"Asset Protection in Plain English"
by Jeffrey L. Crown
Protecting your Patrimony From Pernicious Predations of Porcine Plaintiffs
In a survey by “Trusts and Estates” magazine, business owners were asked what really kept them up at night. Taxes? Labor issues? Succession? No. The overwhelming response was that they were most afraid of losing what they spent their entire lifetimes building.
Unfortunately, litigation has become a growth industry. A combination of people with a “lottery” mentality, greedy lawyers and
judges who won’t dismiss spurious claims or reduce outrageous awards has made owning a family business a very scary thing.
Probably a larger threat than litigation comes from what are sometimes politely called domestic relations. “High maintenance” spouses and “entitlement” minded in-laws can create cash hemorrhages.
Note: For purposes of this discussion, we are using the term “asset protection” in the context of a successful business owner or professional who wants to shield what he or she has earned. It has nothing to do with avoiding legitimate debt.
Massad Ayoob, one of the nation’s foremost police instructors (and one of my instructors), has a motto that would serve us well in asset protection planning and in life, generally:
“Anticipate where the attack is coming from and have an effective counter in place.”
ANTICIPATING THE “ATTACK”
What do we mean by “creditors?” We can acquire creditors in any number of ways, as we drive to work, do our jobs or engage in sports. Here are some examples. This list is far from exhaustive.
- Cars, boats, planes, homes, offices.
- Professional malpractice claims.
- Poor business decisions.
- Business formation.
- Disregard of entity rules & regulations.
- Your business partner’s spouse and children.
- Second, third, etc. spouses.
- Your son (daughter)-in-law who wants a piece of your business.
- Employees who view their boss as a “human ATM.”
- Assets can be easily lost by leaving them to the wrong people or to the “right” people too soon.
- Surviving spouse or child who has no financial experience.
- “Non-involved” children who inherit business interests.
- Effect of disability (especially emotional or mental) of a partner or shareholder.
- Long term illness -- Family left without sufficient funds.
- Special needs children.
- Disability Insurance.
- Disability Income
- Long term care
- Disability insurance in buy and sell agreements.
HAVING AN EFFECTIVE COUNTER IN PLACE
Some Relatively Simple Ways to Protect from Creditors and Predators.
- More Insurance. The first line of protection is insurance. It doesn’t distort your asset picture, is relatively uncomplicated and is generally effective. Keep in mind that one can’t insure against intentional acts.
- “Personal umbrella” policy? This is a very inexpensive way to provide really meaningful coverage for auto and household accidents and some recreational activities.
- Professional Liability. Are your liability contracts tailored to your specific needs?
- Retirement Plans. Under Connecticut law, qualified plan assets, including 401(k) and 403(b) accounts, even “one person” plans and most IRAs are exempt from creditors’ claims.
- Transferring assets. This can be an effective technique, but LOOK OUT! If one transfers a house or other asset in contemplation of a current or reasonably anticipated creditor then, as to that creditor, the transfer may be set aside as “fraudulent.” To be effective, the transfer has to be “old and cold.” It has to have been made at a time when the transferor had no creditors and none were looming on the horizon. There are other considerations:
- The ransferee could acquire creditors.
- The transferee could sell the house or evict the transferor.
Some More Sophisticated Techniques.
- Family Limited Partnerships. Family Limited Partnerships (FLPs) are probably one of the most talked and written about estate planning strategies. All too often, the focus is on obtaining estate tax discounts. There were limited partnerships before there was an estate tax and we would still use them if the estate tax were repealed. Limited partnerships and general partnerships are entirely different in terms of creditor protection.
- General Partnerships. A creditor of a partner in a general partnership can reach all of his assets. This arrangement offers very little protection at all.
- Limited Partnerships. A creditor of a limited partner is limited to distributions actually made to the partner. This is referred to as a “charging order.”
- Limited Liability Companies.
- Try to avoid single member LLCs, if possible.
- Run it like a business.
- Separate bank accounts and TINs.
- Do not co-mingle assets.
- Separate insurance policies.
- Comply with all registration and reporting requirements.
- Avoid “boilerplate” operating agreements.
- “Thinning Out Equity.” Creating and using a “family bank.”
