Asset Protection Planning has been utilized for decades. Business persons have always had concerns over the exposure of their personal assets to claims against their business. The corporate form of business entity that provides for limited liability has been invoked for centuries. Certainly, protecting one’s assets from the myriad of risks involved in business and personal financial planning and real estate investment is not a novel objective, nor an immoral planning idea.
Since the 1970’s, expanding theories of liability and the proliferation of litigation have given increased emphasis to asset protection planning to the extent that it is now a well-recognized area of the law. It certainly comes within the umbrella of lifetime estate planning involving the protection and conservation of accumulated wealth or asset base.
The major role of asset protection planning is to substantially diminish one’s financial profile. If a person can restructure his/her assets in such a way that it places them beyond the reach of future creditors, while at the same time maintaining a beneficial interest in those assets, one has succeeded in substantially reducing his/her financial profile. Accordingly, one is a far less attractive target for litigation because of issues of doubt of collectability, which reduces the likelihood that one will be sued; or if he/she is sued, increasing the likelihood of a favorable settlement. (See Appendix VII and VIII for application examples).
Business owners, physicians, other professionals and real estate investors and owners must always be concerned about potential liability against their personal assets arising from the operation of the business or ownership of their real estate.
In asset protection, creditors are often characterized as either “inside” or “outside”. Inside creditors are those creditors whose claims are directed against the business operation or real estate operation and known inside of a separate business entity. Hopefully, the entity involved can withstand any piercing attack to its liability veil and the creditor then will be limited to remedies against the assets within or inside of the entity itself. A great example would be a person slipping or falling at an apartment house owned by a property structure that is maintained in an LLC. That person only has the right to assert the claim against the LLC itself. The members and the managers of the LLC have no personal liability to the inside creditor assuming that the LLC can stand up to any attacks of piercing the liability veil.
Most business entities have liability insurance to protect against inside creditors. This requires that the business owner or investor carefully examine and review the liability policy to make sure that it is relevant and will stand up against any potential claims asserted. Unfortunately, there are many claims that fall outside of the parameters of the policy either with respect to coverage or policy limits. For inside creditor protection against business operations, the corporation shield is well tested and has great strength. However, business operation can also be carried on within a limited liability company with the same liability results. Real estate is definitely better titled in an LLC than any other type of business entity. The LLC provides the shield of liability while at the same time giving much better tax consequences and flexibility.
Anyone who owns and operates a business should definitely consider incorporating or forming an LLC in which the business can be operated. Real estate should be placed in an LLC under most conditions.
In the book that I have authored which is published by the American Bar Association entitled ABA Consumer Guide To Asset Protection, I have delineated what I call the Ladder of Success with respect to asset protection planning.
Asset Protection – The Eight Steps:
Step One: Business Planning
Step One on the Ladder is the business entity. It should be properly formed and operated and stand up against any piercing attempts by a creditor whose claim is against the business itself. The corporation requires certain formalities that have to be adhered to, whereas the LLC is more lenient in this regard. If one doesn’t have a business or own real estate (independent of a personal residence) Step One is not applicable.
Step Two: Estate Planning
Step Two on the Ladder is basic Estate Planning which we have already discussed previously.
Step Three: Exemptions and Bankruptcy
Step Three on the Ladder is Exemptions and Bankruptcy. Bankruptcy is not a very viable alternative for people that have assets and wealth. Bankruptcy judges have broad powers to access assets.
Many states, including California, have homestead exemption laws. In California, the Homestead Exemption is $75,000 for a single person, $100,000 if you live with another family member and $175,000 if you are 55 or older or disabled. There are other states that have more generous homestead exemptions, including Florida and Texas where the exemption is unlimited.
