Introduction To Asset Protection
Subjects of Interest
Asset protection is a method of arranging assets in a way that will preserve as much value as possible for an individual and his family in the face of creditor attack. The process of asset protection is an interdisciplinary endeavor that involves not only debtor-creditor law, but also the following areas of: fraudulent transfers; ethics; criminal law; estate and gift taxation; trusts; partnerships; laws of foreign countries; conflicts of law; pension plans; corporate law; family law; Social Security; Medicare, and Medicaid.
Application of Fraudulent Transfer Laws
Every asset protection plan must consider the application of the fraudulent transfer laws. Violation of these laws will render all transactions void-able and may subject all parties to the transaction, including the attorney, to civil and criminal liability. The most important factor in determining whether transfers are fraudulent is whether the transferor is insolvent. Accordingly, it is incumbent on all lawyers that engage in asset protection to ascertain the client's financial status. This usually requires the lawyer to create a balance sheet of assets and liabilities for the client as of the date of the proposed transfers. In some circumstances this may warrant engaging the client's accountant to make the determination. The computation of assets and liabilities varies from jurisdiction. As a general rule, jurisdictions in which the Uniform Fraudulent Conveyance Act is in effect are more likely to find insolvency than jurisdictions where the Uniform Fraudulent Transfer Act is in effect or in those situations where the Bankruptcy Code applies.
In addition, the lawyer should be aware that the very process of asset protection planning can render a client insolvent. For example, assets that are transferred to others or overseas and held in a foreign trust are not counted for purposes of determining solvency. Similarly, if assets are transferred to a a partnership or other entity, the value of which is discounted, the retained interest should be taken into account at its discounted value, because only that value is available to creditors.
[1] Intent to Defraud
Even if the client is solvent, the proposed asset protection transactions can be fraudulent if accomplished with the actual intent to defraud a particular creditor. Direct evidence of such intent, e.g., a statement by the transferor, is rarely present. Consequently, the surrounding circumstances are examined to ascertain the existence of the badges of fraud, such as lack of consideration and secrecy. If actual fraudulent intent is established, then all creditors, including those creditors that arise after the transaction, will be able to assert the broad remedies available under the fraudulent transfer laws to protect their financial interests.
[2] Constructive Fraud
In the absence of actual fraud, the transaction can be set aside on a finding of constructive fraud. This type of fraud is present regardless of the transferor's intent where a transfer is made without consideration and any one of the following three considerations exists:
1. The transferor is insolvent or is rendered insolvent.
2. The transferor is left with unreasonably small capital.
3. The transferor is about to incur debts beyond his ability to pay.
If the circumstances at the time of the contemplated transfer are such that the fraudulent transfer laws will be violated, then the transfer is voidable. If the debtor's circumstances are such that bankruptcy is imminent, then the debtor can consider pre-bankruptcy planning in order to salvage as many assets as possible.
[3] Pre-bankruptcy Planning
Pre-bankruptcy planning involves striking a balance between the rights of debtors to fully use available exemptions and the sense of equity that a court has that will prevent debtors from abusing exemptions to shield excessive assets from creditors. Unfortunately, there are no bright lines regarding this area and the application of rules is often inconsistent.
The Bankruptcy Code permits a debtor to convert nonexempt property into exempt property. This relatively straightforward rule has spawned considerable litigation. The ends of the spectrum provide easily decided cases. Thus, conversion into exempt property of modest amounts will usually not be challenged. And conversion of significant amounts accompanied by fraud, such as deliberately lying to and misleading creditors will not be successful.
Where the conversion is unsuccessful owing to the debtor's fraudulent conduct, courts frequently deny the debtor a discharge for all debts, a result that leaves the debtor without the protection of the bankruptcy courts. This is significant because there are numerous indicia of fraud, and some of these would not ordinarily be considered fraud, such as converting substantial nonexempt property into exempt property and borrowing money or using business assets to acquire exempt property. In addition, there is a division of authority as to whether, once the fraud has occurred, the fraudulent taint can be purged by unwinding the transactions and restoring the parties to the same place they would have been if the fraud had not occurred.
