By: Randall A. Denha, J.D., LL.M.
“It wasn’t raining when Noah built the ark.” The point of this quote is to get you to begin thinking about what to do now relative to your estate planning. A typical estate plan does not ordinarily implement strategies to protect you in the event of a creditor attack. To be effective, such defensive estate planning or “asset protection” planning must be done prospectively (before there is a real threat of litigation) and conservatively (that is, any attempt to shield too many assets with one technique could result in none of those assets being sheltered). The goal is always to safeguard future earnings and assets through legitimate planning techniques.
Most states have what is called a “fraudulent conveyance” statute. Such statutes are designed to help creditors collect lawful debts by providing remedies to creditors whose collection has been hindered by debtors who have transferred assets. Not every transfer of an asset by a debtor who knows that it owes a creditor or creditors is necessarily a fraudulent transfer. If transfers are not done in compliance with the law, and a creditor can prove that a transfer was “fraudulent,” the creditor may be able to set aside the transfer, and to collect against the transferred asset.
Nonetheless, many states have exempted certain transfers from the application of fraudulent conveyance statues, including such transfers involving certain estate planning techniques, qualified benefit plans, IRA accounts, certain trusts, and various business transfers.
A proper asset protection strategy often involves the use of estate planning techniques. These techniques should (1) be undertaken before there is any threat of a creditor claim; (2) be motivated by legitimate estate planning purposes and not simply to protect assets; and (3) not involve too large a percentage of the individual’s net worth. Such techniques include:
- use of a spousal trust;
- use of family limited partnerships and LLCs;
- use of irrevocable life insurance trusts;
- use of “charitable” trusts;
- use of joint tenancy between spouses;
- use of gifting techniques to spouse and children; and
- use of “upstream” estate planning (that is, having parents structure gifts to a creditor‑conscience child in some protected form), so that the inheritance stays in a trust protected by a “spendthrift” clause.
Life Insurance & Annuities
Life insurance and annuities may be used for asset protection as well as estate planning. Both federal and state laws include some exemptions for the cash value or the proceeds of life insurance. As with other exemptions (like wages, homestead), the amount protected from creditors varies from state to state. With annuities, not every state protects them from creditors, and the ones that do vary in terms of the amount protected and under what circumstances. For example, in Michigan there is a seeming incompatibility between the statutory law and the case law (court-based law) in Michigan. In MCL 500.2207(1) it says that the proceeds of any life insurance policy payable to the wife, husband or children of the insured or to a trust for their benefit, including the cash value thereof, is exempt from claims of the insured’s creditors (read it by clicking here). However, there are cases that have permitted a creditor garnish the cash value of the insured (debtor’s) life insurance policy.
There are two basic types of life insurance, term life, in which you pay only for a death benefit, and whole life, in which you pay additional money, which builds up as savings. Exemptions in most states protect at least some of the value of your policy from creditors’ claims. Upon your death, in most states, the proceeds can pass to your beneficiaries free of any claims of your creditors. In some states, property that is purchased with the proceeds of a life insurance policy is also exempt.
There are exceptions to the protections, however. In a few states, a life insurance policy is exempt from creditors’ claims only if the beneficiaries are the spouse, children or other dependent(s). In some states, if the owner of the policy has the power to change the beneficiary, the proceeds are not protected. Additionally, even if a policy is originally exempt, the protection can be lost by:
Assigning your policy to a creditor. Note that often loan papers prepared by banks contain clauses that can give the bank a right to your life insurance policy. Read the fine print!
Buying a policy and paying the premium for it when you are insolvent. This would constitute a fraudulent conveyance and, if challenged, be found nonexempt.
Extra asset protection may be provided if you place your insurance policy in an irrevocable life insurance trust. With this type of trust, you transfer either an existing policy or the funds to buy one.
Annuities offer another option for protection from creditors’ claims in some states. An annuity is an agreement whereby a person is to get a sum of money regularly over a period of years. There are fixed annuities where the amounts are determined in the beginning, and variable annuities where the amount to be paid out depends upon the return on investment. To set one up, you can pay a lump sum, or you can make periodic payments. They are useful in asset protection planning because they are exempt from claims in several states. The exemption ranges from a few hundred dollars in some states, to an unlimited amount in others. In some states, all annuities are exempt, while in others only annuities payable to one’s spouse, children or other dependents are exempt.
