Personal Asset Protection: Can It Work?
By George A. LaMarca
A fundamental objective for many clients is the protection of their hard-earned assets from current or potential creditors and claimants.
Business owners who have guaranteed their corporations’ loans, or who fear lawsuits from employees, customers or even the government-whether in contract or in tort-are prime candidates for asset protection plans.
Many professionals, especially physicians, also realize that malpractice insurance is not a guaranteed solution, since coverage limits may be inadequate, punitive damages may be excluded and insurers can become insolvent.
For many clients, divorce is the biggest financial risk-or at least the one that worries them most. They may be eager to maneuver their property out of the reach of their current spouses (especially if no effective prenuptial agreement is in place) or of their ex-spouses.
It is difficult to legally protect all of your assets from the claims of present or future creditors. Sound asset protection requires long term planning. In many respects, our legal system is designed to assist creditors in collecting their claims. However, if you are willing to accept the burdens, you can legally employ a variety of methods designed to shield some types of assets. The major drawback is that any sheltering of real estate, personal property, or other assets often entails losing control over it. If a person insists on retaining all his or her rights to their possessions, they may also have to accept the rights of creditors to grab their slices, too.
Believe it or not, the government has already done some asset protection for you. Each state has established a list of property that is exempt from any judgment or claim of creditors. These are called “exemptions.” Even debtors in bankruptcy are allowed to keep these assets. A “homestead” exemption for your primary home equity is universal. Some states impose strict dollar limits on the amount of the exemption, while a few (including Iowa, Florida and Texas) do not. In Iowa, the Homestead exemption will cover up to half an acre in the city, or forty acres in the country. Negotiating a homestead exemption can be tricky. For example, while a debtor’s house is fully exempt, other buildings on the property might not be exempt if their value exceeds $300.00. The Iowa Homestead Exemption is detailed in Iowa Code chapter 561 (2007).
Automobiles, clothing, personal belongings, tools of the debtor’s trade, and insurance or annuity cash values or proceeds also are frequently exempt, within limits. While some states (and the federal government) apply a cost of living index to exemption limits, Iowa does not. For example, the exemption for household furnishings, goods and appliances is only two thousand dollars. The Iowa Exemption Statute is at Iowa Code § 627.6 (2007).
Once you know what assets are exempt, you can then determine how to shift assets into exempt categories. This is one of the few legal protection techniques that does not require surrendering ownership or control over your assets. For instance, Iowa (like a few other states) imposes no limit on the exemption for cash-value life insurance when spouses or children are the beneficiaries. In Iowa, you can buy a large amount of insurance and still have access to much of the money through policy loans. However, the exemption does not apply to any amount paid in the two years prior to claiming bankruptcy, if that amount exceeds ten thousand dollars. Sound asset protection requires long term planning.
Why can’t a person simply give all his property away to confound his creditors? To defeat the “it’s all in my wife’s name” ploy, most states have adopted some form of fraudulent conveyance statute. Iowa’s law is found at chapter 684 of the Iowa Code. These laws allow creditors to reach any assets that are transferred with the intent to delay, defraud or hinder creditors. Even in the absence of actual fraud, an intent to defraud may be presumed if the transaction meets certain criteria The following is a partial list of the factor’s the court will look at to determine if a transfer is fraudulent:
- The debtor becomes insolvent after the transfer,
- The transfer occurs shortly before or after assuming a large debt.
- The debtor transfers nearly all his assets,
- The transfer is concealed, or
- The transfer is made to the debtor’s relatives, close friends or others under his control
Actual fraud, however, is not an essential element. This means that a transfer of assets made in good faith may, in some circumstances, be “voided” by the court.
At the same time, not all transfers undertaken to avoid a just debt are subject to being set aside by the court. Here is a brief analysis of methods that may be effective in protecting your assets from creditors:
1. Good Faith Transfer. Fraudulent transfer statutes do not stand in the way of legitimate tax and estate planning. Asset transfers with bona fide reasons addressed in writing behind them cannot be reached. Thus, you should always document the legitimate justifications for asset transfers, and ensure that the form and substance of the transactions are consistent with the reasons behind them. Letters from investment or legal professionals advising you on such good faith matters are excellent documentation.
Furthermore, planning and implementing should be completed well before creditor problems arise. Last-minute attempts to secrete assets are prone to be rescinded by a court, as “preferential” or “fraudulent” transfers.
2. Interspousal Transfers. Although a debtor cannot get away with putting everything in his spouse’s name, transfers between spouses can provide some creditor protection when supported by other legitimate reasons (and a solid marriage), and the debtor gives up all control over and enjoyment of the assets. For example, a person may shift money to his or her spouse to equalize their estates, for the justifiable purpose of saving estate taxes. The transferred funds then could be safe from creditors.
While joint or community ownership provides modest protection against creditors’ rights, it also exposes all the property to litigation involving the claims of either spouse’s claimants. So separate ownership is safer when only one spouse is likely to come under creditor attack.
