Asset Protection Planning

A great many clients have told us that they expect that their revocable living trust would protect them and the assets in the trust from the claims of creditors. Other clients have told us that they expected that the plan prescribed by a prior advisor should have protected their assets from creditors when it would have been relatively easy to do so. Still other clients express surprise that significant creditor exposure that could have been avoided or at least understood were not pointed out to them in estate planning consultation.

The estate planner should have a general background on debtor/creditor law, particularly as relates to exemption planning (what assets creditors generally cannot seize) and the overall business and personal activities of the client that can result in creditor exposure.

You may want to share your own version – localized to your state’s laws – of the list attached in Exhibit A – with clients so that they can think through activities they might be engaged in that can cause significant liability. The importance of having appropriate insurance coverages and understanding what insurance will and will not cover can also be discussed. At a minimum, the estate planner should make clear what advice they are not giving or what areas of planning they are not able to assist with when it comes to asset protection advice.

Common examples of circumstances that should be discussed are real estate that may have hazardous waste issues, rental or business activities that are done in a proprietorship or general partnership form, situations where there could be a de facto partnership involving activities of others, and making sure that there is plenty of liability insurance covering automobile driving and professional activities.

At the same time, the planner should stress that there are ways to own assets or certain assets that are less creditor accessible, and that the law does allow an individual to situate their affairs so as to be insulated from creditors and also to limit the exposure of a particular activity to the assets involved with that particular activity (“firewall protection” such as using a corporation to be involved with a high risk activity and keeping only minimal assets within the corporation).

In conjunction with asset protection planning, many clients also naturally believe that assets within a revocable trust would not be accessible to Medicaid and that the client would be able to qualify for Medicaid because of having set up a revocable trust. For the elderly client, Medicaid eligibility planning can be a very important activity, both from a fiscal and psychological standpoint. The many planning opportunities that are available in the Medicaid arena need to be discussed or the estate planner should limit their responsibility where appropriate. The estate planner should have a general background to be able to spot major issues and Medicaid eligibility candidates as to clients, their parents, and children and loved ones who may have disabilities.

Any significant outright devise or gift raises the question of whether the recipient will be able to have full enjoyment after the transfer, given considerations relating to potential creditor, divorce, or child support claims against a beneficiary. Is the beneficiary well suited to handle investment and spending decisions, and will the beneficiary be subject to pressure from a spouse or other individual to place the assets into joint names, to make gifts that they might not otherwise want to make, or to make high risk investments or loans?

Most educated clients offered the choice between providing an inheritance outright or through a trust where the client has significant input as trustee or co-trustee and the trust assets gain significant protection from creditor claims, divorce claims, and also estate tax planning benefits, will generally choose such a protective trust.

Clients often come to the author with estate plans that provide for distributions to pay out certain percentages at specified ages. Quite often, such clients, upon brief reflection, change the distribution provision to provide that instead, the beneficiary may become co-trustee at a certain age, co-trustee with their choice of any licensed trust company or any one or more persons from a list provided in the document at a later age, and perhaps sole trustee of the whole trust or a sub-trust that would break off at a certain age or upon the happening of a certain event.

Beneficiaries who are or will in the near future be elderly or may have mental or physical infirmities are certainly candidates for this type of protective trust mechanism. How many clients with several children and grandchildren can actually look their estate planner in the eye and say that there is no potential divorce, creditor, spendthrift, or mismanagement situation that could ever apply to any of their beneficiaries?

In law school we are taught that fraud is a terrible and actionable tort, and many times a criminal act as well. We were also taught that transferring assets for the purpose of avoiding creditors can be a “fraudulent transfer.” What we are not taught is that a fraudulent transfer does not constitute a fraud, notwithstanding the nomenclature. In most states, the transfer of assets to avoid a creditor’s claim is not considered to be a tort or a crime. Under most fraudulent transfer statutes, the sole remedy of a creditor is the ability to reach to where the assets were transferred in order to have access to them to the extent permitted under state law. The fraudulent transfer statutes generally do not have any attorney’s fee provision, and thus the making of a fraudulent transfer is not necessarily a high risk endeavor.

Further, the burden of proof is generally on the creditor to prove that a fraudulent transfer was made. Creditors can have a hard time satisfying this burden where, at the time of a transfer, the debtor’s situation was such that in all probability a particular claim or risk of claim would be resolved by insurance policies, other parties who are more responsible than the defendant, or by the debtor retaining sufficient assets to satisfy the reasonably expected obligations of the claim. Further, in many cases there are business and tax reasons for making transfers. Would you advise a client not to have proper estate tax planning because the execution of the document might be considered a fraudulent transfer that may protect their assets from a creditor situation if it ever got out of control?