Attorney Liability Back to Subjects of Interest
The determination of whether the proposed asset protection planning results in a fraudulent transfer is portentous for attorneys. A lawyer who assists a client to engage in a fraudulent transfer will be subject to both civil and criminal liability. In addition, the lawyer may also be subject to disciplinary action.
The attorney-client privilege may not protect evidence of the attorney's involvement. If the client reveals to the attorney an intent to defraud, delay, or hinder a creditor, and if the lawyer assists the client to implement this intent, then the conversation is not protected under the attorney-client privilege. Moreover, counsel should bear in mind that the attorney-client privilege applies only to statements made by the client to the attorney and not to statements made by the attorney to the client.
Although an attorney cannot assist a client to engage in fraudulent conduct, an attorney can explore with a client various courses of conduct, including conduct that would be criminal or fraudulent, provided that the discussion is not for the purpose of assisting the client to carry out a criminal or fraudulent plan. If the client misuses the attorney's advice, the attorney will not be responsible unless he knew of the criminal or fraudulent intent, at which point the attorney would have to withdraw from representing the client.
There are a variety of other asset protection circumstances that give rise to ethical issues, most of which relate to conflicts of interests. For example, asset protection for married couples frequently involves the division of property, which can have implications on divorce. This clearly presents a conflict of interest that must be disclosed and waived by the parties. In addition, it may require that one of the spouses be independently represented.
Asset Protection in Common Estate Planning Situations
The process of asset protection invariably involves taking inventory of one's assets and liabilities. Consequently it is often done in conjunction with estate planning. Often, asset protection employs commonly used estate planning tools, such as trusts, family limited partnerships, and various split interest arrangements, many of which can be configured as annuities.
Protective Trusts Back to Subjects of Interest
Trusts are often employed in estate planning. For example, when a married couple creates their estate plan, a common dispositive scheme is as follows:
1. The first spouse to die leaves all property to the surviving spouse.
2. On the death of the surviving spouse all property remaining is left to their children.
This common dispositive scheme is an opportunity to create asset protection trusts for both the surviving spouse and children.
For example, instead of being left outright to the surviving spouse, the property can be left in a trust that will not be available to satisfy creditor claims. Further, instead of being left outright to children, such property can be transferred to a protective trust that will provide for the child's security during his entire life. The disadvantages of such an arrangement are the costs associated with maintaining trusts, and, perhaps more importantly, the requirement that the beneficiary of the trust have a cotrustee, so that the beneficiary cannot act autonomously with regard to trust assets.
Protective trusts for spouses can be funded with assets that would not otherwise be exempt. For example, if the estate consists in part of stock in a closely held corporation, stock representing voting control of the corporation could be held in a protective trust so that creditors would be unable to gain control of the corporation.
There are several types of trusts that will protect assets. The type of trust used depends on the settlor's desires and the beneficiary's circumstances. Perhaps the best known protective trust is one that has a spendthrift provision, that is, a provision imposed by the settlor that prevents a beneficiary from transferring his interest in the trust. Since creditors step into the shoes of the beneficiary, the beneficiary's inability to dispose of or anticipant the interest in the trust similarly prevents the creditors from doing so.
Another kind of protective trust is a discretionary trust, which gives the trustee broad discretion to make distributions to the beneficiary. Here, the beneficiary is, again, prevented from transferring the interest in the trust, not because of any condition imposed by the settlor, but rather because of the beneficiary's lack of ability to compel the trustee to make distributions. Similarly, the creditor of a beneficiary of a discretionary trust is prevented from seizing trust assets.
Other protective trusts, which are of limited usefulness, include a support trust, in which the beneficiary has only the right to receive support, a right that is not subject to creditor attachment; a blend trust, which has many beneficiaries, none of whose interests are sufficiently defined to allow a court to seize the interest; and a personal trust, which gives the beneficiary the right to use property, a personal right that cannot be assigned or seized.
