms of joint ownership. For example, with TBE property, each spouse is deemed to own the entire property and neither spouse is recognized as having any separate right to the property. Because spouses have no separate right to TBE property, both spouses must agree before encumbering (mortgaging) or alienating (selling) the property. Because of these special rules, a creditior of only one individual spouse cannot reach the TBE property to satisfy a claim against that one spouse. A joint creditor (i.e., a creditor of both the husband and wife) can reach TBE property.
Because a creditor of one spouse cannot reach TBE property, owning property as TBE offers limited asset protection. For example, if one spouse is a doctor and gets sued, a creditor would not be able to reach property owned by the doctor as TBE with his or her spouse.
TBE property, however, has significant limitations from an asset protection perspective. For example, if one spouse dies, the property is no longer TBE property. This means that property which was once protected is now vulnerable to a creditor's claim. In the example above, if the doctor's spouse dies, the doctor now owns the TBE property individually. The doctor's creditor can thereafter reach the property. The same would be true if spouses divorce.
Also, TBE property provides no protection from a joint liability of both a husband and a wife. For example, if a husband and wife own rental property jointly and get sued, any TBE property would be available to satisfy a creditor's claim.
Because of these and other reasons, owning property as TBE does not ususally provide sufficient protection for the long term if asset protection is a primary concern.
3. Exemption Planning. Both state and federal law provide various exemptions that can protect certain types of property from creditors' claims. Although most of the exemptions do not provide for significant protection, they are worth considering when engaging in asset protection.
Missouri, for instance, has a homestead exemption which can be used to protect an equity interest in a residence. The maximum amount of the exemption is $15,000. Missouri also has an exempton for automobiles which protects up to $3,000 in car value. Other small exemptions for personal property, life insurance and other types of property are also available for Missouri residents.
Perhaps the most significant exemption for asset protection purposes relates to retirement plans. For most people, retirement plans represent the most significant part of their net worth. EIRSA qualified retirement plans (profit-sharing plans, 401(k) plans and the like) are generally protected from creditors claims while the assets are retained in the qualified plan. Depending on which state you live in, IRA's may also be protected. Missouri, provides protection for IRA's from claims of creditors while the assets are in the IRA.
4. Gifting. Many people consider gifting as a technique to protect assets. For example, a parent can give property to a child and once gifted, that property would not be subject to claims of the parent's creditors.
Outright gifts or gifts in trust could have gift tax implications which should be considered. For 2011, a person can make outright gifts of up to $13,000 per donee (and a married couple can give up to $26,000) without incurring any gift tax liability. Each individual (donor) also has a lifetime exemption for gifts which is $5,000,000 per donor for 2011 and 2012 (assuming no part of a donor's exemption has been previously utilized).
One of the main problems with gifting from an asset protection standpoint is that by making a gift, you have put the gifted assets outside of your reach in addition to the reach of your creditors. Simply put, property which you gift is no longer yours. In addition, the gifted property may now be subject to claims against the donee or person you gave the property to. For example, if property is gifted to a child, that property is now subject to claims of your child's creditors. If your child dies or is divorced, it is possible that the property may go to your son or daughter-in-law if additional planning is not implemented.
5. Domestic Asset Protection Trusts. Trusts are often used for estate planning purposes. Some trusts provide asset protection benefits, while other trusts do not.
Generally if a trust is revocable by the trust's creator (the grantor or settlor), any assets in the trust will not be asset protected. This means that a typical Revocable Living Trust does not provide asset protection benefits for the grantor or creator of the trust.
A number of states have laws which allow a person to establish an irrevocable trust that provides for asset protection benefits from creditors. These trusts are typically known as "domestic asset protection trusts." Missouri (as well as Alaska, Nevada, Rhode Island and Delaware) all have laws which allow for the creation of domestic asset protection trusts.
The requirements to create a Missouri domestic asset protection trust are as follows:
- The funding of the trust cannot be a fraudulent transfer or conveyance;
- The grantor or creator of the trust cannot have the ability to amend or revoke the trust (i.e., the trust must be irrevocable);
- The grantor or creator of the trust cannot be the only beneficiary of the trust (meaning there must be additional present or contingent beneficiaries of trust income or principal);
- The trustee of the trust must have complete discretion to make distributions to the grantor or creator of the trust as a beneficiary (meaning the grantor or creator of the trust cannot compel distributions); and
- The trust must contain a spendthrift provision.
If the above requirements are satisfied, assets which are transferred into a domestic asset protection trust should not be available for attachment by a person's future creditors. Let's look at an example. Suppose a doctor transfers investment assets into an asset protection trust where the doctor and his children are beneficiaries. Now suppose the doctor gets sued and a judgement is rendered against him for an amount in excess of his malpractice coverage. If properly established, the creditor should not be able to attach assets in the trust. In contrast, if the doctor owned the assets individually and outside the trust, the creditor would be able to reach the assets.
Many people may by unwilling or reluctant to make an irrevocable transfer of property to a trust where they cannot compel distributions from the trust. In these cases, a person can establish an irrevocable trust for their spouse. If the trust is drafted to qualify for the marital deduction, there should be no gift tax consequences when the trust is established. The person who created the trust could serve as trustee and his or her spouse would be the beneficiary. The assets transferred to the trust should not be subject to the claims of either spouses' creditors. Of course, a person needs to be secure in his or her marriage to engage in this planning strategy.
6. Domestic Family Limited Partnerships. A family limited partnership ("FLP") is an excellent tool to provide asset protection for family wealth. An FLP is a limited partnership that has one or more general partners and one or more limited partners. As long as there are at least two or more persons or entities who are partners, the same person can be both a general partner and a limited partner.