There is unlimited protection for qualified plans under ERISA in a bankruptcy situation. Moreover, there is a one-million-dollar aggregate protection for IRAs. These exemptions, however, apply only to bankruptcy. Outside of bankruptcy, if a creditor is seeking to enforce the judgment against the debtor, there is unlimited protection for qualified plans under ERISA with a caveat that the qualified plan must have other participants besides the sole debtor or business owner. There are probably some state law protections for IRAs that do not come within the blanket coverage of ERISA. Many states (like California) allow creditor exemption for IRAs based on the reasonable need of the debtor. The amount of the reasonable need is determined by an economic analysis taking into account the debtor’s age, living standards and the cost of living requirements in the area in which the debtor resides.
In June of 2014, the case of Clark v. Rameker was decided by the US Supreme Court. The case held that inherited funds in an IRA are not protected in bankruptcy. Accordingly, a popular strategy to protect IRA assets from creditors is to name a trust rather than a person as the beneficiary of the IRA.
Normally, joint ownership of the property does not provide the protection desired. The exception is tenancy by the entirety that is provided for in a few states (but not in California). In California, the separate property of each spouse is fully protected from the claims against the other spouse. However, any community property owned by spouses is subject to the claims against either spouse.
So if the husband is sued and the judgment obtained, all of the community property of the spouses is subject to this claim. The only exception would be the separate property of the non-debtor spouse.
Many times, it may be possible to transmute community property into separate property, but it has to be by fair market consideration. For example, a lawyer and his spouse may own a very nice residence. They can transmute the residence into the separate property of the non-lawyer spouse for more liability protection. It should be kept in mind, however, that solid asset protection and marital planning will also stand up in divorce, and transmuting community property into separate property will be honored by the courts in divorce even though the original intent was for estate or asset protection planning purposes.
Step Four: Liability Protected Entities
Step Four on the Ladder is liability protected entities for investment assets. Real estate assets are subject to claims by creditors which are often beyond the scope of insurance coverage in both amount and in the type of claim. When it comes to business operations, many times a corporation is the proper form providing the necessary shield of liability for operating business assets and is the most common vehicle selected for business operations. The LLC has many of the same characteristics and shield of liability that a corporation has without the necessity of corporate compliance. Therefore, for a smaller organization or small family business or single ownership business an LLC may be the entity of choice.
With respect to real estate and investment assets, the LLC is the preferred entity of choice. It provides more flexibility tax wise and has the same shield of liability as a corporation. The LLC is a passive entity for tax purposes because it is either a disregarded entity, taxed like a proprietorship if it is a single member LLC, or it is a pass through entity, taxed like a partnership for a multi- member LLC. The LLC can also elect to be taxed as an S Corporation or even a C Corporation.
Earlier, we discussed inside and outside creditors and the differences between them. The inside creditor is that creditor who has a claim against the real estate or business operation itself. The outside creditor not only has, perhaps, that claim, but also one against the owner and operator of the business and real estate. The LLC provides better protection against outside creditors than the corporation while at the same time it provides the same protection against inside creditors as the corporation.
The Charging Order
The reason for this is that an outside creditor trying to get to the assets of an LLC is limited by law to the charging order. A charging order is a court mandate available to a judgment creditor directed to the LLC (of which the judgment debtor is a partner or member) which provides the judgment creditor with the right to whatever distributions might be due to the debtor partner or member whose interest is being charged. The charging order is a remedy only available to the creditor who has obtained a personal judgment against the LP partner or member of the LLC. The charging order remedy is not available in the corporation context. For example, let’s assume that a creditor has a personal judgment against the owner of a corporation. A creditor can levy on the stock of the debtor shareholder and then become the director and chief executive of the corporation. In this capacity, the creditor can liquidate the assets in the corporation to satisfy the creditor’s judgment.
On the other hand, in an LLC, the best the creditor may be able to do is to obtain a charging order. The creditor cannot reach the assets themselves nor theoretically have the voting rights to manage and control the assets. It has to be satisfied with only distributions that can be withheld in many cases. Unfortunately, in California, the charging order remedy is broadly interpreted, which in reality can result in the creditor obtaining access to the LLC business or real estate.
