Keep Things Rolling with Asset Protection Strategies for You & Your Beneficiaries
What is asset protection and how can it protect me and my beneficiaries from the claims of creditors? Put simply, asset protection is positioning your property in such a way so it is not subject to the claims of plaintiffs in lawsuits.
- Asset protection provides a way to shield hard-earned assets from the claims of creditors
- Planning your asset protection strategy in advance is important because fraudulent conveyance laws are strict
- Asset protection plans often a combination of trusts and separate entities like corporations, partnerships and limited liability companies
A good asset protection plan allows for individuals to keep control over assets that might otherwise be subject to court control because of creditor claims. Without an asset protection plan, a defendant can virtually be held hostage to the extortionate demands of plaintiffs and their attorneys. An asset protection plan, if properly set up, will avoid these threats and put everyone on a level playing field. In fact, corporations, limited partnerships, trusts and other asset protection devices were created, in part, to protect hard-earned assets from the claims of creditors.
WHY DO I NEED ASSET PROTECTION ESTATE PLANNING?
You might be wondering why you need asset protection planning if you already have a revocable living trust-based estate plan. The answer is simple: a revocable living trust does nothing to protect your assets from creditors; instead it provides a set of guidelines for the handling of your assets during incapacity and/or death. Asset protection planning is the way to protect your family’s property and income from the attacks of gold-digging plaintiffs or creditors.
To make sure your assets are protected from creditors, you'll need to make sure your revocable living trust is coordinated with a set of asset protection vehicles like irrevocable trusts and separate entities. Again, if you do not incorporate asset protection strategies into your estate planning, you leave your assets vulnerable to creditors. As you can likely imagine, this can affect both you and your beneficiaries.
California, along with the federal government and the IRS, has enacted statutes defining certain assets as exempt from execution by creditors. Exempt assets are those assets that a person is entitled to keep even if the person files bankruptcy or if judgment creditors attempt to see if a person's assets satisfy judgment. California's list of exempt assets derive from Code of Civil Procedure §§ 703.140(b) and 703.010 et seq. However, state law does not define which assets are protected from execution by the IRS; these assets are specifically defined by federal law.
WHY IS ASSET PROTECTION PLANNING IN ADVANCE SO IMPORTANT?
An easy way to understand how how asset protection works is to think about insurance. Like insurance, asset protection can provide a way for you to protect yourself, loved ones and assets. However, arranging for this protection in advance is vital to making sure this protection applies when it matters most.
If you were to buy insurance for your boat, you could not legally insure that boat after it had already been in an accident. In fact, you would not be able to buy insurance after your boat's engines have stopped running and you are starting to sink. To take it a step further, you wouldn't be able to buy insurance even when the boat's engines are running and it isn't full of water, but you’re out on the ocean in the middle of a storm. Instead, you need to insure your boat while it's in shipshape and the seas are calm, with no storms on the horizon.
The same goes for asset protection. In order to ensure your assets are protected, you'll need to plan in advance due to fraudulent conveyance laws. These laws prevent people from making transfers when things are "not in shipshape" with the intention of hindering, delaying, or defrauding present or subsequent creditors. Present creditors are easy to think of, while subsequent creditors often give rise to questions. Usually the answers lie in determining whether the individual doing the estate planning made the transfers with the intent to hinder, delay, or to defraud a specific future creditor. If there is such an intent, then the transfer will be nullified and treated as if it never happened so the assets in question are available to the judgment creditor.
For this reason, it is important to conduct asset protection planning as soon as practicable. If the planning is done in advance, there is no intent to hinder, delay, or to defraud because the transfer is made by a person who has no pending or threatened claims, and has no reason to believe that legal problems will develop.
If you are currently involved in a lawsuit, you will not be able to set up an asset protection trust. However, it may be possible to transfer some of your assets while still leaving enough to honor the existing claim. For more information in this regard, get in touch!
WHAT ARE MY ASSET PROTECTION OPTIONS?
There are a few options available to you that will allow you to protect assets from the claims of creditors. None of these options means that you have to hide your assets in the way you might have heard in movies or books. No off-shore trusts needed here.
One of your first options is to give away assets. Giving your assets away is one of the quickest and easiest ways of protecting them from creditors. However, like we discussed earlier, due to fraudulent conveyance laws, these transfers should occur before there is any inkling that a creditor could make a claim; otherwise, you risk having a transfer is considered fraudulent.