In many cases it will be appropriate to confer with a bankruptcy or debtor/creditor law specialist to determine whether a transfer is permissible or advisable, and to also confer with litigation counsel to determine what the reasonable probability and expected exposure of a claim or claims may be. Then a well-educated client can make a proper decision as to how to proceed.

Clients do need to be informed of the state fraudulent transfer statutes, and also of Bankruptcy Code Section under which a discharge can be denied if a fraudulent transfer has taken place within one year of filing bankruptcy. Bankruptcy counsel may advise, however, that it is nearly impossible for a single creditor to force a debtor into bankruptcy within a year of receiving a judgment where the debtor has plenty of exempt assets to pay their other bills and obligations as they come due.

A good many “asset protection specialists” are typically pitching one or two mechanisms, and certainly from a client satisfaction and closure standpoint, it’s easiest to make one or two mechanisms seem to be the right solution for just about every client’s problems. But there are a number of potential problems inherent with this type of strategy, which quite often involves an offshore asset protection trust, a limited partnership, or a combination of these two techniques.

Although charging order protection is apparently available in all states, and unless there has been a fraudulent transfer to the partnership entity creditors should not be able to seize assets directly from the partnership, clients need to understand that having a charging order against their limited partnership can effectively prohibit them from receiving any economic benefit from the
partnership without sharing with the creditor. The debtor would have to rely upon a court of equity to allow them to obtain economic benefits from the partnership, such as compensation for services rendered or to use partnership assets to capitalize a business that they may work in. While most creditors can probably be bought out of charging orders for pennies on the dollar, this will not always be the case and the clients need to know this.

With respect to asset protection trusts, the recent appellate decisions which have resulted in at least two offshore trust planning debtors facing time in jail on contempt must be reviewed with any client considering this strategy. While the Anderson and Lawrence cases each involve egregious facts, the language of the 9th Circuit of Appeals to the effect that it will be presumed that a debtor has control over an offshore trust mechanism where the bulk of their assets have been conveyed to the mechanism makes the “impossibility of performance” defense a challenging opposition in the offshore trust arena, particularly where clients have named themselves or close friends or relatives the trust protectors of the trust and where the trust protectors have plenary powers over the trust arrangement.

While most plaintiffs’ lawyers will probably settle for limited liability on a policy available where the only other assets are in an offshore trust mechanism, this did not work for Mr. and Mrs. Anderson, Mr. Lawrence, or Mr. Brennan, and each of their cases would have been much stronger if they had not had all of their assets in the offshore mechanism.

With the availability of life insurance policies, annuity policies, pensions and IRAs, limited partnerships, limited liability companies, tenancy by the entireties, placing assets in a non-risk spouse’s name, domestic asset protection trusts which have significant utility for estate tax planning purposes, and gifting, most clients will be well advised to use a variety of planning methods and vehicles simultaneously, particularly where they have a high value, multiple asset and family member situation. We often tell clients that for every complicated situation there is a simple answer – – – and that it is the wrong answer. Complicated situations will often be resolved by complicated solutions.

Over 90 different strategies for asset protection are set forth in the author’s outline on Asset Protection in the Estate Plan which can be accessed on the Internet at gassmanpa.com.

Many planners have made the “limited partnership” the save-all instrument of asset protection planning, without giving clients a good background on alternative exempt assets, asset protection trust planning, and what a court of equity might do with a charging order situation. While it’s easy to tell a client that a creditor can do very little with a charging order, there’s no way
to predict what the evolution of the law will be in this area with the proliferation of so many aggressively structured asset protection limited partnerships.

Further, a court in equity is not necessarily going to look very kindly upon a debtor who attempts to derive significant wages or other benefits from partnership property or who provides such benefits for their family members while thumbing their noses at a creditor with a charging order. Further, the Revenue Ruling which is often touted as requiring that the creditor with a charging order receive a K-1 for partnership income is not directly on point. In that ruling, the creditor received an assignment of a partnership interest as opposed to a charging order. Many commentators have written that the same result will not necessarily apply in a charging order situation. Thus, it could be the debtor partner who has to pay income tax on income derived from an asset that he or she has no access to.

Many clients will choose to ignore a problem that should not be ignored, or are not aware of legal rights that they have which may not be fully pursued by the liability company or the liability company’s legal counsel defending a claim.

For example, failure to timely report a claim to a liability insurance carrier could result in loss of coverage. Further, liability insurance carriers have an obligation to settle a matter within limits of coverage when the opportunity becomes reasonably available to them. In many situations, plaintiff’s counsel will offer to settle within the limits of liability, and the liability insurance carrier, based upon statistical experience, is willing to take the risk of not settling and going to jury trial knowing that perhaps three out of four or four out of five times the jury verdict will come in substantially less than defense costs plus the plaintiff’s last offered settlement amount.

