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Planning for Advanced Asset Protection
Asset protection is vitally important in our ever more litigious
society, and more wealth planning teams are needed who understand the
intricacies of this area and can collaboratively implement advanced
strategies. Whether creating an entire plan for the client or creating
additional asset protection measures added on to an existing plan, you
want to know with a high degree of certainty that the plan will be
effective if an attack ever comes.
Asset protection planning is
designed to provide increasing levels of protection, starting with where
the client is today and moving to where he or she would like to be.
Planning appropriately includes making sure there is neither too little
nor too much planning.
In this issue of The Wealth Counselor,
we will review and build on a prior issue (“Asset Protection Planning —
Teamwork Is Required for Success”). We will also include some specific
advanced asset protection strategies that will strengthen the plans you
and your colleagues create for your mutual clients.
The Advisor Team Approach: The Three-Meeting Strategy
Asset
protection planning is advanced. It is anything but “one size fits
all”! Therefore, it requires both an in-depth understanding of the
client and a collaboration of all the professionals involved. Therefore,
we highly recommend that an asset protection engagement proceed
deliberately and with a structure agreed to in advance by the client and
the team members. The recommended and proven structure is:
- Initial Meeting with Advisors and Client: The
purpose of this meeting is to gather financial and objective
information and to build a relationship with the client. To preserve the
attorney/client privilege, it may be necessary to excuse non-attorney
advisors from part of the meeting so the client and attorney can talk
freely. It is also important to set some reasonable expectations and
explain what asset protection is, how the laws work, and what the client
can expect.
- Advisors’ Meeting: After the initial
meeting, the client’s involved advisors (attorney, CPA, financial
advisors, insurance advisors, etc.) meet without the client present to
review the client’s objectives, discuss various legal and financial
solutions, and determine a consensus solution. During this meeting, it
is important to lean on the expertise of specific advisors to determine a
comprehensive solution. All potential ideas and concerns should be
discussed and explored and differences of opinion ironed out here, not
in front of the client.
- Client Solution Meeting: Here
the advisor team presents a unified solution plan, including all legal
and financial components, to the client and gets the clients’ approval
to proceed with plan implementation.
Talking Points for the Initial Meeting
It
is important to explain to clients that asset protection is not about
hiding or concealing assets. Rather, it is using existing laws
appropriately to obtain the best possible level of protection for their
assets. The goal is to take advantage of planning opportunities in a way
that they can be as defensible as possible if and when the time comes
that they are needed.
Client objectives typically include:
- High degree of certainty of the outcome.
While there may be circumstances that neither client nor advisors can
control, the end result should be considerably better than if the client
had done no planning at all.
- Maintain control of their assets and their destiny. This is typically especially important to professionals and entrepreneurs.
- Discourage lawsuits from the outset. Rearranging
business affairs and asset ownership can make clients less likely to be
personally liable. For example, rental properties that are owned
individually or in a revocable living trust can be moved to an asset
protected arrangement like a limited liability company (LLC).
- Avoid liability “traps” like partnerships and joint ownership.
It’s one thing to be responsible for your own actions, but quite
another to have your assets vulnerable to the actions of another.
Types of risks faced by clients often include:
- Professional liability:
As a general rule, you cannot limit your own professional liability.
Also, most states do not permit nonprofessionals to own a portion of a
professional practice. Professional liability protection therefore
begins with adequate malpractice or errors and omissions insurance
coverage.
- Professional liability of a partner or employee: In
a partnership, each professional is exposed to liability for the
malpractice of every other partner and employee. The practice can be
legally structured in such a way that each professional is protected
from personal liability for the errors of others.
- Non-practice personal liabilities:
These could come from business deals that have gone bad or tort claims
(auto accidents, etc.). Within the practice, there could be
non-professional liabilities from employment practices, employment
discrimination, premises liability, and sexual harassment claims. Again,
structures can be set up that isolate clients and client assets from
these risks.
- Estate planning risks: These can include
unnecessary or excessive income and estate taxes; a partner’s next
spouse who might be a problem with ownership interests; children’s
spouses and their behavior which can lead to loss of family assets, etc.
These can be dealt with in general estate planning.
The
best and most effective time to plan is before a claim arises, when
there are only unknown potential future creditors. But even with an
existing claim, some options (such as making a contribution to an ERISA
qualified plan or doing a Roth conversion) may still be available to
shield assets.