In many other states, however, the charging order is the exclusive remedy for a creditor and the creditor is explicitly limited to that remedy. Arizona, Nevada, Wyoming, South Dakota and Alaska are examples of states which have specific and exclusive charging order protection. That is why it may be appropriate to forum shop when creating an LLC. It may be a good idea to set up the LLC in one of sole remedy states rather than in California which has a much broader charging order process. California courts may disregard the law of the other states, but at least it gives some substantial protection and is an issue that it can be used as leverage in the settlement negotiation process.
In conclusion, one has to take into account the importance of placing real estate assets other than a personal residence into an LLC. This provides not only inside protection but outside protection. For example, suppose a person owns a condominium that he/she rents. If the condominium is placed in an LLC, it would have a shield of liability protection against the claimant who is a victim of injury or harm while in the condo. Insurance may cover this, but, if it does not, it is important that any claims be limited to the condo itself and not to the other property of the owner. In addition, if there is a judgment against the owner of the property, it is much better if the property is in an LLC where the charging order remedy is the exclusive remedy rather than having the creditor have access to the property itself to satisfy the judgment. .
Personal Residence Protection
A personal residence cannot be placed inside an LLC because there is no business purpose behind such an action. For the best protection for a personal residence, it is better to “equity strip” it by obtaining loans and placing mortgage encumbrances on the property. If there is business conducted on the residence, then there may be some justification for placing it into an LLC. If it is in an LLC, however, it would seem that fair market rent would have to be paid which really does not make much sense in most cases.
It may also be appropriate to place the residence in a Qualified Personal Residence Trust. Later on, we will discuss the Domestic Asset Protection Trust which may also be a viable option for protection of the personal residence. It should be noted although single member LLC provides protection against inside creditors, recent case law has made it clear that the charging order remedy may not be available for single member LLCs. Therefore, it may be appropriate to have other members in the LLC, even if they are family members. But, if they are members, they have to contribute their respective percentage capital contribution in order to have the structure stand up. If the member interest is a gift, then it has to be reported as a gift and the proper Gift Tax Return has to be filed. The gift must be made in advance of any credit claim. Nevada, Wyoming, Delaware and South Dakota all have specific legislation making the charging order the exclusive creditor remedy against single member as well as multi member LLCs. However, other states may not choose to follow such law.
Step Five: Domestic Asset Protection Trusts
Step Five on the Ladder involves Domestic Asset Protection Trusts and modular planning utilizing LLCs. As we have discussed previously, there are many advantages in creating and utilizing Domestic Trusts. A typical Revocable Living Trust provides no asset protection for the Trustor. The Trust can include spendthrift provisions that will protect the third-party beneficiary’s interest in the Trust from creditor claims, but these spendthrift provisions do not protect the trustor. Nevertheless, they can be effective for protecting beneficiaries against claims of an ex-spouse or creditor.
Most US law has been applied to allow creditor’s access to the assets of a Self-Settled Trust. A Self-Settled Trust is a trust like a typical Revocable Living Trust where the trustor is both the maker of the Trust and a beneficiary of the Trust. For well over a hundred years, individuals have utilized Self-Settled Offshore Trusts to protect their assets. Many offshore jurisdictions have favorable laws that provide for creditor protection for Self-Settled Trusts. The Offshore Asset Protection Trust will be discussed in Step Six later on.
Domestic Asset Protection Trusts
Contrary to traditional common law, several states have passed enabling legislation allowing for Domestic Asset Protection Self-Settled Trusts. Many other states are considering such legislation. The most favorable state law seems to be Nevada, South Dakota, Alaska and Delaware. Many individuals will choose one of these jurisdictions to establish their trusts. The trust will stand up better if it involves property within the jurisdiction of the trust itself rather than property in another state. For example, if a California resident sets up a Nevada Trust, it is more likely that the California courts will sustain the asset protection features of the trust if the settlor or trustor of the Trust has property and connections in Nevada as well as California. But even so, the California court may refuse to honor Nevada law. However, at the very least, it is a firewall that gives more leverage in the settlement process and also requires more time consuming and expensive effort on the part of the creditor to penetrate the trust. Setting up a Domestic Asset Protection Trust requires experience and particular skill by the attorney who drafts the trust. There are many requirements that have to be met in order for the trust to be valid and stand up to creditors.