The problem is, however, that one out of four or one out of five times a verdict may come in well above policy limits, leaving the client in the lurch unless it can be shown that the carrier failed to act reasonably in order to settle the case. Private defense counsel cannot only look over the shoulders of the insurer’s defense counsel to make sure that a proper defense is provided, but might also be able to communicate with the plaintiff’s attorney to induce a settlement offer within policy limits, and then provide correspondence to the insurance carrier demanding settlement within policy limits to establish that an excess verdict is going to be the responsibility of the insurance carrier to the extent provided under state law.

Once it is established that a particular situation is covered by insurance and that the insurance carrier has had or has the reasonable opportunity to settle within policy limits, the chances of the client being considered as insolvent become quite remote given the insurance coverage up to policy limits and the bad faith cause of action that would exist above policy limits. At that time, it should be possible for the insured to transfer assets without such a transfer being considered as “fraudulent” with respect to the plaintiff. Of course the documentation needs to be in place to support these items.

These are examples of why specialty counsel will often be retained by an estate planning lawyer who has an asset protection project underway.

Litigation counsel can also opine as to the potential liability of a case where there is no insurance coverage to help document that the client or other entities associated with the problem have sufficient financial wherewithal after making estate planning transfers to handle the problem.

Just as importantly, seeking assistance from an experienced bankruptcy attorney can be very useful.

Oftentimes a client will come to our office several months after a claim has been filed against them, with significant assets totally exposed. When asked why the client has not transferred the assets to an exempt status, they will often indicate that they consulted with another lawyer who told them that asset protection strategies might not work. Besides confusion over the meaning and effect of fraudulent transfer statutes, such prior counsel, being the perfectionist tax lawyers that so many of us have been trained to be, may have been thinking in terms of a 5% or 10% chance that a strategy might not work, as opposed to a 90% to 95% chance that the strategy would work and that the assets would be saved. If you were the client, which course of action would you embrace?

The author is reminded of the many clients who have been advised not to establish limited partnerships because the discounts “might not work” and the many lawyers who are still not using family limited partnerships notwithstanding the case law that firmly supports their existence.

The fact is that from a negotiation standpoint, the client has a much better chance of settling the matter if they can look into the eye of the plaintiff or the plaintiff’s lawyer and indicate “go ahead and spend all your time and money pursuing me in court, I’m judgment proof anyway.” At that point most plaintiff lawyers are going to recommend to their client that they accept available insurances or a nuisance value settlement. Rarely will the plaintiff’s lawyer be so bold as to ask “when did you become insolvent and will I be able to set it aside?” The natural answer to that, however, would be “that’s for me to know and you to find out and good luck ever touching my assets.”

Notwithstanding mistake number 3 described above, clients are well advised to have their estate planning and asset protection coordination finished well before any reasonably expected circumstances arise which cause liability. For example, an estate planner doing an estate plan for a neurosurgeon should of course have the neurosurgeon completely judgment proof as a part of the planning objectives. Failure to do so will expose the estate planner to malpractice liability.

As with many areas of law, the rules concerning exempt and non-exempt assets, rights of lienholders, and fraudulent transfer rules can be quite challenging. Simply reading the exemption statute of a particular state or a short treatise excerpt falls short of the due diligence that needs to occur before a client is advised as to creditor exemption planning. Not only is it important to understand the case law in these areas, but quite often there are Achilles heels in factual scenarios which have not yet become the subject of case law.

A good example of this is the Florida Wage Exemption Statute. This statute provides that the wages of the primary earner in a family are protected from creditor claims as an exempt asset for up to six months if not commingled with other assets. The statute specifically provides that an independent contractor’s earnings can qualify for this exemption. But case law in Florida has held that where the debtor is a “controlling shareholder” of the company that he or she works for, the ability to “manipulate” between dividends and wages opens the statute up to too much abuse to provide any protection. Therefore, in one published decision, a dentist who was a 50/50 shareholder in a dental practice and whose wages were based upon his personal productivity less a fair share of the overhead was deprived of any protection under this statute.

Notwithstanding this, an almost identically worded statute in California has been held to apply even where a well known entertainer had a solely-owned production company and designated revenues from entertainment related endeavors to be wages. Also, some conservative bankruptcy lawyers believe that monies from a wage account transferred to another form of exempt asset within one year of bankruptcy could trigger the Fraudulent Transfer rule that applies under the Bankruptcy Code.

