In today's litigious society, insulating assets from attachment by creditors and other claimants (including tort claimants and divorcing spouses) has become a hot topic. Asset protection planning is particularly relevant for those individuals, such as physicians, who are in high-risk occupations. Although the term "asset protection planning" conjures up images of off-shore trust accounts in exotic locales, the truth is that asset protection planning often can be accomplished in a domestic setting and with less complex and costly devices than an off-shore trust.
Planning for Asset Protection
Planning to protect one's assets from future claimants should be undertaken carefully, with a comprehensive consideration of the costs, risks, and benefits of such planning, and with the aid of an experienced advisor. As far as possible, keep things simple. If a risk can be insured against, acquiring such insurance is likely to be the least expensive and easiest way to protect assets. For example, a retired individual's greatest risk of liability probably arises from operating an automobile. That risk easily can be handled through an automobile liability policy, perhaps supplemented by an excess liability umbrella policy. However, in some cases, insurance may be unavailable or insufficient, which necessitates further planning.
Asset protection planning should always take into account the tax consequences of any proposed course of action. Certain transfers of assets may generate gift taxes, may run contrary to an established estate plan, or may have unanticipated income tax effects. Consultation with a tax advisor is critical.
Clients should keep in mind that large damage awards in lawsuits are the exception, not the norm. While news accounts often make it appear that every doctor and business owner is being successfully sued for multi-millions of dollars, the truth is far different. That having been said, if an individual is motivated to minimize risk by building walls around his or her wealth, it is critically important that the individual take steps to do so now, rather than later. Any asset protection strategy implemented after a claim is made (or even anticipated) generally is negated as a so called "fraudulent conveyance."
The remainder of this article summarizes some of the asset protection techniques that are available:
Ownership of Assets
One way to defeat the claims of future claimants is by altering the way in which one's assets are held:
- Transfer of Assets to Spouse. A married individual who perceives himself or herself as being at risk sometimes puts all assets in a spouse's name for safekeeping. If the transferred assets truly become the spouse's separate property, such a change in ownership should be effective to insulate the assets against claims of the creditors of the transferor (so long as the spouse is not also liable). However, it is important that the transferor spouse truly give up control of the transferred assets. For example, if the transferor continues to exercise investment authority over a transferred brokerage account or continues to have check writing authority over a transferred bank account, those assets are likely to be considered to be owned by the transferor.
Of course, this "spousal defense" assumes that the couple has a solid marriage, as a transfer could affect the division of assets upon a subsequent separation or divorce. For example, if a husband takes assets which he inherited from his parents (and which in a divorce setting would be considered his separate property, not subject to division) and transfers them into his spouse's name for asset protection purposes, he transforms those assets into "marital property," which is subject to an equitable division with his wife upon a divorce.
- Tenancy by the Entirety. In North Carolina, if a married couple owns real property jointly as a "tenancy by the entirety," then a creditor of one spouse may not enforce a lien against the entireties property. Thus, entireties ownership of real estate may be advisable where one spouse is engaged in a high risk occupation. Such protection is not absolute, however. For example, if the couple subsequently divorces, each spouse's one-half interest in the property is attachable by his or her creditors. Furthermore, when one spouse dies, the property passes to the other spouse by operation of law; if the surviving spouse is the one against whom claims have been asserted, that real estate is no longer protected from creditors. Moreover, the legal protection of entireties property from creditors may be breaking down. The U.S. Supreme Court recently held that the IRS may place a lien against one spouse's interest in entireties real estate. It remains to be seen whether this doctrine will be applied in other settings with other creditors.
- IRAs and Retirement Plans. IRAs and qualified retirement plans are exempt from the claims of creditors under federal and North Carolina law. Accordingly, one asset protection technique is to maximize contributions to such retirement accounts. Ultimately, of course, the law requires the owner of the retirement account to withdraw those funds, starting no later than April 1 of the year following the year in which the individual reaches age 70½. At that point, the amounts withdrawn would become subject to the claims of creditors.
A so-called "spendthrift trust," under which the trustee has complete discretion as to whether to distribute income and principal of the trust to the trust beneficiary, is immune from the claims of the beneficiary's creditors. Thus, if a parent places assets in trust for a child, either during the parent's lifetime or at death, and such trust is a discretionary trust with a third party trustee, the trust assets will be insulated from any unfortunate events which may incur in the child's life (e.g., tort liability, divorce, or bankruptcy).
Given the asset protection afforded by such a trust, even parents with mature, responsible children should consider placing at least a portion of a child's inheritance in a spendthrift trust. It is generally possible to design the trust so that the child has at least indirect control over the management of the trust, thereby affording asset protection while providing the child with the beneficial enjoyment of the trust assets.
Moreover, such a trust is an excellent vehicle for generation-skipping planning. A spendthrift trust to which the donor's generation-skipping transfer tax (GST) exemption is allocated will not be included in the child's taxable estate, thereby passing the trust assets on to grandchildren or future generations without the incurrence of an additional level of estate taxation.