While this is a simple option available to you, there are obvious downsides to giving away property. First, you may not want to give up the benefit of holding title to that property. Doing so would cause you to lose total control and enjoyment of the assets. Another issue with giving property away is you will have to file a federal gift tax return and use a portion of your gift tax applicable exclusion to the extent the gift is in excess of the annual allowable federal gift tax threshold or it does not fall within an exception. If so, you'll also pay federal gift taxes (California does not have a state gift tax).
Also, gifting property away causes the assets to become subject to the claims of the recipient's creditors. This includes a spouse in divorce. Gifting the property away to a minor also causes some obstacles because minors cannot control property. In this case, the minor will have to receive the property through a special arrangement, which could include a trust or blocked account, but ultimately, the minor will have to wait to control the property until he or she reaches the age of majority. Before then, the assets will be controlled by a third-party acting in a fiduciary capacity.
I could have sworn my revocable living trust protects my assets. Doesn't it?
You might be thinking: I have an estate plan; I have a revocable living trust; isn't that enough? In short, no. However, if your trust has a spendthrift provision in it, it may be able to protect your beneficiaries' inheritance from their creditors. A spendthrift trust is a trust which, sets certain restraints upon the voluntary or involuntary transfer of the interest held in the trust for the benefit of a beneficiary.
The purpose of a spendthrift trust is to protect a beneficiaries inheritance from his or her own improvidence. This sort of trust allows the trustee to retain some control over the assets in question, and can be set up so the beneficiary cannot force the trustee to make distributions whenever the beneficiary sees fit. Limitations can be set to only allow distributions under certain circumstances. With limitations like these, creditors of the beneficiary are unable to attach the assets held for the beneficiary or force an early distribution to pay the beneficiaries' debts (once assets are distributed, creditors can attach them insofar as they are not protected further with additional trusts).
All of that said, this arrangement does not address the issue of protecting your assets from your own creditors. Like we discussed earlier, irrevocably gifting an asset away will provide protection, but this is not always a solution because you may want to be able to retain control and beneficial use of the property. This is where irrevocable trusts come into the picture.
Is there a trust that I can create for my benefit that protects me from my creditors?
Trusts that are set up to protect yourself from your own creditors are sometimes called self-settled trusts because the settlor (trust maker) is the same person as the beneficiary. California does not take kindly to self-settled trusts in that Prob. Code § 15304(a) affirmatively invalidates any restraint on property wherein the settlor is also the beneficiary. However, Alaska, Delaware, Nevada, and Rhode Island have passed legislation that allows settlors to also be beneficiaries. Under this legislation, you can transfer assets to an irrevocable trust set up in one of the states, and your creditors will be unable to make claims against those assets, even though you are the beneficiary.
The requirements of how the trusts are constructed vary from state to state, but there are certain common requirements for creating this type of trust which include the following: assets must be located in the state, such as in a bank, brokerage, or trust company in the state; at least one trustee must be located in the state; you, as the settlor, may not have the power to revoke the trust; and the trustee must have sole discretion to make or withhold distributions to you, even though you are the beneficiary. This arrangement will allow you to shield your assets from your creditors in that they will not be able to compel the trustee to distribute the assets. That said, California residents should be wary of creating self-settled trusts in other states because of California's very clear opposition to the arrangement.
What are the features of a self-settled asset protection trust?
If a settlor establishes an irrevocable trust in one of the states that allows this type of trust, the settlor is also a beneficiary eligible to receive distributions of income and principal at the discretion of the trustee. As the settlor, you fund the trust with whatever amount you're willing to give up control of in exchange for the benefit of shielding those assets from your creditors.
Generally, at least some of the assets must be in the state where the trust is formed. This is usually accomplished by partnering with a financial institution in the state. In some states, creditor protection features do not begin until two or three years after the formation of the trust so as to make sure the transfer of the assets is not fraudulent. This delay should allow you to avoid being faced with a court declaring your assets available to creditors.
Are these trusts and ironclad asset protection plan?
Unfortunately, they're not. The state laws that prohibit levying or enforcing judgment against trust assets upon judgment against the trust-maker beneficiary do not remove the trustee from the personal jurisdiction of any federal court, anywhere in the country. This means a Federal court could still order you as the trust-maker to hold up distribution of assets and even to transfer assets to the custody of the court. Refusal to comply could subject the trustee to contempt proceedings by the court. Also, certain types of debts cannot be avoided through these trusts; these exempt assets are alimony, child support, and taxes.
Remember, the true purpose of asset protection is not to cheat creditors to whom legitimate debts are owed, but to plan in advance so as to proactively create a level playing field against any unscrupulous plaintiffs and their lawyers should you be unfortunate enough to comes across them in your lifetime.