One of the most important aspects of a Domestic Asset Protection Trust is that the Trustee has to be domiciled in the state chosen in which to form the trust. For example, a California resident who sets up a Nevada Asset Protection Trust has to have a Nevada Trustee as trustee of the trust. A personal residence can be transferred directly to the trust, but any bank accounts and investment accounts that are in the name of the trust require the Trustee to manage those assets and be the signatory on any financial accounts. Because of the expense and inconvenience involved in that process, many clients choose to utilize what we refer to as the Modular Structure of Asset Protection. This structure is typified by the figure below. In effect, it involves setting up the Asset Protection Trust and then creating domestic asset protection LLCs, preferably those that are within the jurisdiction providing for the exclusive charging order remedy. As a result, with respect to the modular structuring the Trust owns the LLCs and not the individual. The individual could be the manager of the LLCs, have the signatory authority over investment and bank accounts and management authority over the real estate, but in the event of litigation and claim against the owner/manager, the owner/manager should resign and appoint an independent third person to be the manager.
Asset Protection Modular Structure
For several decades, many offshore jurisdictions have utilized what is referred to as a Trust Protector to guard the interest of the trustor and the beneficiaries of the Trust. The Trust Protector is now also utilized with Domestic Trusts. The Protector is an independent third party to whom the trustor gives certain discretion over certain functions. For example, the power to amend the trust, the power to change trust situs or domicile, the power to remove the trustee and to substitute a new trustee, the power to veto trustee decisions and the power to change distributions. The Domestic Asset Protection Trust is more effective and successful when it is combined with the utilization of LLCs in the modular structure as well as designating a trust protector. In this manner, the trustor can still provide control of the assets but also protection by the fact that the trust maker does not really own the assets of the trust. The same modular structure can be utilized with the addition of the Offshore Trust and Offshore LLC. See the Diagram above. We would recommend that the LLC have an independent manager, but if this is not practical, then the maker of the trust can be the manager and can resign at the time of any problem.
Step Six: Foreign Asset Protection Trusts (“FAPT”)
Step Six on the Ladder is the Offshore Asset Protection Trust and the modular planning that accompanies it.
Introduction and Overview – Offshore asset protection planning normally involves the utilization of offshore trusts and other entities. Offshore planning generally raises justifiable concerns with respect to asset security and tax issues. The most efficacious manner to address these concerns is to make certain that you are receiving the best advice and counsel from a qualified expert in the area. You must be sure that the attorney with whom you are dealing has expertise in the field and is recognized in this regard by his peers.
A FAPT is a trust that is set up in an offshore jurisdiction which has enabling trust legislation providing for substantial protection against creditors of the trustor. One of the greatest advantages of the FAPT is the fact that any legal attacks against its assets are transferred abroad to a different legal system. The FAPT is generally much more expensive to set up and create than a domestic trust and requires a certain willingness on the part of the trustor to deal with offshore jurisdiction and trust entities. The FAPT’s greatest value is for asset protection planning well in advance of any potential creditor problem. Moreover, many times FAPTs are only used when the client already has some international connections and networking. Recent cases have emphasized the need for careful planning in the structuring of the FAPT if it is to be legally successful in meeting the purpose and objective of the trustor.
Advantages of the FAPT
No Comity of Law in Foreign Jurisdiction – Most foreign jurisdictions do not recognize US judgments. This likely forces a trial de novo on the merits under the laws of the foreign situs in order for the creditor to impose liability on the trustor and reach the asset of the FAPT. Obviously, the fees and expenses of this trial de novo and the burden of having to select offshore counsel can be substantial. Moreover, the FAPT jurisdiction generally requires plaintiffs to employ attorneys who are licensed in that jurisdiction.
More Favorable Law – Most foreign jurisdictions require that the burden of proof in challenging asset transfers to a FAPT is on the creditor and does not shift to the trustor. Moreover, many foreign jurisdictions impose a higher standard of proof upon civil litigation plaintiffs such as the “beyond the reasonable doubt” standard. This is in sharp contrast to the “preponderance of the evidence” principle utilized in US domestic civil cases.