State law also defines creditors’ ability to collect against annuity assets, and there, the provisions are much more varied. In some states, annuities are treated as being similar to IRAs and other retirement accounts, with the result being almost complete creditor protection. You’ll often find additional provisions that provide exceptions to this general rule that apply in cases of potential abuse, such as buying an annuity immediately before declaring bankruptcy or becoming insolvent. In some states, such as Florida, annuities have especially strong protection. In one case, a woman who was injured in an auto accident had her million-dollar settlement structured as an annuity. Years later, she caused an accident and injured someone else. Her victim was unable to get anything from her beyond her liability insurance policy.
Besides asset protection, another benefit available with annuities is the tax-free compounding of the investment, since the interest is not taxable until it is paid out. It is like an IRA but with no limit on the amount you can contribute.
Insurance can be a very useful tool for asset protection. It is designed to transfer the risk of loss away from the insured person and to the insurance company in exchange for a relatively inexpensive fee – the premium. The purpose of insurance is to manage your risks with asset protection as a secondary role.
If you are at risk of being sued, you should purchase as much insurance as fiscally practical. The goal is to create a scenario where a plaintiff and his or her attorney are very likely to accept the limits of the insurance coverage in settlement of a claim, even if the plaintiff’s potential recovery is greater than the limits. The focus should be on the insurance company rather than on the defendant. At the very least, every company should have a general liability policy and every household should have umbrella coverage in addition to homeowner and auto liability policies.
Why Insurance Alone Isn’t Enough
Insurance, however, is not a perfect answer. One problem is that it may not be enough no matter how much you get. An unforeseen accident may result in a multi-million dollar award. Such awards have become more commonplace in recent years.
If you have large assets, you may want to get an umbrella policy with $5 million in coverage, but even that may not be enough protection. Don’t misunderstand; insurance should never be overlooked as a means of protection. The many claims it does cover may save you a lot of money (and aggravation). Just be aware that total reliance on insurance may be foolhardy because it does not cover all possible liabilities or provide unlimited dollars to cover claims made against you. Read your policy—you are not covered for everything!
Despite these limitations, be aware, that a great benefit of insurance is that the duty of an insurance company to defend (pay for your legal defense) is much broader than its duty to indemnify (pay for a judgment against you). Legal fees alone can be very expensive. Keep plenty of insurance, but be ready for anything.
ERISA Retirement Plans
Federal bankruptcy law provides full protection for contributions to pension plans, profit-sharing plans, 401(k) plans, 403(b) plans, and Section 457 deferred compensation plans – whether the debtor elects state or federal bankruptcy exemptions. Bankruptcy law also shields assets held in SEP-IRAs, Simple IRAs, traditional IRAs and Roth IRAs. Therefore, an individual can roll assets from a qualified plan to an IRA with full protection from creditors. But the amount of traditional IRA and Roth IRA assets protected is limited to $1 million (adjusted for inflation) in the state of Michigan
By keeping two separate IRAs, it will be easier to identify IRAs with unlimited protection (rollover) from those subject to the $1 million limitation (traditional and Roth IRAs). In a nonbankruptcy context, Michigan law protects one IRA (including a rollover IRA) along with all qualified retirement. If your retirement plan is qualified under the Federal Employee Retirement Income and Security Act (ERISA), your ownership in the plan is exempt. No third party is able to get to retirement funds held in ERISA qualified plans. This makes an ERISA qualified plan an excellent asset protection technique.
From an asset protection standpoint, you should consider maximizing the earnings that are placed into your ERISA retirement plan. In addition to the deferral of income tax, you obtain substantial protection against creditors while the funds remain in the retirement plan. In most instances, funds are protected until they are distributed out of the retirement plan and placed in your hands.
Domestic Trusts & Entities
If you want to protect your cash and other assets from vexatious litigants, a grasping ex-spouse or pesky creditors, then offshore trusts and other entities are a good option. However, there are similar domestic techniques that can provide ample protection against such creditors.
In fact, over the past few years many states have passed new trust laws favorable to debtors. New Hampshire became the twelfth state to allow what are commonly referred to as “self-settled” trusts. As the competition has intensified, states have been tweaking their laws to make them even more favorable to debtors. Currently Alaska, Delaware, Nevada and South Dakota have the most trust business and the most pro-debtor laws.
These aren’t the garden-variety trusts set up for the benefit of your heirs. These are “self-settled” trusts, meaning you put the money inside the trust while still benefiting from such assets. But after a certain period of time your creditors can’t get at these funds. If you file for bankruptcy, a federal court can retrieve assets you’ve transferred during the previous ten years, if the intention was to avoid creditors (a “fraudulent conveyance”). Outside of bankruptcy, however, these states give past and future creditors a much shorter period to get at assets after they’ve been put into a trust. Nevada, the most debtor-friendly state, provides creditors just two years. Moreover, unlike other states, it doesn’t give ex-spouses any special rights to get at the money for alimony, property settlements or even child support.
