Methven and Associates, the Business Law Counselors | Protection of Personal Assets from Business or Real Estate Liabilities and Debt

Asset Protection

Protection of Other Personal Assets from Business or Real Estate Liabilities
1. Sole proprietorships and general partnerships leave the individuals fully responsible for the liabilities of the business or the real estate that they own.
2. If you create certain entities – a corporation, a limited liability company or a limited partnership – and place a business or piece of real estate in it, then generally any liability generated by that business or property cannot affect your other assets. In that situation, creditors can only reach the assets in that entity; they cannot reach your other assets.
  1. Caveat: with a limited partnership you want to have a corporation or LLC as the general partner, since if an individual is the general partner he/she will have full personal responsibility for the liabilities of the limited partnership.
3. For this to work, you have to follow certain "corporate formalities" after the entity is created:
  1. The entity has to have a separate bank account and employer identification number and you cannot commingle your personal money with the entity’s money. (You can, of course, be paid salary, bonuses, dividends, etc.)
  2. The entity has to have adequate initial capitalization. This can vary dramatically from situation to situation, but a rule of thumb is that the entity should have enough cash to cover at least one month’s worth of expenses.
    1. Having insurance on the business or real estate goes a long way to proving adequate capitalization.
  3. You have to file tax returns for the entity and complete and return whatever forms the state of formation sends.
  4. If you have a corporation, you should have annual shareholder meetings and at least annual board of directors meetings – and keep minutes.
    1. A limited liability company ("LLC") does not have this requirement. If you want the benefits of a Subchapter S corporation with respect to the self-employment tax, one option is to form an LLC and make an election to be taxed as a Subchapter S corporation. (The pros and cons of an LLC versus a Subchapter S corporation are discussed in another article.)
4. Trusts by themselves provide no protection, but a trust can own a corporation, LLC or limited partnership, which does.
The Personal Creditor Problem
1. Placing a business or real estate in an entity protects your other assets from liabilities arising from that business or property. It does not protect your assets if you are sued personally.
2. People in some professions – such as doctors – are particularly likely to be sued personally. Officers and directors of companies (or managers of LLC’s) sometimes are sued personally by employees or other owners. Sellers of businesses may get sued personally as well.
3. Most of this article deals with protecting assets against litigation brought against you personally.
4. You cannot transfer assets to escape an existing or a likely creditor or it will be deemed a fraudulent transfer.
5. Basically, if you have a "reasonably foreseeable" creditor you cannot legitimately transfer your assets. Still, a transfer due to caution is not fraudulent.
6. The moral of the story: take your asset-protection steps in advance of likely claims. Once a claim exists or is likely, there is much less that can be done.
LLC and Limited Partnership Protection Versus that of Corporations
1. Creditors can get at assets held by corporations more easily than at assets held by an LLC or a limited partnership.
  1. With corporations, creditors can obtain the stock and then can vote it. If they get enough stock, they have control over the company.
  2. With LLC’s and limited partnerships, basically the best creditors can get is an economic interest. This means they can get a right to receive the owner’s profits (if there are any) but have no say in the management of the entity. For this reason, creditors tend to be put off with trying to go after ownership interests in an LLC or limited partnership.
  3. The operating agreement or partnership agreement should also, of course, contain a provision stating that ownership interests cannot be sold – or the entity dissolved – without the permission of the other owners.
2. In some states – though not in California – creditors cannot get at membership interests in an LLC at all on the theory that it unfairly harms the other members. At the moment, this list probably includes Arkansas, Illinois, Nevada, Connecticut, Louisiana, Oklahoma, Delaware, Maryland, Rhode Island, Idaho, Minnesota, Virginia.
  1. Note that there is one bankruptcy court ruling stating that this applies only if there are at least two owners of the LLC.
  2. This works fairly well if you are a resident of one of those states and your assets are located in them.
  3. The problem is that California and other states are unlikely to honor this approach because they don’t recognize it for their own LLC’s. In other words, this type of shielding probably only works if the litigation is brought in one of those states that allows the shielding.
Limited Insurance Protection
1. It depends on the state, but insurance is usually exempt from creditors.
2. In California, life insurance proceeds are exempt to the extent reasonably necessary for support of the debtor and his/her dependents, although this has been interpreted fairly narrowly.
Marital Property Issues
1. All community property is subject to creditor claims for community debts. This includes liabilities from business or professional endeavors undertaken to earn community property. Separate property is subject only to the claims against the owner of that property. As a result, one approach is for the spouse of the person who is likely to be sued to hold all property as separate property.
2. Spouses can accomplish this simply by signing an agreement, although if real property is involved, a deed with that change has to be recorded. The agreement cannot cover future earnings, though. Obviously, there also can be very adverse consequences if the spouses divorce.
Protection for Retirement Accounts
1. With retirement plans, if ERISA applies the plan is protected from creditors.
  1. There have to be other employees for ERISA to apply. Coverage only for the owner doesn’t work. There has to be at least one other employee, and that employee cannot be the owner’s spouse.