Protective trusts shield trust assets from most creditor claims. However, certain preferred claims can pierce many protective trusts. These include without limitation, claims for alimony, child support, federal taxes, and reimbursement for necessities furnished to the beneficiary.
If the settlor knows that such claims will likely be pending against the beneficiary, the settlor can minimize the likelihood that trust assets will be seized by selecting a situs for the trust that will not enforce the claims. For example, a foreign jurisdiction in which a trust is sitused will not ordinarily honor a claim for federal taxes. Similarly, the settlor can provide flexibility by allowing the trustee to move the situs of the trust at any time. The settlor can also provide that the type of interest the beneficiary holds will shift on the occurrence of certain events. For example, although a spendthrift trust would not protect assets from a claim for alimony, if the trust includes provisions that require or allow it to be shifted to a discretionary trust, it very often would be protected. As a further layer of protection, the settlor can provide that the beneficiary's interest will be suspended or terminated if certain claims are asserted.
Family Limited Partnerships Back to Subjects of Interest
A major asset protection and estate planning tool is the family limited partnership, i.e., a limited partnership in which members of the same family hold interests. The values of such interests are significantly discounted. Furthermore, the family limited partnership allows the donor to act as general partner and thereby retain considerably more control over the enterprise without risking adverse tax consequences.
Once the property is transferred to a limited partnership, state law transforms what a partner owns from a direct interest in the property into an interest in a limited partnership. Because a limited partnership restricts the rights of limited partners, including the right to vote on partnership matters, the right to receive income, and the right to transfer the interest, the value of an interest in a limited partnership is substantially discounted in relationship to the underlying assets of the partnership. This discount affects the value of the partnership interest not only for tax purposes, but also for debtor-creditor purposes.
Numerous factors should be considered in connection with the formation of a family limited partnership and the transfer of property to the partnership, including, without limitation, income tax, gift tax, estate tax, state property tax, and certain non-tax consequences, such as the continuance of casualty insurance on the property and the possible triggering of the due-on-sale clause in mortgages to which property is subject.
In addition, the partnership must be properly maintained in order for it to be effective for both asset protection and tax purposes. For example, it must be treated as a bona fide separate business that conducts business with unrelated entities or at least has the capacity to do so. Thus, partners who use any property that is transferred to the partnership should pay fair market value for the use of such property. Moreover, partners should keep in mind that what they own are interests in a limited partnership and not the underling assets of the partnership. Accordingly, financial statements of individual partners should not list assets of the partnership, rather such statements should only list limited partnership interests and at the discounted value.
There are many other estate planning tools that also have asset protection utility. For example, children's trusts can be used to transfer a variety of assets that can be held for the settlor's issue, including, without limitation, business assets that can be leased to the business and interests in business entities, such as limited partnerships and corporations. Such transfers both reduce the value of the settlor's estate for estate tax purposes and render the settlor's property less valuable to creditors.
Annuities are also frequently used in estate planning. An annuity allows the donor to transfer property out of his estate in exchange for the right to receive payments over a period. After an annuity is established, the property is effectively divided into two parts. One interest is the income interest, which is retained by the donor, and the other is the remainder interest, which is given to the donee. The value of each part is determined actuarially by reference to tables issued by the Internal Revenue Service (IRS). The asset protection utility of an annuity is that the remainder interest is shielded from the annuitant's creditors. In addition, all or a portion of the payments to an annuitant can be exempt, depending on applicable state law.
Annuities are also often used to reduce estate and gift taxes. The value of the gift is limited to the value of the remainder interest, as opposed to the value of the entire property. This allows donors to leverage their gifts. In addition, if the donor outlives the annuity period, the entire value of transferred property at the end of the annuity, including all appreciation thereon, is excluded from the donor's estate.