Limited Liability Business Entities
Another form of asset protection planning is to segregate assets into various business entities (such as corporations, limited partnerships, or limited liability companies), rather than maintaining direct ownership of the assets. For example, if real estate is placed in a limited liability company (LLC), with the client retaining only an ownership interest in the LLC, then creditors of the client typically would not be allowed to attach the underlying real estate itself, but only to obtain an economic interest in the client's LLC membership interest. That economic interest only entitles the creditor to receive any distributions which are actually made to that membership interest. If a third party is serving as manager of the LLC and chooses not to make distributions, the creditor has no effective recovery, making the asset highly unattractive to creditors. This asset protection is enhanced if a client's assets are segregated among several limited liability business entities.
Domestic Asset Protection Trusts
In North Carolina, an individual may not create a spendthrift trust for himself or herself (a so-called "self settled spendthrift trust") and have the trust assets protected from the individual's creditors. This rule is grounded in the public policy consideration that a person should not be allowed to retain beneficial enjoyment of his assets while removing those assets from liability for his debts, and it has its genesis in statutes enacted by the English Parliament in the reigns of Henry VIII and Elizabeth I.
However, several states (notably, Delaware and Alaska) recently have removed the rule against self-settled spendthrift trusts. Accordingly, it is possible to create a Delaware or Alaska trust with one's own assets and remain a discretionary beneficiary of that trust. Through various safeguards, such as the use of a so-called "Trust Protector," the person creating the trust may also retain indirect control over the management of the trust assets and access to the trust funds. Certain procedural requirements apply: for example, the trust typically must have as one of its trustees a corporate fiduciary located in the state where the trust is established, and some portion of the trust assets must be held in that state.
The use of a domestic, rather than a foreign, asset protection trust is appealing because the trust and the corporate trustee are subject to U.S. laws and regulations. Clients generally have a greater comfort level with a U. S.-based trustee than with one located in an obscure island in the South Pacific. However, because domestic asset protection trusts are relatively new, many questions remain regarding their effectiveness. For example, some commentators have suggested that the U.S. Constitution's "full faith and credit" clause may require that a Delaware court enforce against a Delaware asset protection trust a judgment rendered against the trust settlor/beneficiary in a North Carolina court. While most commentators and practitioners view this result as unlikely, there are no reported cases deciding this issue.
Domestic asset protection trusts may also be used as an estate planning technique. Because the trust assets are not subject to the claims of creditors of the trust settlor, those assets may be removed from the settlor's taxable estate, even though he or she retains beneficial enjoyment of those assets. Such a trust could be designed as a generation-skipping trust through the allocation of the settlor's GST exemption. For example, a settlor could fund a Delaware asset protection trust with $1,000,000, allocating both his lifetime gift tax exemption and a portion of his GST exemption, and remove the trust assets (along with all future earnings and appreciation) from the settlor's and his family's taxable estates indefinitely.
Off-Shore Asset Protection Trusts
Off-shore asset protection trusts work in a similar fashion to domestic asset protection trusts, except that the legal situs of the trust, the place of business of the trustee, and the location of the investment assets are located outside of the United States. These trusts are formed in one of a number of smaller countries (often islands in the Caribbean, the Pacific, or the English Channel) which have enacted special legislation promoting the effectiveness of asset protection trusts by limiting the rights of creditors. These statutes, together with the logistical difficulties involved in pursuing a claim in a foreign jurisdiction, make the assets held in an off-shore asset protection trust highly unattractive to creditors.
Some unscrupulous promoters of off-shore trusts claim that such trusts have the added benefit of avoidance of U.S. income tax. These claims are false, and the IRS is aggressively cracking down on these abusive trust schemes. In fact, use of a foreign trust subjects the settlor to additional income tax reporting requirements and may heighten the chance of an IRS tax audit.
The very thing that makes off-shore trusts an effective asset protection device - the difficulty in pursuing the assets in a foreign jurisdiction - makes such trusts potentially dangerous for settlors. Foreign trustees are not subject to the same regulatory oversight as U.S.-based trustees, and the risk of misappropriation of assets is heightened. Accordingly, the use of an off-shore trust mandates frequent "due diligence" reviews of the trustee's handling of the assets and suggests the segregation of trust management duties among several foreign trustees, each such trustee acting as a check and balance on the others. Accordingly, the annual maintenance costs for an off-shore trust can be high.
Asset protection planning may be accomplished in a multitude of ways, with varying degrees of complexity and expense. Clients typically should not rely on a single asset protection technique, but rather should layer one asset protection technique on top of another. For example, assets might first be placed in a limited liability company and the limited liability company interests might then be contributed to an asset protection trust. Although some asset protection techniques (such as domestic asset protection trusts) ultimately may be subject to legal challenge, use of such techniques will hinder creditors and will enhance the likelihood of favorable settlements of creditors' claims. As with any estate planning technique, the appropriateness of asset protection planning can be determined only by a qualified attorney after a complete review of a client's situation.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.