Planning Tip: Be
aware of potentially fraudulent transfers. Also, because clients often
submit incomplete information, obtain a solvency certificate and seek
permission to independently investigate their financial situation
through online/court house records and other advisors.
Levels of Asset Protection
Level 1: Exemptions:
Certain assets are automatically protected by state or federal
exemptions. State exemptions include personal property, life insurance,
annuities, IRAs, homestead, joint tenancy or tenancy by the entirety.
Different states protect assets differently and amounts of the
exemptions will vary greatly. Federal exemptions include ERISA which
covers 401(k), pension and profit sharing plans. The Pension Protection
Act protects up to $1 million in IRAs for bankruptcy purposes.
Planning Tip: Sometimes
it is possible to convert non-exempt assets into exempt assets. For
example, cash can be used to pay down a mortgage to increase home
equity. An IRA that is not well protected under state law could be put
into an ERISA qualified retirement plan that is absolutely protected
from creditors. Outside cash can be used to pay taxes on a Roth
conversion, thereby increasing the net protected asset pool.
Level 2: Transmutation agreements (in community property states):
Separate property assets of the “safe spouse” generally are not
reachable to pay certain creditors of the “at risk spouse.” Community
property assets can be converted to separate property for the spouse not
at risk, but once transmuted, the property may not become community
property again in some states.
Planning Tip: Commutation
of community property to separate property will have consequences,
including the loss of stepped-up basis on the death of the non-owner
spouse. Also, in the event of a future divorce, these assets would
already be owned by the “safe spouse.” It is important to explain these
implications and possible consequences to the clients in writing. Be
sure to evaluate commutations from a fraudulent transfer perspective
before the transfer.
Level 3: Professional entity formation (PA/PC/PLLC): State
laws will vary, but if available, a PLLC is usually more desirable than
other forms of entity because of the charging order limitations that
prevent a creditor from seizing the creditor’s ownership interest in a
multi-member entity. Instead, the creditor is often limited to the
distributions that would have been made to the affected member. Income
tax consequences for the creditor and debtor must also be considered.
Using a jurisdiction that makes the charging order the sole creditor
remedy is highly desirable.
Planning Tip: Using separate entities or a PLLC can limit liability for a partner’s malpractice claims.
Level 4: Equipment and Premises Leasing LLCs: LLCs
can be created to own specialized or valuable equipment and/or real
estate to remove these assets from the business or professional
practice. Lease agreements can then be created between the professional
practice and the asset holding LLCs. It is important to segregate real
estate, equipment and securities accounts from malpractice exposure and
it may be desirable to separate them from each other. The state in which
the LLC is formed is very important, as a jurisdiction that allows the
charging order as the sole remedy is highly desirable.
Planning Tip: Accounts
receivable, which can be significant, can be protected by pledging them
to a friendly creditor or factoring them. In the event an unfriendly
judgment creditor appears in the future, the unfriendly creditor will
not be able to attach to the receivables because they are already
pledged or factored to another creditor.
Planning Tip: One
structure to consider is creating an irrevocable life insurance trust
(ILIT) and funding it with a life insurance policy that is designed to
have significant cash build up over time. Using a conventional trust
structure that works in every jurisdiction, the insured is not a
beneficiary, but the spouse and descendants can be. (If the insured is
to be a beneficiary, a self-settled asset protection trust would need to
be used.) The ILIT trustee (an independent party) can use discretion
and enter into a credit line arrangement with the insured (the business
owner/professional). In exchange for granting the credit line access to
the cash value of the insurance policy, the insured would need to pledge
significant assets to secure the potential drawdown. These pledged
assets can include accounts receivable. There are turnkey accounts
receivable protection plans that include bundling (creation and funding
of the ILIT with a particular insurance product, along with the proper
documentation) or the advisor team can create one. Either way, be sure
to document carefully.
Level 5: FLP/FLLC to own non-practice assets: Consider
forming a family limited partnership (FLP) or family limited liability
company (FLLC) to own non-practice assets. These can include personal
use real estate, investment accounts, cash or bank accounts, investment
real estate and highly valued collectibles (vehicles, artwork, etc.).
These can be leased back to an individual for personal use. Again, a
favorable jurisdiction that has the charging order as the sole remedy is
preferred.