The FLP's general partner is responsible for the management and control of the partnership. The limited partners are really just silent investors and have no voice in how the FLP is managed or controlled.
From a liability perspective, the general partner or partners have unlimited liability for all of the FLP's debts and obligations. The limited partner or partners have no personal liability and can only lose the amount contributed to the FLP.
Under the typical arrangement, the FLP is set up so that a husband and wife are each general partners. A single person can also set up an FLP where he or she is the only general partner. Oftentimes, for added asset protection, an entity such as a limited liability company is established to serve as the general partner. The general partners would own 1% to 2% of the FLP. However, even though the general partner only owns a small minority interest in the FLP, the general partner still controls the FLP.
The remaining 98% or 99% of the FLP would be owned by the husband and wife, possibly their children, or a domestic asset protection trust for their benefit.
After establishing the FLP, safe or non-risky assets (such as investment assets) are transferred to the FLP. Hot or risky assets (such as rental property) are generally segregated from the assets placed in the FLP. Once the investment property is transferred, the owners of the FLP no longer directly own those assets. Instead, they own interests in an FLP, and it is the FLP which owns the investment assets.
So how does this structure provided for creditor protection? The answer is that a creditor of a partner of the FLP cannot reach into the partnership and seize or attach the FLP's property (the investment assets). For example, assume that a husband and wife establish an FLP and one of them gets sued for $1,000,000. The creditor would like to attach the investment assets in the FLP. However, under limited partnership law, the creditor of a partner cannot reach into the partnership and take specific assets. That is, the creditor has no rights to any property owned by the partnership. The most the creditor can get is what is known as a "charging order." A charging order allows a creditor to satisfy his or her judgement only if distributions are made by the general partner. The creditor cannot compel the general partner to make distributions. Further, if the main owners of the FLP are asset protected trusts (discussed above), the creditor would not have a claim against those trusts for a judgment against the husband or the wife.
7. Domestic Limited Liability Companies. A limited liability company ("LLC") is a legal entity created under state law. An LLC allows individuals to conduct business and financial affairs in a relatively simple and efficient manner. It combines some of the best features of corporate and partnership law while eliminating a lot of the complexities and red tape associated with each.
An LLC provides for asset protection benefits similiar to a corporation. That is, the owners of an LLC are not personally liable for the LLC's debts. The most the owners stand to lose is their investment in the LLC.
To understand these benefits, let's look at an example. Assume husband and wife own rental property in their joint names. If this rental property leads to a lawsuit (like by a tenant, a lender, or a future buyer of the property), the husband and wife would be personally liable. They can lose not only the rental property, but all other personal assets they own (investment assets and the like) if such assets are not otherwise asset protected. Further, a lawsuit against husband or wife which is unrelated to the property could expose the rental property to that claim.
If husband and wife transfer the rental property to an LLC, a lawsuit related to that property should not expose all of their other property (investment assets and the like) to risk because the lawsuit is against the LLC and not its individual owners. Further, a lawsuit against either husband or wife which is unrelated to the rental property should not expose the rental property to a risk of loss.
It is worth noting that in this example, we are using a LLC to own the rental property instead of an FLP which was discussed in the previous section. The reason an FLP is not typically used for rental property is that this type of property is hot property which - by it's nature - can give rise to laiblilty (as opposed to investment assets). Since general partners of FLP's are liable for partnership debts, we do not want to put hot or risky assets in an FLP. Instead, other planning strategies such as limited liability companies are typically utilized. Often, a person's asset protection plan includes both FLP's and LLC's to protect more of their assets.
8. Offshore Planning. For people who are very risk adverse and have considerable wealth, consideration may be given to what is referred to as "offshore asset protection planning." With offshore planning, assets are transferred to a trust or other entity established under the laws of another country. Sometimes the actual assets can remain in the United States, but more protecton is typically available if the assets are held overseas as well. The country which is selected for this type of planning is a country which has extremely favorable asset protection laws. These countries tend to have laws which do not automaticaly honor judgments granted outside of the foreign jurisdiction. This means that if a judgment is rendered against you it would not be recognized in the foreign jurisdiction. This is different from the United States where each state gives full faith and credit to judgments rendered in other states. Accordingly, offshore planning adds geographical, financial and procedural impediments that a creditor must navigate through even if they get a domestic judgment against you.
Asset protection planning is not implemented in a vacuum. It must be integrated with other parts of your wealth management plan. It also needs to be consistent with your overall goals and objectives. Some people may not be concerned about asset protecton planning and decide to do nothing. Others may want simplier protection, while others may want greater protection because their exposure is greater or their risk tolerence level is low.
We trust you found informative information in this newsletter. If you would like to learn more about asset protection planning or how it may apply to your specific situation, please do not hesitate to contact us.
CIRCULAR 230 DISCLOSURE
Under U.S. Treasury Department guidelines, we are required to inform you that (1) any tax advice contained in this communication is not intended or written to be used, and cannot be used by you, for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or by any party to market or promote any transaction or matter addressed herein without the express and written consent of the Richard C. Petrofsky Law Office and Helfrey, Neiers & Jones, P.C., (2) the Richard C. Petrofsky Law Office and Helfrey, Neiers & Jones, P.C. imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein, and (3) any fees otherwise payable to the Richard C. Petrofsky Law Office or Helfrey, Neiers & Jones, P.C. in connection with this written tax advice are not refundable or contingent on your realization of federal tax benefits from the advice contained herein.