There are many ways in which an annuity can be created, including a private annuity, trusts in which the grantor retains the right to receive an annuity, and various charitable annuities. These vehicles can be funded with various assets, e.g., interests in family limited partnerships. Each annuity must comply with unique tax requirements.
Foreign trusts can be used by non-citizens not only for asset protection purposes but also to allay a major concern for many non-citizens, namely the possible seizure of assets by either their country of citizenship or the United States. The use of the foreign trust by a non-citizen generally is income tax neutral to that individual.
Use of a foreign trust by a non-citizen should also take into account estate and gift tax consequences. These taxes can be minimized or avoided by not establishing a domicile in the United States and not owning property that has a situs or deemed situs inside the United States. Further, aggressive programs of gifts of intangible property, such as corporate stock, which is not subject to U.S. gift tax, can also be beneficial in reducing any ultimate U.S. estate tax liability.
Arranging One's Estate to Maximize Asset Protection
There are various assets that are asset protection favored under either or both state law and federal law. The most common of these assets are retirement plans and property used as the debtor's residence. The exemptions afforded other assets, such as annuities, individual retirement accounts, and insurance, vary considerably from state to state. In addition, one can obtain a significant amount of protection by conducting business through a corporation or other entity that limits liability.
[1] Retirement Plans
Retirement plans that are required to include an antialienation provision (i.e., spendthrift clause) under the Employee Retirement Income Security Act of 1974 (ERISA) – in other words, most IRS-qualified plans – are excluded from the debtor's bankruptcy estate and exempt under federal law with regard to state court proceedings. Accordingly, asset protection sensitive debtors may benefit from maximizing their benefits in retirement plans. It is unclear whether the exclusion and exemption apply where the plan covers only the owner of a business and the owner's spouse. Accordingly, under that circumstance another employee should be included in the plan, or alternatively, the debtor can rely on the applicable state exemption.
Some states also provide exemptions for retirement plans, which can include plans that are not qualified by the IRS and IRS-qualified plans that cover only owners and their spouses. However, the statutes authorizing these exemptions are often subject to varying interpretations and, depending on how they are drafted, may be preempted by ERISA. Generally, if the law avoids making specific reference to ERISA or the Internal Revenue Code and is a statute of general application, it will not be preempted.
Many of the statutes not preempted by ERISA cover a broader array of retirement plans than IRS-qualified plans. Such broad state exemption statutes also exempt plans that are not IRS-qualified, such as top hat plans, excess benefit plans, and secular trusts. The benefit of these non-IRS-qualified plans is that unlimited amounts can be transferred to the plans and these plans can discriminate by covering only highly paid employees.
There are also other grounds for exempting such plans. For example, state spendthrift laws may apply to such plans to extend protection to a debtor's interest in a top hat plan, an excess benefit plan, or a secular trust – in some jurisdictions, even if the trust is deemed self-settled. A secular trust can also be exempt under ERISA if it is funded, as opposed to a plan that is un-funded or a plan that is funded with insurance. Finally, such non-IRS-qualified plans can be held by tenants by the entireties and obtain the benefit of that exemption to the extent available under applicable state law.
Another benefit of relying on some state statutes is that some state exemptions apparently extend the exemption to distributions from retirement plans. Thus, a retired person can protect distributions from retirement plans by segregating those funds in a separate account so they are clearly identifiable. In this regard, Social Security payments are also exempt in both bankruptcy and non-bankruptcy proceedings. In addition, if a debtor in a bankruptcy proceeding elects state exemptions rather than federal exemptions, the exemptions will be extended to accumulated Social Security payments.
[2] Family Residence
A debtor's residence is frequently a significant family asset. The strategies employed to protect one's residence depend on applicable state law and the value of the residence. The amount of the exemption for a residence varies greatly from state to state. Thus, if the debtor lives in a jurisdiction that grants a complete exemption for a homestead (or an amount that equals or exceeds the value of the residence), then the debtor's equity in the homestead should be increased to the maximum amount possible. If the applicable state law is not so generous, then a number of strategies can be employed.
