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Asset protection (sometimes also referred to as debtor-creditor law) refers to a set of legal techniques and a body of statutory and common law dealing with protecting assets of individuals and business entities from civil money judgments.
Origins of asset protection
Asset protection began to develop as a stand-alone area of the law in the late 1970s. It began coming into prominence in the late 1980s, with the advent and the marketing of offshore asset protection trusts. Colorado attorney Barry Engel is credited with the introduction of that concept and the development of asset protection trust law statutes in the Cook Islands.[1]
Over the years, this new field of law enjoyed a marginal reputation, but started going mainstream in the mid-1990s. A 2003 article in the Wall Street Journal claimed that 60% of America's millionaires have considered engaging in asset protection planning.[2]
Legal substance behind asset protection
Asset protection is based on the basic principle that any asset owned by a person (with some minor exceptions, like an ERISA-qualified retirement plan) can be reached by that person's creditor. Asset protection sets as its goal the concept of removing assets from a debtor's legal ownership, while retaining control and beneficial ownership. Over the year, numerous legal structures have been developed to split up legal title to assets from control and beneficial enjoyment.
There are literally dozens of various asset protection structures in use today. The specific structure best suited for each person will depend on: (1) the nature of the asset being protected (i.e., different structures are used to protection rental real estate, a personal residence, a bank account, a retirement plan, etc.); (2) the timing of the claim or lawsuit; (3) the debtor's risk adversity; and (4) the aggressiveness and the intelligence of the creditor.
For example, when seeking to protect a personal residence, there are approximately 7 different options (according to some asset protection articles written by an asset protection attorney-expert Jacob Stein.[3] These may include: transfering ownership to a living trust with a generic name, transfering ownership to an irrevocable trust, encumber the residence by borrowing against it, recording a naked deed of trust, selling the residence on an installment basis to a family member, selling for cash to a third-party. According to Jacob Stein simply changing legal title to a living trust with a generic name may work to defeat the claims of some creditors, but not most. For someone who wants real protection, a better option may be an irrevocable trust or an outright sale of the residence.
It is preferrable to engage in asset protection planning before there is any need for it. Engaging in after-the-fact asset protection planning may be deemed to be a fraudulent transfer allowing the creditor to set aside the planning.
Depending on the assets you seek to protection, here are some possible strategies. Reprinted with the permission of Jacob Stein from his February 2007 article on Asset Protection Planning for Surgeons.[4]
In Depth Legal Article on Asset Protection
The term "asset protection" is commonly misunderstood. Many believe that it refers to the techniques used to shield a debtor's assets from creditors' claims. Because it is impossible to "bulletproof" a debtor, asset protection involves structures and techniques that make it more difficult and expensive for a creditor to reach a debtor's assets. The objective is to change the creditor's economic analysis, making the pursuit so difficult and expensive, the creditor will either give up or be willing to negotiate on terms more favorable to the debtor.
Asset protection does not deal with secrecy or hiding assets. Hiding assets is an ineffective means of shielding them from creditors because a debtor would usually have to disclose his assets in a debtor exam, under penalty of perjury. A properly structured asset protection plan allows the debtor to reveal the nature and the structure of the plan without sacrificing its efficacy.
The general proposition underlying asset protection is that a creditor can reach any asset owned by a debtor (with some statutory exemptions like the homestead exemption and certain types of retirement plans), but cannot reach assets not owned by the debtor. Consequently, the focus of all asset protection planning is to remove the debtor from legal ownership of assets, while retaining the debtor's control over and beneficial enjoyment of the assets.
Asset protection that works must be very practical. The planning is done within a statutory framework, but it is the practical implications of the planning that shape the exact nature of the structures and techniques. For example, a creditor may be able to make a successful legal argument that a given structure should not stand, and thus be able to retrieve the debtor's assets. But, if making such an argument will be sufficiently expensive and time consuming, the creditor may never make it. Practitioners must take into account both the substantive legal issues and the practical aspects of a plan. This article will focus on the more practical aspects and results of asset protection planning, touching on the underlying substantive law only in passing.
Several different factors determine the nature and the type of planning that should be used for a given client. The three most important factors are: (i) the identity of the creditor pursuing the client, (ii) the nature of the assets that will be pursued by the creditor, and (iii) the extent to which the debtor is willing to go to protect his assets. The identity of the creditor refers to how aggressively the creditor will pursue the debtor's assets, and how knowledgeable the creditor is about debt collection laws. The more aggressive and knowledgeable the creditor, the more obstacles we need to erect in his path. The nature of the assets refers to the specific assets owned by the debtor. There is no "magic bullet" asset protection strategy; different structures are used to protect different types of assets.
The extent to which the debtor is willing to pursue asset protection is important in determining the appropriate strategy. Some debtors may be willing to do nothing more than shuffle paper agreements, whereas others may be willing to go through a divorce, move assets offshore or sell their home.