Statute of Limitations – The FAPT legislation of many jurisdictions establishes a statute of limitations for challenging asset transfers to a FAPT that begins to run on the date of transfer. This is contrary to US law where the statute may begin to run the date the transfer is “discovered” by someone with a claim against the trustor. Additionally, the statute of limitations of many FAPT jurisdictions is much shorter than the typical four-year statute found under US law.
Fees and Expenses of Litigating in Foreign Jurisdictions – It is much more expensive and inconvenient to prosecute a claim offshore. Think of the inconvenience of having to pursue a claim out of state and then multiply that by two to three time the cost to pursue the matter in a foreign jurisdiction. Many foreign jurisdictions prohibit contingency fee arrangements, forcing the claimant to finance a litigation process entirely on his/her own. Creditors may think twice about having to deal with a completely different legal system out of the country. This unfamiliarity, plus the additional expenses and costs, and the entire uncertainty with respect to the process, adds a substantial element of protection to the FAPT.
How the FAPT Protects Your Assets?
Liquid Assets – The easiest way to understand how a FAPT protects case and securities is to focus on the process by which a claimant would try to reach trust assets. A claimant must either bring the case in a court that has jurisdiction over the trustee so that the court can order the trustee to give up the assets, or initiate the litigation in the court that has jurisdiction over the assets themselves so that the court can attach or seize the assets. However, if the client’s offshore planning strategy is properly structured and implemented, no domestic court can successfully attack the plan because it would not have the ability to force the offshore trustee to expatriate or return the asset, nor would it have the ability to levy on assets properly held outside of the United States (no jurisdiction).
Non-liquid Assets – Protecting non-liquid assets like real estate, accounts receivable and business equipment may involve the process of equity stripping. Although some of these assets can be put in charging order protected entities that may provide some limited protection, the most effective strategy available to protect a domestic illiquid asset is to strip that asset of its value by encumbering it as collateral for a loan and protecting the loan proceeds with your other liquid assets in the FAPT. Creditors are going to be very discouraged attempting to levy on an asset that may have substantial value, but has very little equity because of a loan encumbrance or lien.
US Tax Consequences
Generally speaking, the establishment of the offshore asset protection plan will be tax neutral. The FAPT will either be a US grantor trust or a foreign grantor trust with a US grantor for US income tax purposes. It will be necessary to file various forms with the Internal Revenue Service in either case, but these forms will only demonstrate that the taxpayer is a responsible and law abiding citizen.
Offshore Planning Structure
One very typical arrangement with respect to a possible offshore strategy would be for the client to establish the offshore asset protection trust utilizing an offshore trustee. The trust would then set up an offshore limited liability company, which would be entirely owned by the offshore trust. You could be the manager of the LLC with direct signature control over the bank accounts and securities accounts. In the event of a crisis, you would obviously resign as a manager and appoint a trusted friend, relative, or a management company. There are modular variations to this strategy that can be worked out with your professional advisors.
Conclusion
The proliferation of plaintiff lawsuits and the expanding concept of liability that has become second nature in our court system has engendered much concern and anxiety about the preservation of wealth in the United States. Many professionals like doctors and lawyers as well as business owners; corporate executives, real estate developers and investors, contractors and others operate in an environment of high risk. Many such people lack confidence that they will be treated fairly by the US legal system and are desirous of reducing their financial profile and eliminating their liability potential. For these individuals, the offshore planning alternative may very well be the best planning device available for maximum comfort and peace of mind. See Appendix VII and VIII
Step Seven
Step Seven on the Ladder is the utilization of Advanced Estate Planning techniques some of which we have already discussed, including the Life Insurance Trust (“ILIT”), Charitable Structures and Family Limited Liability Companies.
For more information on Asset Protection In The State Of California, an initial consultation is your next best step. Get the information and legal answers you are seeking by calling (714) 384-6300 today.