One approach is to have a portion of the residence owned by a person who is unlikely to have debtor-creditor problems. But the ownership must be genuine, and the debtor cannot treat the entire property as his own. For example, the debtor should not list the entire property on a financial statement.
A variation on this theme is to transfer title to the residence to a split interest trust, in which the settlor retains an interest for a term of years. Under these circumstances, the remainder interest would be protected from creditors. In addition, if the settlor outlives the term of the trust, there can be significant estate tax advantages. Further, in those jurisdictions where tenancy by the entireties is exempt, the residence can be so held by spouses.
[3] Effective Use of Corporations
Individuals engaged in business should attempt to limit their liability by conducting their business through a corporation. The effective use of corporations focuses on preventing the corporation from being disregarded as an entity separate and apart from its shareholders. Where the corporation's separate identity is disregarded, it will not shield the shareholders from liability; i.e., the corporate veil will be pierced. It is also possible that the corporation will be disregarded and that shareholders will be treated as the owners of the assets to which the corporation holds title – a reverse pierce.
The preservation of the corporate veil largely depends on adherence to formalities, avoiding the commingling of corporate and personal assets, and respecting the separateness the corporation, such as not using corporate assets for personal purposes. But shareholders should understand that even the most meticulous planning cannot prevent a pierce under certain circumstances. For example, the corporate veil is often pierced on the basis of a subjective standard, such as unfairness. Consequently, the protection afforded shareholders is often uncertain and unpredictable. Accordingly, it should be relied on cautiously.
Another basis for piercing the corporate veil is statutory exceptions to the rules of limited shareholder liability. For example, professionals, e.g., lawyers and doctors, often conduct their business through a corporation. However, this way of doing business will not shield the professional from liability arising from his conduct as a professional, although it often provides protection from liability from other sources, most notably the conduct of other shareholders of the professional corporation.
Family Law Considerations
Both marriage and divorce can be arranged to maximize asset protection. For example, if the parties are going to divorce, then transfer of assets by the debtor spouse prior to the divorce can shield those assets. Married people can also arrange to protect their assets by minimizing ownership of assets by the spouse at risk.
A marital agreement will be the foundation of many asset protection plans. In order to be enforceable, the marital agreement must meet certain requirements. Among the most important is that the agreement cannot encourage divorce. In addition, the parties must adhere to their agreement or it may be disregarded. For example, if a major asset such as the family residence is transferred to the name of one spouse, then that asset should not be treated as owned by the other spouse, such as by listing it as an asset of the other spouse for the purpose of securing credit.
In addition, the nature of the agreement will vary depending on whether the parties live in a community property or common-law jurisdiction. In both community property and common-law states, substantial property should be held in the name of the spouse not at risk. But simply placing property into the name of the spouse not at risk is not sufficient. The parties must also avoid the creation of an implied trust, which is a mechanism pursuant to which the at-risk spouse will be treated as the owner of the property even though it is held in the name of the other spouse. There are a number of ways to minimize the risk of an implied trust, including the following:
1. Transferring property pursuant to a marital agreement
2. Holding the assets transferred in a trust, irrevocable if possible
3. Ensuring that transferor retains sufficient assets so that he is not completely at the mercy of the transferee spouse
The inter-spousal transfer of properties usually is intended to be a gift, as opposed to a sale or other transaction. In order to be effective, the gift must be complete, which requires the donor to adhere to certain formalities, such as a writing evidencing the gift and a clear change in possession.
One of the dangers of making gifts is that the donee may squander the property. There are various means that enable the donor to prevent this from occurring, including the following:
1. Transferring property to a business entity, such as a partnership or a corporation, making gifts of interests in the entity (as opposed to a direct interest in the property), and retaining control and management of the business entity.
2. Transferring property to a trust and retaining a limited power of appointment with regard to the corpus of the trust. This will prevent the property from being sold. In addition, the limited power will allow the holder to transfer the property to another, as could occur if the donee is a spouse and the parties divorce.
