In this, the third installment of the “Taming the B.E.A.S.T.” series, we will be expounding on the “A” – Asset Protection for the entrepreneur.
Once overlooked when discussing the planning needs of the entrepreneur, now asset protection has emerged as a fundamental piece of the core plan. Indeed, asset protection has evolved into its own discipline in law, and many advisors, including the author, believe it is malpractice when estate planning attorneys fail to address asset protection options when providing estate planning services. After all, even the most elegant estate planning documents are rendered meaningless if the decedent has been sued and lost all of his or her estate assets prior to death.
Not surprisingly, when entrepreneurs are given the alternatives of having assets exposed to creditor attack or insulated from attack, they opt for insulating the assets. A key problem is that most clients are not aware which assets are exposed, and most estate planners are not aware of the asset protection solutions available to solve the problem.
For the entrepreneur, in addition to carrying sufficient insurance and conducting one’s affairs in a manner that minimizes risk, there are generally two components to a proper asset protection plan: 1) business protection, and 2) personal protection. Each needs to be adequately addressed, for one overlooked area could jeopardize the other.
First, with respect to business matters, to be clear, no entrepreneur should be operating as a sole proprietor or in a general partnership with another. These forms of business expose the owner to unlimited liability for claims against the business. Corporate law exists, and has continued to evolve, to ensure that those who run businesses can separate the liability of the business from one’s personal affairs and assets. Entities that provide this insulation are called limited liability entities.
In this regard, a wide variety of company forms have been created in law to allow for the isolation of business liabilities, including: 1) C corporations, 2) S corporations, 3) limited partnerships, 4) limited liability partnerships, and 5) limited liability companies. Each has its own merits, and unique tax treatment, but all provide the same key benefit – they should prevent a creditor of the company from attacking the owner’s personal assets in the event of a lawsuit. Properly formed and implemented, the limited liability entity creates a “veil” between the business and the owner, and in the event the assets of the business are insufficient to settle the claim of a creditor, the business simply goes bankrupt. The owner is not on the hook personally and therefore has limited liability.
In addition, as the business succeeds, a single entity may not be the optimal solution. The larger the asset base of the entity, the more of a target it may become. Therefore, to minimize potential loss, it is often advisable to use multiple entities to own separate assets of the business. For example, substantial real estate, intellectual property, or equipment is usually placed into its own dedicated entity and leased, licensed, or otherwise contracted for the benefit of the primary operating company. In this manner, a lawsuit against the operating company should not adversely impact the property that has been stripped out. The operations can simply be bankrupted, a new operating company formed, and the assets can be redirected to the new company. Once the overall asset base of the operations reaches an uncomfortable critical mass level, the idea of setting up additional companies should be explored.
Second, as profits of the successful entrepreneurial venture are taken off the table and distributed to the owner, the protective shield of the business is now meaningless as the asset is converted from a corporate asset to a personal asset. Therefore, to ensure that such assets are actually preserved, it is imperative that each entrepreneur develop a personal asset protection structure to properly receive such assets.
Personal asset protection planning breaks down into two steps:
o Step 1 – Maximize exempt assets.
o Step 2 – Transfer non-exempt assets to asset protection vehicles.
Exempt Asset Planning
Exempt asset planning under step 1 is based entirely on the laws of the state in which the entrepreneur resides. Each state has a basket of identified assets that are exempt from creditor attachment in the event one declares personal bankruptcy. Depending on the state, exempt assets may include:
1) The homestead;
2) Property owned in “tenancy by the entirety;”
3) Qualified retirement plans (i.e., ERISA plans);
4) Non-qualified retirement plans (i.e., IRAs);
5) Life insurance – cash value and/or death proceeds;
6) Annuities – cash value and/or annuity payout; and
7) Other select personal property exemptions (guns, watches, livestock, etc.).