Limited Liability Companies
What is a limited liability company?
The limited liability company or LLC is a business form that is very popular because of its simplicity and flexibility. An LLC offers the following asset protection benefits: Like a corporation, all members or owners of an LLC enjoy limited liability; there’s no requirement that any member have unlimited liability; and the management function can be completely severed from ownership so members of an LLC can be actively involved in management without losing their limited liability, which is not the case with a limited partnership.
What protection does an LLC offer its members from the liabilities of the company?
An LLC offers great protection for its managers in members from the liabilities of the LLC. For example, if the limited liability company fails to repay a bank loan and a lawsuit arises, the limited liability company can be held liable for the bank loan, but the managers, officers, and members generally cannot be held liable. Exceptions exist as to this general rule for situations where the limited liability is used to perpetrate a fraud or the members failed to follow the rules for holding meetings and documenting decisions made on the LLC’s behalf.
Based on this limited liability, it is often a great idea to hold title to real property that is income producing (rental property) in an LLC because in the event a situation arises where the LLC is liable to a renter, it's entirely possible that your personal assets as the LLC member/property owner will not be available to the renter in their capacity as a judgment creditor.
What protection does the LLC have from my personal creditors?
Property owned by an LLC is generally not available to someone who has a claim against you personally. Thus, someone who has obtained a judgment against you cannot get to a motor vehicle that is titled in the name of the LLC.
However, your ownership interest in the LLC his subject to the claims of your personal creditors. For example, in California a creditor can obtain a charging order against an LLC member, which is an order directing the LLC to pay to the creditor any distributions of income or profit that would otherwise be distributed to the LLC member. In obtaining a charging order, an LLC member is essentially gaining an interest in the LLC member's financial rights. Nonetheless, the creditor will not be able to force management of the LLC to distribute the funds because the creditor does not also gain an interest in management. This causes some charging orders to be toothless, but can also lead to an inability to remove monies from the LLC before paying off the creditor that has obtained the charging order.
Another option for creditors is foreclosure on LLC member's interest, which is essentially a forced sale. Basically, a creditor that receives a charging order, but is not paid anything because it has only obtained a financial interest in the LLC member's share of the company, but not a seat at the management table, then gets a court order for foreclosure against the LLC member's interest in the LLC. This can obviously cause a lot of problems for an LLC. Instead of bringing in a creditor as an LLC member, the parties settle the dispute (and essentially pay out the charging order or something close to it).
Ultimately, California LLC law protections that are provided to LLC members that are not indebted to creditors are unclear when there is only a single member of the LLC. While there is no outright rule, it is possible that in California, a single member LLC may not be afforded the same protections as a multi-member LLC. So, if there is inherent risk in operating the LLC because of your personal debts, you may want to consider forming the LLC in another state that is friendly to debtors, like Nevada. Or you could think about adding another LLC member by making them a true co-owner with a financial stake in the business and management position.
WHAT STEPS SHOULD I TAKE IF I WANT TO START PROTECTING MY ASSETS WITH ESTATE PLANNING?
First, you’ll want to assess your need for asset protection. Whether you need asset protection planning is a function of your potential exposure to lawsuits. In assessing your need for asset protection, consider the following as you decide your needs: are you employed in a professional activity that makes you potential defendant; have you been sued before; or are there any gaps in your liability insurance or the limits of your policy?
Second, make sure that you plan in advance and before any trouble starts. The best time to engage an asset protection planning is when things are going smoothly. Once you’ve been sued, or threatened with litigation, it’s likely too late to shield your assets.
Third, work with an asset protection attorney. Asset protection is a complex field and only and an attorney skilled an asset protection planning can adequately assist you. If you're ready, and you have assets that you would like to protect with a combination of estate planning and asset protection strategies, we have a solution for you. Ask about our Layaway Payment Plan, which is a pay-as-you-go option for those on a tight budget. If you’d like guidance and assistance with creating comprehensive estate plans, schedule a strategy session today; we're happy to help.
Matthew Schlau is a co-founding principal of Schlau|Rogers and an estate and business planning lawyer practicing in Orange, San Diego, Los Angeles and Riverside counties. He is a husband, father, blogger, crossfitter, and really good at helping people achieve their goals.
At Schlau|Rogers, we do more than just estate and business planning, probate and trust administration. Our objective is to provide individually-tailored plans that allow you the opportunity to reach your goals, all while minimizing headaches and risk, and maximizing peace of mind.
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