In my practice I regularly get questions on asset protection. Most of the questions usually focus on a particular potential or existing liability, but this article is focused on general information about asset protection.
The first step in talking about asset protection is to define what you want to be protected against. Most people think of lawsuits or creditors, but the risks are far broader than just those. We face risks from fire and flood, to tax liability, to business risks, to illness, to disability and death. Some are more likely than others and some are more catastrophic in the way they affect our lives.
I categorize asset protection solutions in 10 steps or levels, from the simplest and least costly at level 1 to the most complex and expensive schemes at 10. For many people levels 1 and 2 are sufficient to deal with most issues and for business owners levels 3 and 4 should suffice. But for people whose lifestyle, professions or wealth make them particularly susceptible to various liabilities, more complex strategies are needed. In this article, I am going to just cover levels 1-4.
Before we move forward, I want to caution you that the evaluation of your particular risks should be done by you and your professionals. The strategies in this article are generalizations and may or may not be effective for your particular circumstances.
Level 1 or Risk Avoidance: To some degree we all practice this Level of asset protection. Simply avoid doing risky things. For example, don’t text and drive, don’t buy a house in a flood plain, and don’t go into the basement when spooky music is playing. This level is the practice of being safe. Reduce taxes by consulting an accountant before year end and filing your return on time; reduce health issues by eating right and exercising; or reduce financial risk by consulting a certified financial professional.
Level 2 or Risk Transfer: Most of us do this as well. Simply put risk transfer is the basis of insurance. At a fundamental level insurance is accepting a small certain risk (called a premium) in exchange for protection should an uncertain risk occurs. For example you pay $1,500 a year for homeowners insurance to gain reimbursement in the event of fire, theft, and liability for accidents to others. Most of us don’t use this protection often, but when an event occurs it often results in tens or hundreds of thousands of dollars of loss.
Level 3 or Structural Protection: Generally this level is for business owners. Structural protections use different types of legal entities to create asset protection. At its simplest, it is incorporating a business to protect the owner and his assets from activities inside the business. (Take the term “incorporating” to mean S-Corporations, C-Corporations, Limited Liability Companies, Limited Partnerships, etc.)
Structural protection is almost always a part of more complex asset protections strategies. For example a corporation is frequently used as the general partner of a limited partnership. (I told you it gets more complex as we move up the levels). In addition to liability protection, entities are used to manage control of a business or other assets. In the case of the limited partnership, the limited partners have little or no vote on the actions of the company. The general partner often has total control even though the general partner may own very little of the company itself. In trade the general partner takes on all of the liability of the company, which is why a corporation is used to protect the general partner.
Professionals (doctors, accountants, attorneys, architects, etc.) have their own worries because corporations, partnership or limited liability companies do not protect professionals from liability. However, often those entities are used to protect professions from the liability of their fellow owners.
Generally, follow the rules; requiring the registration of the company with the State, filing regular paperwork, and maintaining the company as a separate entity. That is a gross simplification and ignores a number of exceptions but that is the general idea.
Another advantage of legal entities is that they allow you to generate some tax protections. These include additional typical business deductions on the tax return and the ability to establish tax favored structures such as 401(k)s, health plans, and pension plans.
As you can tell there is greater complexity with structural protection over Levels 1 and 2, but entities are flexible and can solve a myriad of liability issues. Depending on size the cost to maintain one is from two thousand dollars a year and up. While forming an entity is straight forward, making the choice of which type, setting up the internal documents and the proper use to accomplish your asset protection goals should be done with the assistance of an experienced attorney.
Level 4 or Trusts: Much like Level 3 Structure Protection, trusts can be used as stand-alone entities or in combination with other items and are often integral pieces of more complex protection plans.
There are two basic types of trusts – Revocable and Irrevocable. Revocable trusts, which are your common estate planning documents, are used to protect you from probate, conservatorships, taxes, and hopefully your estate from litigation. Because revocable trusts can be changed at any time they do not provide liability or asset protection for you.
Irrevocable trusts are generally, but not always, considered to be a separate entity from you for most tax and liability issues. Irrevocable trusts generally have their own tax identification number and file a separate tax return. The flexibility in irrevocable trusts causes them to be used extensively in estate planning to solve issues of control, taxation, and access. This also makes it critical to have them planned, drafted and implemented by knowledgeable professionals. Very often they must be maintained over many years. So having an experienced professional team to assist is critical to your success.
Over a dozen states such as Alaska, Delaware and Nevada, have created a type of asset protection called a self-settled asset protection trust. In general, you create an irrevocable trust, put a bank or professional trustee in the state of choice in charge, and put certain types of assets, such as cash, securities and other financial investments, into the trust. If no one makes a claim against you in 3-4 years, then the assets in the trust are protected by seizure creditors. Not all types of assets are appropriate for such trusts, real estate in particular will be under the jurisdiction of the state in which it is located and the courts may disregard the asset protection laws of another state.
Now, don’t jump for joy just yet, self-settled trusts are not a panacea for asset protection. Depending on the state you reside in and the state where you choose to form your trust, there may be vulnerability to certain liabilities for items such as child support or alimony. Most non-asset protection states are openly hostile to self-settled trusts. There is much conflict between the laws of the federal government, states who don’t have laws supporting self-settled trusts and those states that do have such laws.
At this point I want to mention that similar trusts are used to hold assets outside of the United States. However, because of the unique risks, costs, complexity and tax issues, offshore trusts are at a higher Asset Protection Level.
Irrevocable trusts can be used to protect gifts and inheritance to others. Often gifts made by a decedent are held in an irrevocable trust for minor children or other beneficiaries because minors cannot hold assets in their own name until there are adults. By making testamentary gifts in trust to adults you can grant your beneficiaries divorce and asset protection from their creditors. This is not one hundred percent inviolate, but provides strong protections.
Recently, the Supreme Court found that inherited IRAs (those received from a decedent) do not have any special protection in Bankruptcy Court. (Clark v. Rameker 134 S.Ct. 2242 (2014)) (See Level 5 for more on protections offered by Retirement Plans). Accordingly there is increasing use of irrevocable trusts to provide asset protection for IRA’s transferred after you die.
Costs for irrevocable trusts vary greatly depending on the goals you are trying to accomplish. From a few thousand dollars as part of an estate plan to ten thousand for a self-settled trust to tens of thousands for a complex plan. They are useful for estate, tax, liability, and control protection.
With six more levels to discuss you can see that Asset Protection can be a very complex subject. Your first step should be to figure out just what risks you want to protect yourself from and then seek professional assistance in evaluation the best plan for you and your loved ones. I have assembled a team of legal, financial and tax professionals to give you specialized comprehensive solutions for your asset protection needs.
Michael E. Garner, JD, CPF®