2. Keogh and IRA accounts are usually only protected to extent reasonably necessary for support of the person and his/her immediate family.
  1. Still, under California law, retirement plans sponsored by a "C" corporation are probably protected from creditors even if the plans don’t qualify under ERISA. Of course, if there are profits with the "C" corporation, then there is the double taxation issue: the corporation pays taxes on its profits and the owners pay taxes on the compensation and dividends that they receive.
Problems With Protecting Personal Residences in California
1. Homestead One can homestead a personal residence in California, but the homestead exemption from creditors is relatively minor.
  1. The exemption for the residence basically is:
    1. $50,000 for a debtor who is single;
    2. $75,000 for families;
    3. $150,000 if the debtor or spouse is age 65 or older.
  2. One possibility is to take out loans on the property to reduce the equity to the homestead amount or less. Unfortunately, this may make the interest payments so large that they are not fully deductible. See your accountant before trying this.
2. Fractionalization. Sometimes people "fractionalize" title to the residence, giving parts to children or a family limited partnership. The owners may still be able to fully deduct the mortgage interest, assuming they are the ones making the payments. But if fractionalized interests are transferred as gifts and the value of those gifts exceed $11,000 per recipient, the gifts count against your unified estate and gift tax credit. In addition, you lose the residence exclusion for income tax purposes, children can sometimes turn bad, and refinancing can be a nightmare. As a result, this approach is not generally recommended.
3. LLC’s and Limited Partnerships Another alternative is to put the property in an LLC or limited partnership.
  1. In that case, the creditors can only obtain a right to profits – and if you are living there, then presumably there are no profits.
  2. Prop. 13 re-assessment and transfer taxes can be avoided if the transfer is to an LLC where you and/or your spouse are the sole owners; or
  3. The IRS has recently ruled that a husband and wife in community property states can be members of an LLC and elect disregarded entity status. The result would be the same if the husband and wife held the LLC through a revocable or irrevocable their trust. If the election to disregard entity status for tax purposes is made, entity ownership of the residence does not thwart the ability to take the mortgage deduction or to take advantage of the sale-of-residence exclusion.
Real Estate Located in Other States
1. In some states one can hold property by tenants by the entirety and it is exempt from creditors. Tenancy by the entirety is recognized by 29 states.
2. The Florida and Texas residence exemptions are absolute. Still, you have to be domiciled there for two years. This works even if it is done to avoid known creditors.
Issues with Self-Settled Trusts
1. A brief note on definitions: a person creating/funding a trust is known as a "settlor" (because they are "settling" the trust) or "grantor"(because they are granting assets to the trust). A person who receives benefits from a trust – for example an income stream or distributions of money or other property – is known as a beneficiary.
2. In most states, including California, if you create a trust for your own benefit your creditors can get at the assets in the trust. This type of trust is known as a "self-settled trust" and includes things like the revocable trust (or "living trust") used in a great deal of estate planning.
  1. Some other states now allow self-settled trusts that purport to make the assets safe from creditors: Alaska, Delaware, Nevada, Rhode Island and Utah.
    1. California probably won’t honor these trusts as a matter of public policy.
    2. Having the trust assets located in the state allowing the trust may well provide protection, but it’s not certain.
    3. Still, even if the real property is located in California, if the trustee is located in one of the states that allows self-settled trusts, then a creditor obtaining a judgment in California would have to go to the state where the trustee is located to enforce the judgment – and might well not be able to win enforcement there.
  2. These self-settled trusts have a number of requirements. The trusts must:
    1. Be irrevocable.
    2. Have an independent trustee.
    3. Not provide for mandatory distributions of income or principal (i.e., such distributions must always be subject to the discretion of the trustee).
    4. Have a spendthrift clause, meaning that the trustee must have complete discretion over distributions.
  3. iii. There are a number of obvious drawbacks:
    1. Many people don’t like the loss of control that comes with an irrevocable trust.
    2. These trusts are expensive. The administrative and asset management fees alone can add up to several thousand dollars a year.
    3. Again, a big problem is that California and other states are unlikely to recognize this type of shield because they don’t recognize it for their own trusts. One way to avoid this effect is to set up a self-settled trust in one of the states that allows this, then if problems arise, move to that state. This may not protect real property located in California, though.
Protection Allowed by Other Domestic Trusts
1. Self-Settled Trusts With Restrictions. Note that in California if the debtor is the sole beneficiary and sole trustee of an asset-protection trust, creditors can get at it. Also, a creditor of a creator of a self-settled trust can reach trust assets to the maximum extent that the trustee could distribute or apply those assets for the settlor-beneficiary’s benefit.
  1. On the other hand, if the settlor transfers a remainder interest in an asset to a third party, the settlor’s creditors cannot seize that asset.
  2. Still, even if the settlor has created remainder interests, it is safer if the settlor is not both the sole trustee and the sole beneficiary (other than the remainder interests).