As you can guess, since the state legislators create these exemptions under the state’s own bankruptcy act, the states vary widely on their treatment of each of the foregoing. In one state, a particular asset’s value may be fully exempt, while in another state it is afforded no protection whatsoever, and still in another state it may be a number in the middle of the two. Thus, it is important as a first step to review the exempt asset laws of one’s home state and determine which if any of the existing assets benefit from some form of exempt status. In addition, if exemptions exist under the state law for which the entrepreneur does not own such an asset, it may be prudent to convert non-exempt property into exempt property.
The general goal is to maximize one’s exempt asset holdings to the extent it is possible and financially prudent. It may not be prudent, for example, to pay off real estate simply because it is exempt if it creates too much concentration risk to the asset class or the geographic region. The main benefit to exempt assets is that they are inherently protected – you do not need to pay a lawyer to gain the protection! There are costs to the assets of course, but legal fees are avoided.
Transfer Non-exempt Assets to Asset Protection Vehicles
Once the exempt assets are maximized, then step 2 requires transferring all remaining non-exempt assets into an asset protection vehicle of some sort. This, unfortunately, does require a lawyer, and there are essentially two options to pick from: 1) the limited liability company (“LLC”), and 2) the asset protection trust (“APT”). And whereas exempt assets must be U.S. assets, LLCs and APTs may be within or outside the U.S.
Limited Liability Companies
Protection with an LLC is derived from what is known as the “charging order.” Originally established as a judicial remedy, it has now emerged as a statutory remedy dictated by the state act under which the LLC is formed. Properly applied by a court, the charging order prevents a creditor from getting into the LLC and attaching any of its assets. The creditor is limited in its remedy to “stepping into the economic shoes” of the member being sued; this means that the creditor will only receive payment if and only if the manager decides to make a distribution of profits to the member. Since the manager is usually the entrepreneur or a select family member, there is little hope of such a distribution ever being made to the creditor, and the creditor has no right to compel such a distribution. So the likelihood of recovery is bleak.
To make matters worse for the creditor, there is even the possibility with a properly structured LLC that the charging order holder will be forced to pay all of the taxes associated with the charged interest whether profit distributions are made or not. The prospects of never receiving a distribution but paying taxes on the economics along the way is usually a strong incentive for the creditor to go away or settle for a more reasonable sum.
Asset Protection Trusts
Protection with an APT stems from the trust’s “spendthrift clause.” The spendthrift clause is very simple but very powerful. It basically states that the trustee of the trust is prohibited from using trust assets to pay for any claims of a beneficiary’s creditors. The spendthrift clause was initially only permitted in trusts that were established for the benefit of a third party (such as a gift trust for a child), but are now permitted in trusts established for the benefit of oneself (referred to as a self-settled spendthrift trust). Once reserved for foreign trust jurisdictions, these self-settled spendthrift trust statutes are now available in 15 states, and growing…
The key benefit to the APT structure over the LLC is that whereas the LLC does afford a remedy to a creditor through the charging order (it just happens to be an undesirable remedy), a properly structured APT simply provides no remedy to the creditor. The creditor is barred from trying to collect on the trust or impair its assets. The main drawback to the APT is that unlike the LLC where the entrepreneur maintains control by design, the APT is an irrevocable trust that requires an independent trustee. The entrepreneur needs to assess this trade-off to determine the optimal application.
Thoughtful consideration of jurisdiction selection and careful drafting of either the LLC or the APT are required for the application to effective. The entrepreneur should seek experienced counsel to implement either of these options to protect his or her non-exempt assets. If existing counsel has not yet discussed these options with you, then they are not likely to be the right choice to represent you in this regard.
Now is the time…
Lastly, the time to seek counsel for this type of planning is always now. If you wait until you get sued, it can be too late, as you will likely be committing a fraudulent conveyance. Given the “clawback” rules found in state and federal laws, it is important that your structure be “old and cold” to withstand scrutiny and avoid the unwinding of any transfers. Acting during a time of non-duress is certainly your preferred path to protection.
By: James M. Duggan, MBA, JD