3. Gifts to one's spouse can be made to a qualified terminable interest property trust. This will prevent the spouse from squandering or gifting the property. It will also allow the transferor to determine who will receive the property on the spouse's death. A possible downside to this approach is that the beneficiary-spouse will have the benefit of this property regardless of whether the parties divorce. In this regard, such property can be taken into account if the parties divorce.
The specific requirements of marital agreements vary from jurisdiction to jurisdiction and, in large measure, depend on whether community property or common-law rules prevail. For example, one major difference between community property states and common-law states is the time at which a spouse's interest in marital property vests. A creditor has no rights with regard to property interests that are not vested. In common-law jurisdictions, the interest of a non-titled spouse in marital property does not vest until the initiation or conclusion of a divorce proceeding. Consequently, spouses residing in common-law jurisdictions can hold assets free from most claims of their spouse's creditors. In contrast, the interests that spouses have in community property states vest immediately on receipt. Further, during marriage most liabilities incurred by either spouse subject the entire community property to liability. Accordingly, in community property states the community property system should be affirmatively repudiated by spouses pursuant to a marital agreement, and all property should be held as separate property.
Another significant difference between common-law states and community property states relates to how gifts are treated on divorce. Although the at-risk spouse may be willing to make gifts to the spouse not at risk as long as they remain married, he or she may want to receive assurance that the property will be treated as marital property subject to equitable division if the parties divorce. This result occurs in many common-law jurisdictions where inter-spousal gifts remain marital property. However, in many community property states gifts remain the separate property of the donee spouse on divorce, and only community property is divided.
Elder Law and Disabilities Law Considerations
Medical costs for elderly persons and disabled persons can consume assets that have been accumulated over a lifetime. Medicaid, a joint federal and state program, is available to defray all or a portion of the cost of medical care, but only if the claimant and his spouse have modest resources. If the resources are too substantial, then the parties must spend down such excess resources to receive financial assistance for medical care.
The goal of asset protection in this context is to shift as much of the cost of medical care to the government and to retain as much family wealth as possible for the ill family member and for other members of the family. This type of planning is perhaps the most complex and often involves the least amount of money. It can engage federal Social Security law and applicable state law; the law of trusts, estate, and gift tax planning; debtor-creditor law, and the fraudulent transfer laws. In addition, any planning undertaken is subject to the vicissitudes of legislative enactment that could retroactively alter the intended results.
A variety of familiar tools can be employed to prevent the state from seizing the claimant's property. For example, transferring property to an irrevocable trust coupled with a retained limited power of appointment can be an effective device. Although the trust cannot be held for the benefit of the claimant, it will still allow the grantor-claimant to control the property and its ultimate disposition, with a step-up of tax basis on death. It will also protect the assets from the creditors of the beneficiaries. Any transfers made into trust must take into account the sixty-month look-back period rule, pursuant to which any uncompensated transfers made to a trust within sixty-months of being institutionalized will result in ineligibility for a period that is determined by reference to the cost of medical care and the value of assets transferred. Similar rules apply to transfers of assets not in trust, but in such situations the look-back period is only thirty-six months.
Some of the planning resembles bankruptcy planning. For example, certain property is exempt, such as the family residence, and excess nonexempt assets are frequently converted into exempt assets by increasing the value of the residence either through improvements or through a reduction of the mortgage. Similarly, if divorce is anticipated, it can be an effective asset protection tool where the transfers accomplished in connection with the divorce do not violate the fraudulent transfer laws.
The attorney dealing with Medicaid-qualifying transfers is often faced with a conflict of interest that can arise when children initiate planning for their parents. Under these circumstances the attorney must clearly establish that the client is the parent, regardless of who pays for the attorney's services. In addition, the attorney should determine whether the client is capable of understanding the transaction, and if the client is not, the attorney should seek a guardianship. |