- Qualified Personal Residence Trusts. A Qualified Personal Residence Trust (QPRT) is an estate tax device. It’s a way to pass a residence (and sometimes more than one residence) down to a lower generation at a substantial discount. The “owner” makes a gift of the house to the trust and retains an occupancy right for a term of years. The trust agreement may provide that the donor has the right to live in the house after the occupancy period for a fair market value rent.
These trusts might be effective against creditors because the former homeowner no longer owns the house. All he has is an occupancy right. But watch out. There should be a valid estate tax purpose for the trust or it might be looked at as a sham. Also, the “owner” might be forced to convert his occupancy right into a stream of rental income for the creditor’s benefit.
THE SECOND MARRIAGE.
Many people would not be concerned if their spouse were to re-marry after their death. What does cause them to lose sleep is the thought of a second spouse or “live in friend” enjoying their assets and possibly reducing their children’s inheritance.
Q-TIP Trusts. These trusts allow you to obtain an estate tax marital deduction and at the same time limit your surviving spouse’s rights. All she has to have is the right to the income. There is no need to give her any rights to principal distributions, although people often do. After her lifetime, the trust assets pass to your children or other beneficiaries, insulated from claims of a second spouse or creditors.
Lifetime Q-TIPs. Having your cake and eating it too.
- Full Disclosure of Assets.
- Separate, Independent, Counsel. The same attorney cannot represent both parties.
- Watch out: Qualified Retirement Plans. By law, a spouse must be beneficiary unless she waives her or his rights. She cannot waive those rights in a prenuptial agreement because the waiver can only be by a spouse and at the time of the waiver she was not yet a spouse.
DISCRETIONARY AND “SPENDTHRIFT” TRUSTS.
Discretionary Trusts. A “discretionary trust”, in general terms, is a trust where the trustee has the ability to make or withhold distributions. For the most part, courts will not interfere with the trustee’s exercise of his discretion. Generally, a creditor of a trust beneficiary has only the rights in the trust assets that the beneficiary does. If the beneficiary cannot compel distributions, then neither can the creditor. NOTE: The trustee should be truly independent from the beneficiary. There are some exceptions to this “rule,” including:
- Grantor as Beneficiary. In the absence of special statutes (see “Domestic Asset Protection Trusts, below) one cannot create a trust for his own benefit and have the assets be immune to creditors’ claims.
- “Preferred” Creditors. Taxing authorities may have the status of a “super creditor.” Also, claims for support of children and, in some cases, former spouses, may be payable from assets of otherwise “protected” discretionary trusts.
- Some uses for discretionary trusts.
- 2d (or 3d, 4th, etc) spouses.
- “Shopaholic” or lazy children or in-laws.
- Beneficiaries who have abused alcohol or used drugs.
A “spendthrift” trust is a trust in which the beneficiary cannot require distributions to be made and is unable to sell or transfer his interest in the trust. Under current Connecticut law, a general “spendthrift clause” is ineffective. The trust must either provide for the ability to withhold or accumulate the income or be for the beneficiary’s “support.” WATCH OUT! It is dangerous to use the word, “support,” in discretionary trusts meant to be asset protection devices.
“Consensual” Generation Skipping Trusts.
Suppose that you have a child in a high risk profession or perhaps one who’s likely to be divorced or involved in serious litigation. Instead of leaving him or her his or her inheritance outright, you could discuss with him or her the possibility of creating a discretionary trust.
DOMESTIC ASSET PROTECTION TRUSTS (DAPTS).
Some clients have succumbed to the siren song of “offshore” creditor planning. Some of the island paradise proposals are legitimate. Others can result in visits by the criminal division of the IRS. In response to the desire to shelter assets from creditors and possibly to develop business for local banks, several states have enacted Domestic Asset Protection Trust statutes. Although Connecticut does not have a DAPT statute, Rhode Island does. Before considering a DAPT, it is absolutely imperative that you and your lawyer:
Read and understand the statute of the chosen jurisdiction.
Engage counsel in that state.
Establish some “nexus” with that state.
Think about the “choice of law” and “conflict of laws” rules and whether local (CT) law would “trump” the law of the DAPT state.
Above all, think through what your wishes are, what your rights in the DAPT would be and whether you can live in the house that you want to build.
In our increasingly litigious society, it’s only natural to want to do asset protection planning. It’s too bad that well meaning people sometimes become easy prey for purveyors of packages promising perfect paradise. While there are no “quick fixes, there are some workable and understandable asset protections devices that we would be happy to discuss with you.