Asset Protection Strategies For Business Owners With A Twist
By: Randall A. Denha, J.D., LL.M.
Asset protection is not just for business owners. It reaches into all aspects of wealth preservation and estate planning. However, in most cases, business owners are on the front lines of this battle because the act of offering services to the general public can be a risky proposition. As such, this piece will focus on asset protection for business owners and businesses, and will also offer some guidelines for non-business owners, retirees and families alike.
Asset protection is a form of legal planning that incorporates other types of legal planning and fields such as management of risk. Asset protection planning is used by business owners to provide a good defense against creditors and litigants. Asset protection refers to the use of risk management products along with legally acceptable solutions to prevent a person’s wealth from being taken unjustly.
The United States is the most litigious society in the world. Expanding theories of liability have translated to a general belief in society that somebody must pay for every wrong, even if the person who must pay had no direct cause for the wrong. The US court system is available for anybody to file suit against anyone. You don’t even need to have a strong case; you just have to pay a small filing fee to get the ball rolling. Just hobble together something that appears like a legal claim and see if you can win an easy settlement. This is what many plaintiff’s lawyers do, because there is no downside. It’s easy to file a case and there is rarely any punishment for filing frivolous lawsuits.
You may be a target of these frivolous lawsuits if you appear to have assets that can be taken, or if you are a successful professional with high earnings like somebody in the medical field. You can reduce the chances of being a lawsuit target by doing some planning before you get into legal trouble. This type of planning generally involves 1) making yourself look poor (i.e. increasing privacy by removing your name from public databases, and; 2) moving your assets into protective structures like trusts and LLCs.
Timing is an important consideration if an asset protection plan is to be effective. While you can do some things after the filing of the lawsuit, it is always advisable to have the strategies and plan in place before they are required. One of the best ways to look at asset planning is to take it as a form of pre-litigation planning.
Asset Protection Strategies
Successful business owners can use a wide variety of asset protection strategies. High-quality liability insurance is usually the starting point. However, successful business owners have other advanced asset protection strategies that they can use including:
1. Equity Stripping With A Related Entity
It refers to the reduction of equity in a property such as a business. By reducing the amount of equity a successful business owner holds, he or she increases the chances of the assets not being included in a lawsuit. The successful business owner is still able to use cash flows from the assets. So, in the event of a creditor calamity, the lender having a lien on corporate assets will be paid first to the extent that money is owed and secured by the assets of the company. For example, while a typical investor with $1,000,000 of real estate might have bank financing of $700,000 to $800,000, a comparable family business or investment entity may have no debt. Consider having that entity owe another family-related entity or trust, at arm’s length and secured by the assets of the family entity, a debt. This may assure that in the event of a claim against that family business or investment entity, the family members or trust holding debt owed by the entity to them could be paid from a forced sale of the entity assets before a judgment creditor would be paid.
What about a client owning a business or professional practice? A few options are available. First, a client owning a business or professional practice could guarantee debt that is owed by a related party. For example, the business or professional practice entity might guarantee a mortgage owed on real estate that is leased to the business or practice or even having the tenant’s assets pledged as additional collateral for the loan so that in the event of a claim the bank holding the mortgage on the leased property would be able to call the loan and force a sale of the assets of the business entity or professional practice, resulting in the proceeds from sale reducing the amount of the mortgage on the real estate, and not being available to the creditor holding a judgment against the business or practice entity.
Another approach might be to have the business entity enter into a long-term lease with the landlord entity, and provide a lien against the corporate assets so that the landlord entity would be able to accelerate rents to be owed significant monies and force the sale of business or professional assets to pay for the accelerated rents. For example, the lease might provide that in the event of default all future rents during the lease term shall be accelerated.
Finally, the professional practice or business could divide both assets and activities so that the operating entities and more passive entities (i.e. equipment leasing) would not be subject to a lawsuit or other cause of action.
2. Private Placement Life Insurance
Private placement life insurance has been around for decades, but its growing appeal is due in part to the changing industry dynamics. Certain top of the line money managers can more easily provide certain investment expertise to clients within a life insurance policy. The wealth taken out of the business can be invested in such a way that owners and investors can keep the money out of the hands of litigants and creditors. Private placement life insurance is one example of this. Private placement life insurance refers to where alternative investments are tagged under a life insurance banner. This approach offers considerable tax benefits which allow investments to grow tax-free within the insurance wrapper until they are distributed or withdrawn from the policy. It can provide meaningful asset protection from creditors and litigants depending on the jurisdiction.