Many individuals in tenancy by the entireties states (and their lawyers) have been surprised to find that where one spouse files bankruptcy and there is joint debt, joint assets can be brought into the bankruptcy estate notwithstanding the “absolute protection” of tenancy by the entireties. Other debtors have found out that putting the mother-in-law on the joint account as an additional signer can also invalidate tenancy by the entireties.

Debtors filing with pension plans have found that the “absolute protection” provided to qualified plans under the Shumate decision will not apply if there is a technical flaw with the plan that would cause it to be disqualified for income tax purposes, or the debtor and family members are the only participants in the plan so that ERISA protection does not apply.

The treacherous nature of the exemption rules and the fast developing exceptions thereto make it very important for the estate planner to confer periodically with well versed and active bankruptcy counsel. Another example is the statutory protection of annuity and life insurance contracts. When these statutes were passed, there was no such thing as a variable annuity, so a Florida bankruptcy court decision found that variable annuities were not really annuities
as defined by the statute.

This was overturned by the Florida Supreme Court, but another way around this type of statute was found by a creditor in New York where a husband and wife each had life insurance on one another. The New York court in Jacobs apparently found that the debtor husband was not really the owner of his own policy because of the reciprocal arrangement with his wife. See Steve Leimberg’s Estate Protection Planning Newsletter of August 23, 2001 at Leimberg Information Services (www.leimbergservices.com). Once logged in, click on the Asset Protection tab and go to Commentary 8

We have found that oftentimes there are creative solutions to planning challenges that are simply “not thought up” by initial advisors.

The process used in evaluating alternative strategies that may not be readily apparent initially, and the use of basic creativity often involves brainstorming with other professionals, investigation of alternative strategies that at first may not seem useful, review of estate planning and business considerations and alternatives, and sometimes “making things complicated” so that they would not be easily understood by a plaintiff attorney. For example, what can be done with S corporation stock? It needs to be owned by an individual or a qualifying grantor trust to retain the S election, and a foreign grantor trust will not qualify as an S corporation shareholder. S corporation stock can also be owned by a defective grantor trust, but a gratuitous transfer of that stock may be considered to be a fraudulent transfer.

Such stock could be sold at arm’s length in exchange for a long term promissory note, and a creditor is going to be less than excited about receiving a long term promissory note. A promissory note can be sold at arm’s length at a later time, perhaps taking into account a discount. If the client has a shorter than normal life expectancy, the receipt of a private annuity as consideration under this type of arrangement can have a further positive estate tax planning result. Also S corporation stock can be made to be non-voting, and selling a 1% voting interest in S corporation stock to a trusted third party can yield positive estate tax planning results.

Oftentimes banks would like to have liens on assets and entities that may have creditor protection issues. For example, if a physician’s wife owns a building subject to the mortgage, upon refinancing, better terms may be obtained if the bank also receives a lien on the medical practice corporation assets. If the medical practice were to go bankrupt, the doctor’s spouse could buy these assets and the bank could apply the proceeds to pay down the mortgage loan. The personal injury lawyer and their client would be out of luck and unrewarded for pursuing the medical practice – they should settle for limits of coverage.

It is obvious from the above that there are a great many decisions that have to be made and strategies that could be considered in asset protection planning. Obviously, many planners given the same factual scenario would implement significantly different plans. Whose decision should it be as to whether a client will pursue offshore asset protection, get married and put assets as
tenants by the entireties, ignore a situation, or file a Chapter 7 bankruptcy before a judgment is even entered against them?

Educating the client as to the general rules of application, the different strategies available, and the risks associated with each strategy constitutes the best way to assure that the plan chosen is the best one to suit a particular client. This is also the best way to help avoid a malpractice action later on up the road when the client might question why a particular strategy was taken and another particular strategy was not pursued. The planner should keep in mind, however, that if the client files a Chapter 7 bankruptcy, the trustee in bankruptcy has the right to review any and all otherwise privileged attorney-client correspondence, so the “CYA letter” may provide a roadmap to creditors and could be detrimental to the client and the planner.

Nevertheless, characterizing the nature and value of assets as revealed by the client and documenting the file with respect to assets that will be retained after certain transfers may be made can help to prove expected solvency to occur after a transfer in order to help defend allegations of fraudulent transfers. Having the client obtain a second or even third and fourth opinions as to the plan to be pursued can be a good strategy as well.

When filing for bankruptcy the debtor needs to disclose on the application all lawyers consulted within one year of filing and the primary reason for the consultation. It may therefore be advantageous for the client to hire bankruptcy counsel, and for the bankruptcy counsel to bring in sub-specialists through his or her office. This allows the estate planner to maintain contact and continuity of communications throughout the process.