Planning Tip: Ownership
interests can be gifted, often at discounted values, and the current
$5.12 million gift tax exemption provides an exceptional opportunity to
transfer assets this year. Should this exemption decrease to $1 million
in 2013, as the law currently states, the ability to make lifetime gifts
will be significantly affected.
Planning Tip:
With a personal residence, one option would be to borrow the maximum on
the mortgage (through a home equity line of credit) and transfer the
loan proceeds to an asset protection trust (APT) which then becomes a
member of the FLP/FLLC. (Establish the APT first for interim
protection.) A second option would be to sell the residence to an
intentionally defective grantor trust (IDGT) in exchange for a note that
is structured in such a way that it would be unattractive to a
creditor.
Planning Tip:
A qualified personal residence trust (QPRT) can also be used. Under a
QPRT, the grantor retains the right to live in the home for a
pre-determined number of years. At the end of the term, the home is
owned by the trust beneficiaries, which can include the descendants of
the grantor. Because it is a self-settled irrevocable trust, some states
have limitations that can reduce its effectiveness for asset protection
during the primary term. Also, the funding of a QPRT when there is a
known claim could be considered a fraudulent transfer. However, there
may be other reasons to use a QPRT, including the ability to do
significant gift planning and asset value freezing.
Level 6: Domestic asset protection trusts:
Non-practice or leasing LLC assets transferred to a DAPT before any
claim arises may provide additional charging order protection. The
downsides include having to fund the trust in the jurisdiction that
allows it (e.g., Nevada, Delaware, Wyoming, Alaska, etc.) and the need
to have a resident trustee in that jurisdiction, which may be a
significant ongoing cost. There is also the risk under the Bankruptcy
Act of a 10-year clawback for transfers to a DAPT.
Planning Tip: The
creator of a non-APT trust cannot be a beneficiary and still achieve
asset protection. However, the spouse and children can be the
beneficiaries. A flight provision can be included so the assets could go
to another jurisdiction if the trust is attacked. A trust protector can
oversee the trustee, change the trustee, direct the trustee to move the
trust to another jurisdiction, and even be able to decant and move the
assets to another trust for the benefit of the same beneficiaries. The
alternative is to establish a DAPT in a jurisdiction that allows them,
so that the grantor can be a discretionary beneficiary and still achieve
asset protection. (Alaska, Delaware, Nevada and Wyoming are often the
most popular.)
Level 7: Offshore asset protection trusts: These
are established under the laws of a foreign jurisdiction. With an
offshore trust, the assets are in the hands of a foreign trustee and are
outside the reach of any U.S. court. However, there may be tax issues.
Also, if the court orders the assets repatriated and they can’t be, the
client could be cited for civil contempt and even jailed. In addition,
offshore trusts are expensive to establish and maintain.
The Risks of Doing Asset Protection
Proceed
with caution when doing asset protection planning for your clients. Be
aware of potentially fraudulent transfers, concerns of solvency, and
that there may be creditors you don’t find out about. It will be much
better for you if the client will let you do some level of due
diligence. Make sure your client understands the issues and has some
reasonable expectations of what the asset protection planning may or may
not accomplish. Sometimes the advisors will conclude that it may not be
possible to do everything the client wants to do.
Conclusion
Asset
protection planning is a challenging and rewarding area in which the
advisor team has many opportunities to work together for the mutual
benefit of their clients and themselves.
To comply
with the U.S. Treasury regulations, we must inform you that (i) any
U.S. federal tax advice contained in this newsletter was not intended or
written to be used, and cannot be used, by any person for the purpose
of avoiding U.S. federal tax penalties that may be imposed on such
person and (ii) each taxpayer should seek advice from their tax adviser
based on the taxpayer's particular circumstances.
Waypoint Estate and Business Planning assists clients in the greater Chicago area including Lincolnshire, Mundelein, Vernon Hills, Lake Bluff, Grayslake, North Chicago, Lake Forest. Gurnee, Libertyville, Long Grove, Lake Zurich, Buffalo Grove, Northbrook, Deerfield, Glenview, Naperville, Wheaton, Yorkville, Algonquin, Huntley, Crystal Lake, Winnetka, Hawthorn Woods, Wilmette, Skokie, Wauconda and Wadsworth in Lake County, Cook County, DuPage County and McHenry County, Illinois.
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