Practice Pointer: All asset protection planning implicates income, transfer and property tax issues, and fraudulent transfer laws. While a discussion of these issues is beyond the scope of this article, it should be noted that many debtors approach the fraudulent transfer analysis from a very practical perspective, as follows. Assume the debtor is facing a significant lawsuit risk with a large anticipated judgment. The debtor has two asset protection choices: (i) do nothing and stand to lose all assets when the plaintiff becomes a creditor, or (ii) engage in some asset protection planning. Because the common downside of a fraudulent transfer is the creditor's ability to set aside the transfer, a debtor may have nothing to lose (other than the transaction costs) by engaging in planning that may (or may not) be deemed a fraudulent transfer. From a creditor's perspective, a successful fraudulent transfer challenge gives the creditor the legal right to pursue the transferred assets. Having a legal right to do something does not mean having the actual ability to do so, and does not mean that the pursuit of the transferred assets would be cost effective.
Personal Residence
No asset is more important to shield from creditor claims than a personal residence. Personal residences represent the bulk of many people's fortunes, and have great sentimental value.
Creditors do not pursue the residence itself, but the equity in the residence that can be converted into money through a foreclosure sale of the residence. There are two equity stripping techniques.
One way to strip out the equity is by obtaining a bank loan. Even if we assume that a bank would lend an amount sufficient to eliminate 100% of the equity, the cost of this asset protection technique is staggering. A $1 million loan bearing a 7% interest rate, costs $70,000 per year.
Another way to strip out the equity (frequently advocated by clients), is to encumber the residence by recording a deed of trust in favor of a friend. This avoids the carrying costs of an actual bank loan. With this technique it is important to know the intelligence and the aggressiveness of the creditor. Some creditors may stop trying to collect when they realize that there is no equity in the residence. Others may dig deeper, and if the debtor cannot substantiate the transaction as an actual loan, the deed of trust will be set aside by a court as a sham.
In addition to stripping out the equity, it is also possible to protect the residence by transferring ownership but retaining control and beneficial enjoyment. This can be done in one of three ways.
An arm's-length cash sale is the best way to protect the residence (and the equity in the residence) because it is much easier to protect liquid assets (see discussion below) than real estate. While this technique affords the client the best possible protection, it is also the most radical and may result in additional income taxes. Thus, it is important to know the client's asset protection objectives and concerns and the extent the client is willing to go to protect his assets.
An alternative to an outright sale is the sale and leaseback of the residence to a friendly third-party on a deferred installment note. The debtor can make a credible argument that he does not own the residence without having to move out. This structure works only so long as the debtor can establish the legitimacy and the arm's-length nature of the sale. Practitioners should also consider the income tax consequences of the sale, and possible property tax consequences on the transfer of ownership.
The contribution of the residence to a limited liability company ("LLC") or a limited partnership may be another way to protect the personal residence. The protection afforded by LLCs and limited partnerships is derived from the concept of the charging order limitation, addressed in more detail below. While the charging order limitation is generally powerful, its usefulness may not extend to personal residences.
Certain state statutes require LLCs or limited partnerships to have a business purpose, and there is no business purpose in holding a personal residence in a legal entity. This may be remedied by forming the entities in states where there is no business purpose requirement. Other possible downsides include the loss of the Internal Revenue Code Section 121 gain exclusion on the sale of the residence, the loss of the homestead exemption, and the triggering of the due on sale clause in the mortgage.
The final available alternative to protect a personal residence is by contributing the residence to a qualified personal residence trust ("QPRT"). QPRTs are frequently used in estate planning and should be familiar to most estate planning attorneys. Because QPRTs are irrevocable trusts with spendthrift clauses the interest passing to the remainder beneficiaries is generally not subject to creditor claims (absent a fraudulent transfer challenge). The interest retained by the settlor is reachable by the settlors' creditors because that interest is self-settled. However, the interest retained by the settlor (the right to live in the residence, rent-free for a term of years) has little value to a creditor. It is difficult to imagine that a buyer at a foreclosure sale would want to purchase such an interest.
The QPRT is a great example of the practical efficacy of asset protection. While it does not afford the debtor a complete level of protection for the residence, it makes the residence sufficiently unattractive to a creditor so that in practice, creditors very rarely pursue residences in QPRTs.
Rental Real Estate and Other Non-Liquid Investments
Some of the techniques discussed above protect rental real estate, businesses, intellectual property, collectibles or other valuable assets. These assets may be transferred into irrevocable trusts, sold for cash or on installment basis or encumbered.
Irrevocable trusts that are not grantor trusts are not the answer for income-producing assets because of adverse income tax results. To the extent the debtor-settlor retains an interest in the trust, the trust will be deemed self-settled and will not offer the debtor any asset protection. The other techniques face challenges similar to the ones discussed above.
Income producing assets are best protected through LLCs and limited partnerships. Assets owned by a debtor through a legal entity are not deemed owned by the debtor because legal entities have a separate juridical existence. However, if the debtor owns assets through a corporation, the shares of stock of the corporation can be seized by the debtor's creditor. If the creditor can seize a sufficient percentage of the shares, the creditor will acquire control of the corporation and access to the corporation's assets.