So do asset protection trusts work, and which locale works best? The answer depends on when you transfer funds (always best to do so before you’re sued or incur a debt); how wealthy you are; what is your occupation (high risk); where you live; where you’re willing to live; in what do you invest; and your definition of what kind of protection is needed.
Generally, a trust works if it makes it hard–even if not impossible–for someone to find or seize your assets. The idea is to put up a wall that looks so impenetrable it forces a creditor to either go away or settle for pennies on the dollar.
For most of our clients, we recommend wide diversification in their asset protection plan. A diversified strategy makes it harder for a creditor if they have to fight the battle on several different fronts.
For business related assets, its important to have a legal structure that limits the liability of its owners. The legal structure of your business is extremely important. State law enables you to create a legal entity – a separate “identity” from your own person – under which you can transact business, without the risk of exposing your assets to any personal liability that might arise out of your business affairs.
Family Limited Liability Company
The principal advantages to making gifts of membership interests in a family limited liability company (“FLLC”) are control and flexibility. The debtor transfers to the FLLC those assets to be gifted/protected and then makes gifts of non-voting membership interests to family members (or to trusts for their benefit). As the manager of the FLLC, the debtor has complete power and authority to manage the FLLC’s assets. The non-voting members have no voice in the management of the FLLC, and cannot withdraw their share of the FLLC’s assets without the manager’s consent. Another benefit of making gifts of FLLC membership interests is that they may be subject to “valuation discounts” for lack of control and marketability, thereby “leveraging” the debtor’s $14,000 annual gift tax exclusion and $5,450,000 gift tax exemption.
Under Michigan law, the creditors of a member cannot reach the FLLC’s assets. Instead, a creditor’s sole remedy is a “charging order” which entitles the creditor to any distributions made to the indebted member. However, if the FLLC’s operating agreement is properly designed, the manager has the power to withhold distributions by retaining profits within the FLLC. In such event, the creditor might end up with an income tax liability without the cash distributions to pay the tax. Because of this potential for “phantom income”, the creditor may be willing to settle the claim on a favorable basis with the indebted member.
An FLLC can be a powerful estate-planning tool as well as an asset protection tool that may:
- Help reduce income, estate and gift taxes
- Allow you to transfer an ownership interest to other family members while letting you keep control of the business
- Help ensure continued family ownership of the business (family succession)
- Provide liability protection for the member(s)
- Provide both protection from creditors and flexibility because it can be amended
- An FLLC also protect assets from claims of future creditors and spouses of failed marriages. Creditors may not force cash distributions, vote, or own the interest of a member without the consent of the Manager or Voting Member. In the event of a divorce where a member ceases to be a family member, the partnership documents can require a transfer back to the family for fair market value, keeping the asset within the family structure.
There are several other advantages to organizing your business as an FLLC:
- At death, only the value of your ownership interest in the partnership will be included in your gross estate.
- The use of the partnership entity allows you to shift some of the business income and future appreciation of the business assets to other members of your family.
- You maintain management control of the business while transferring limited ownership of the business to family members.
Foreign Trusts & Offshore Entities
For those with substantial means, and thus, larger potential creditor exposure, the best advice is to have a protection plan that is diversified. The use of a variety of protections for a person’s wealth will ensure that at least some of it will be safeguarded from creditors.
The Foreign Trustee – Stopping Creditors from Accessing Funds
One tool commonly used to provide a high degree of asset protection is the offshore foreign trust. Many foreign locations have laws that insulate and protect the grantors who set up such trusts. Basically, when establishing a foreign trust, ownership of the assets is transferred and placed into the trust, and the trust is then managed by a foreign trustee. While there are common destinations for these trusts (Bahamas, Bermuda, the Turks and Caicos Islands, the Cayman Islands, the Cook Islands, Gibraltar, and the Isle of Man), many other countries have extremely good trust laws.
Should creditors come after a person’s assets, even if they were to discover the offshore trust, they will still have to deal with foreign trustees in order to access them. If the trustees are uncooperative, the creditors may find that they have no remedy. The United States courts have no jurisdiction over foreign trustees, as long as they have no offices or agents in the United States. In addition, the physical distance between creditor and foreign trustee may also be a barrier to the creditors.