  3. If the trustee can only make distributions of principal to the settlor-beneficiary only if income is insufficient for support, then the creditor cannot reach the principal unless the settlor-beneficiary’s circumstances require invasion of principal. (If any income is required to be distributed, the creditor can reach that.)
  4. Note that a person who provides assets for a trust, directly or indirectly, is treated as a settlor. Obviously, this could include a spouse, though spouses can sign documents making community property one spouse’s separate property before putting the property in the trust.
2. Trusts Where the Spouse and/or Children Are Beneficiaries. As an alternative, a trust can be created where the spouse and/or children are the beneficiaries. Note that if the spouse as trustee has sole discretion – can get money out without getting consent from a co-trustee – then the creditors may be able to get at the money. Otherwise, a trust where the trustee(s) can "sprinkle" distributions among the spouse and children means creditors probably cannot get at it. Actually, there are several different types of trusts that can be used for this purpose.
  1. Discretionary Trusts. The strongest is a discretionary trust where the trustee(s) has/have complete discretion in making distributions from the trust.
    1. The discretion has to be so complete that the trustee(s) can refuse to make any distributions at all.
    2. If the trustee(s) then provide(s) payments solely for support and education, creditors cannot get at them.
  2. Support Trusts. The other alternative is a support trust where the trustee(s) must at least apply as much income and principal as necessary for the education and support of the beneficiaries.
    1. Here the creditor cannot get at the money as long as its in the trust – but can get at the money once it’s distributed from the trust.
    2. As a practical matter creditors may have trouble intercepting the money since the trustee(s) can pay the beneficiary’s bills directly, and the beneficiary can open new bank accounts and can often spend the money before the creditor can act (though the creditor may be able to get a court order intercepting any payments going directly to the beneficiary).
  3. Trusts With a Limited Power of Appointment.Another alternative is to create a trust for your spouse and children but give yourself a "special" (limited) power of appointment (a general power of appointment won't work), meaning that you can designate who gets money from the trust. Your creditors can't get at it – and their creditors cannot get at it either.
    1. A power of appointment is "general" only to the extent that it is exercisable in favor of the donee, the donee's estate, the donee's creditors, or creditors of the donee's estate, whether or not it is exercisable in favor of others.
    2. A power to obtain distributions from the trust that is limited by an ascertainable standard relating to the person's health, education, support, or maintenance is not a general power of appointment.
3. Potential Problems
  1. One is concern is divorce. The trustee can be given the power to add additional beneficiaries in the event of a divorce, including the grantor. This is probably not a self-settled trust, because it’s contingent.
  2. If you have multiple trustees, to avoid a deadlock among the trustees you can say that a majority of the co-trustees decides. Alternatively, you can designate a "protector" who can fire and appoint trustees, though this may be limited by IRC Section 672(c), which says that immediate family, employees, etc. are presumed to be under the grantor’s control.
  3. If the trust assets are located in California and held directly by the trust, it’s likely that the creditor can get to them. One approach is to form the trust in another state (probably one of the ones that provides protection against creditors for self-settled trusts) and choose a trustee who is located in that state.
    1. Trust property that can be moved can be transferred to the state where the self-settled trust is created.
    2. Assets that cannot be moved can be placed in a limited liability company or a limited partnership (but not a corporation) and then ownership of that entity transferred to the trust. This establishes the site of the trust at the location of the trustee rather than the actual location of the underlying assets.
4. Inheritances. If you may be receiving an inheritance in the future, consider having your parents set up a spendthrift trust for you instead.
Foreign Trusts
1. For even more protection, consider moving the assets offshore.
  1. The trust can be created in a country that allows self-settled trusts.
  2. If assets are transferred to the offshore location, U.S. courts have no jurisdiction over them. Needless to say, the courts of those locations are relatively hostile to creditor attempts to reach trust assets.
  3. In addition, these trusts can be structured as so-called "shifting-interest trusts" which provide that a beneficiary’s interest can be extinguished in the event of a creditor attempt to seize assets, only to reappear when the creditor has given up.
2. One caveat: this doesn’t work for real estate, since the law of the place where the real estate is located governs, unless the real estate is held by an limited liability company or limited partnership and that entity is in turn owned by the trust.
3. Even then, some U.S. courts have refused to recognize foreign trusts, particularly when child or spousal support payments are sought. While it may not be possible for the creditor to gain access to the offshore trust assets, some U.S. courts have jailed debtors for refusing to bring the assets back into the U.S. Also, if the debtor has real property in the U.S., the courts of that state have jurisdiction over that property.
4. There’s no tax advantage to having an offshore trust. If you try to use it for that, you can be jailed.
  1. Offshore entities in no way exempt you from U.S. income tax. You still owe the tax on any income generated by the assets. Moreover, having an offshore entity may subject you to greater tax scrutiny.
  2. There are substantial reporting requirements for offshore trusts (and confiscatory penalties if these requirements are not met), which may mitigate in favor of using a domestic trust.
5. Note also that using an off-shore bank account may make it difficult for your checks to be cashed, and the U.S. government is considering greatly tightening the reporting rules for money flowing in and out of the U.S.