3. Family Partnership. A family limited partnership confers many tax and estate planning benefits. As a bonus, it can keep the creditors of one partner away from the other limited partners’ (family member’s) shares (though this does not apply to creditors of the partnership itself). Moreover, creditors of a minority partner cannot force the partnership to make distributions or to liquidate its assets.
The only remedy of a limited partner’s creditor is a “charging order” against the debtor’s partnership interest. This entitles the creditor to distributions intended for the partner, and to his share of the assets if the partnership is ever liquidated. However, if income distributions are retained in the partnership, the creditor will receive nothing until liquidation. Yet as owner of the distributions, the creditor will be liable for income taxes despite the lack of actual cash flow. This situation can promote the rapid settlement of creditors’ claims on terms favorable to the debtor.
Family limited partnerships may be attacked on the grounds that they are being used only to hinder creditors. A few courts have agreed. Here again, the facts control, and establishing a bona fide business or tax planning purpose for the partnership or trust, aside from asset protection, can help ward off such attacks.
4. Incorporation. Incorporating a closely held business or a professional practice, while now short on tax benefits, is still long on asset protection and permits continued control of the business. A bona fide corporation can shield its owners from personal liability for business debts, tort liabilities, etc. Only the company’s assets are reachable by creditors.
A professional corporation, used by doctors and lawyers, is ineffective to exonerate the professional from personal liability for his professional activities. The PC can, however, insulate its owner from the misdeeds of corporate employees and of other professionals in the practice.
5. Guarantee Elimination. Many business owners co-sign their corporation’s loans, putting their personal assets on the line. To avoid this, see if your lender will accept a bond, insurance, or even just the corporation’s credit, as security for a loan. Always try to replace or avoid personal guarantees with other security. Draw the line at having both spouses sign a guarantee, a valid request if it is for a business in which only one spouse has any ownership.
6. Spendthrift Trusts. Many types of irrevocable trusts are used in income tax and estate planning, but are widely overlooked as asset protection devices. The use of “spendthrift” clauses, which limit a beneficiary’s right to transfer or pledge his interest, can be creatively used. If a beneficiary (other than the grantor) is forbidden from reaching the assets in an irrevocable trust, his creditors are, too. Of course, placing your assets in a trust entails transferring title to the trustee. Unlike transferring assets to your brother in law, the trust imposes a fiduciary duty on the trustee to manage the assets in accordance with the wishes of the grantor (the person who set up the trust). A well-constructed spendthrift trust will increase the likelihood that the trust’s assets are used for the right purposes.
7. Qualified Retirement Plans. Assets in ERISA-qualified retirement plans, including Keoghs for the self-employed, generally are out of reach of the employer’s creditors (except for self-controlled, single participant plans). Any money that you have in an IRS-qualified retirement or profit-sharing plan will be protected from the claims of your creditors. The U.S. Supreme Court decided in 1992 that qualified plans are excluded from the bankruptcy estate of a participant (Patterson v. Shumate). However, three bankruptcy decisions have held that Shumate does not apply to single-person pension plans of the type frequently held by solo professionals and other small-business owners. See, “Professionals, Sole Proprietors Lose Pensions in Bankruptcy,” Lawyers Weekly USA, May 10, 1993, page. 1.
Some non-ERISA qualified retirement plans may also be exempt from claims of participants’ creditors, such as certain types of government and church pension plans.
8. Individual Retirement Accounts. While federal law governs ERISA-qualified retirement plans, state laws cover IRAs. The U.S. Supreme Court determined that an IRA is part of a participant’s bankruptcy estate (Patterson v. Shumate), but observed that it might be exempt under state law. In Iowa, the legislature has exempted IRA’s from an individual’s bankruptcy estate, except for contributions made in the two years prior to declaring bankruptcy, but only if those contributions exceed certain limits.
9. Insurance-Funded Plans. Funding a qualified retirement plan with insurance products may offer an extra level of protection, since some states’ laws shield life insurance and annuity contracts from creditors. Iowa law exempts proceeds from an insurance annuity, and the cash value of the annuity or policy itself, when the beneficiary is the debtor’s spouse, child or dependent. Insurance-funded nonqualified deferred compensation plans may also be secure under state insurance codes.
10. Welfare Benefit Trusts. Multiple-employer welfare benefit trusts (WBTs) provide tax-favored severance, disability, and death benefits. Among their many advantages is the shelter afforded to trust assets under federal law against participants’ and employers’ creditors.
Remember, though, that in addition to control issues, many of these techniques carry tax, estate planning, or other consequences that must be carefully weighed when considering how to protect your assets. Both legal and tax advice are necessary when considering any of these techniques. This is not an area for “do-it-yourself” types. None of the above techniques should be employed without competent legal and tax advice, or, as they say in the medical profession, “the care can be worse than the disease.”