In most states (and many foreign jurisdictions) interests of debtors in LLCs and limited partnerships are not subject to attachment because of the so-called charging order limitation. The charging order limitation limits a creditor's remedy to a lien against the distributions from the entity, without conferring on the creditor any voting or management rights. Because the debtor frequently remains in control of the entity and can defer distributions, the creditor has no way of enforcing the judgment against the debtor's LLC or limited partnership interest or the assets owned by these entities.
LLCs and limited partnerships are yet another example that asset protection is not bulletproof. The use of these entities is not an absolute shield against creditors, because a creditor cannot be forced to go away. In some cases a creditor will obtain a charging order and try to out wait the debtor. Eventually the debtor may need to make a distribution that would be intercepted by the charging order.
As a practical matter, LLCs and limited partnerships create a formidable obstacle to the creditor's collection efforts and usually force the creditor to drop his collection efforts or to settle. Creditors do not want to play the waiting game, and would prefer to settle for a sum certain today, than wait for a possible distribution from an LLC or a limited partnership.
Liquid Assets
Liquid assets may be protected through many of the techniques described above, including LLCs, limited partnerships and irrevocable trusts. In addition to these techniques, liquid assets may also be protected with a foreign trust.
The term "foreign trust" usually means an irrevocable trust domiciled in and governed by the laws of a foreign jurisdiction. Foreign trusts offer two major advantages to debtors. From a practical perspective, because the trustee is domiciled in a foreign nation, at some point the creditor would have to litigate its claim against the trustee in that foreign nation. That is a costly proposition for all creditors, particularly if the creditor is a plaintiff's attorney who is not licensed to litigate in that foreign nation.
From a legal perspective, several offshore jurisdictions have enacted trust laws that are particularly favorable to debtors. Jurisdictions like the Cook Islands (in the South Pacific), Saint Vincent, and Nevis (both in the West Indies) are among the best currently available foreign trust jurisdictions.
Using Saint Vincent as an example (all three jurisdictions have similar provisions), the following favorable asset protection provisions have been incorporated into that nation's trust laws: (i) it does not recognize foreign judgments with respect to trusts; (ii) it has very short statutes of limitations on fraudulent transfers; (iii) to establish a fraudulent transfer the creditor must show that the debtor was insolvent, and must establish the debtor's intent to "hinder, delay or defraud" beyond a reasonable doubt; (iv) it incorporates anti-duress provisions into its statutes; and (v) it extends spendthrift protection to self-settled trusts.
The nonrecognition of foreign judgments is the most important protective feature of these jurisdictions. Assume that a creditor obtains a judgment against a debtor in New York and would like to enforce the judgment against the debtor's assets. The debtor's assets have been transferred into a Saint Vincent trust which in turn funded a Swiss bank account.
The creditor will be unable to domesticate its judgment in Saint Vincent, and will usually be unable to litigate its case de novo in Saint Vincent. Consequently, the creditor's sole remedy would be to bring a fraudulent transfer action against the trustee of the foreign trust, and attempt to show that the settlement of the trust by the debtor constituted a fraudulent transfer.
Given that the more favorable asset protection jurisdictions have a very short statute of limitation for bringing a fraudulent transfer action, require proof of intent beyond a reasonable doubt and require proof of debtor's insolvency, the creditor faces a daunting task.
Consequently, by using the foreign trust mechanism, a debtor may be able to place his assets beyond the reach of creditors, while retaining some control through such mechanisms as trust protectors and letters of wishes.
Although there have been a few successful challenges by creditors against foreign trust structures, they represent a fraction of all foreign trust structures. Even when a creditor has the legal ability to challenge the protection of a foreign trust, the costs and difficulties of the challenge are usually insurmountable.
Practice Pointer: Many debtors believe that simply moving money to an offshore bank account will serve as sufficient protection from creditors. While the creditor may have a difficult time enforcing its judgment in a foreign country and levying on a foreign bank account, the debtor will never have a problem withdrawing the money if the account is directly in the debtor's name. Consequently, the creditor may petition the court for a turnover order, which would direct the debtor to withdraw the money from the foreign account and pay it over to the creditor. With a foreign trust that can never be a problem, because the debtor is never in control of the assets of the trust.
Conclusion
Creditors not motivated by personal animosity, but by financial incentive, will always take into account the economics of their collection actions. Practitioners should keep in mind not only the underlying substantive law, but the obstacles presented to the creditor by the practical implications of asset protection planning. Depending on the creditor's intelligence and aggressiveness, timing, the debtor's risk-tolerance and other factors, the strategies discussed in this article may significantly tilt the economic equation in the debtor's favor.
References
- ^ Low-Tax.net Cook Islands Table of Statutes, May 2007
- ^ Wall Street Journal, Oct. 14, 2003, Rachel Emma Silverman, "Litigation Boom Spurs Efforts to Shield Assets"
- ^ Orthodontic Products Online, April, May 2007, "Asset Protection for Orthodontists"
- ^ Plastic Surgery Products Magazine, February 2007, "Hands Off! An Expert Shows You How to Protect Your Assets"
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