3. Captive Insurance Companies
Successful business owners find captive insurance companies quite appealing. They are created to help businesses insure themselves against certain risks. Captive insurance companies provide the benefit of asset protection along with the following benefits:
– Insuring risks that would have otherwise been too costly or otherwise uninsurable risks.
– Potential savings because of access to the reinsurance market
– Wealth accumulation capability in a tax-advantaged structure
– Tax deductions of the insurance premiums
A captive is a unique insurance company. It includes its own corporation, insurance license, reserves, policies, policyholders, and claims. It is a formal way for business owners to self-insure risk, and captives are generally formed to insure primarily though not exclusively the risks of one or more businesses owned by the same or related parties.
There are almost no circumstances where a captive insurance company would be liable for its actions. Likewise, there are almost no circumstances where a business or business owner’s creditors would be able to level a claim against a captive insurance company. In a matter of speaking, a captive insurance company is like an innocent bystander that is lawfully disassociated from the business and its owner in matters of liability.
4. Qualified Retirement Plans (“QRP”)
Qualified retirement plans can be highly effective asset protection plans. However, complications arise since most successful business owners find it difficult to amass significant amounts of money in such plans. Retirement accounts may be protected from the claims of creditors. However, the protection differs depending on whether the account is a qualified retirement plan, a pension plan or an IRA. It also depends on whether the creditor action is one in bankruptcy or non-bankruptcy.
Internal Revenue Code Section 401 governs QRPs. Such plans constitute a stock bonus, pension or profit-sharing plan of an employer for the exclusive benefit of employees. A Section 401(k) QRP is a type of plan that falls under this category. With QRPs, employees save for their own retirement in a separate account.
A U.S. Supreme Court case dealt with the creditor protection of a debtor’s retirement accounts. The case, Patterson v. Shumate, held that a participant’s interest in a QRP also governed by Employee Retirement Income Security Act of 1974 (“ERISA”) was excluded from the participant’s bankruptcy estate and couldn’t be used to satisfy the claims of the participant’s creditors. The court invented a term, “ERISA-QRP,” but didn’t define that term in its ruling. This failure to define the term has led to a great deal of confusion. Although the Court concluded decision in a bankruptcy context, a non-bankruptcy situation should yield the same result.
5. Offshore Asset Protection Trusts & Domestic Asset Protection Trusts (“DAPT”)
Offshore asset protection trusts can be used for asset protection but require professional intervention to ensure that they are established and managed in the right way. The effectiveness of such trusts depends on how hard it is to obtain assets and get a judgment. It is critical to choose the correct jurisdiction in which to establish the trusts. DAPTs cannot be created everywhere. The laws of about 17 states permit them. The most popular of these states have been Delaware, Alaska, Nevada and South Dakota, although the laws of some more recent states may also be favorable, like Michigan. Because most states still do not permit DAPTs, the trusts must be created in one of these states using a trustee in that state. Here is how a DAPT works:
1. The trust is domestic rather than international. In other words, it’s set up in the United States. There are offshore asset protection trusts, which have their own set of issues. But domestic trusts cost less to set up and administer and are not subject to the political and other risks of offshore jurisdictions.
2. The trust doesn’t allow the beneficiary to assign their interest in the trust to someone else. In other words, it includes a “spendthrift” clause which allows for asset protection.
3. The trust doesn’t provide a standard which allows a creditor to force the trustee to make a distribution to them. In other words, the trust is typically completely discretionary. A trust with an ascertainable standard, like a trust with a distribution standard like “health, education, maintenance, and support” would allow a creditor (standing in the shoes of the beneficiary) to force the trustee to make distributions falling within that standard.
4. The trust is self-settled. In other words, the assets going into the trust came from one of the permissible beneficiaries of the trust. In most states, such a trust can be pierced by a creditor of the grantor/beneficiary, i.e., the person setting up the trust. However, the current laws in all 17 states which permit DAPT’s, the creditors cannot do so, as long as the rules have been followed.
The Bottom Line
Successful business owners have a variety of effective asset protection strategies at their disposal. Irrespective of the choice of asset protection strategy, it is important that they address other legal and financial concerns besides asset protection and that their use is customized to the needs of successful business owners.
