July 2004

Asset Protection Planning in a Nutshell

(Learning about DAPTs and Nevis)

            The U.S. Supreme Court recently decided a case about the scope of the federal pension law’s protection of a person’s retirement plan from his creditors.  The ruling is hardly a landmark, as it merely confirmed what most understood the law to be anyway.  Nonetheless, the case adds to the hysteria we've all been hearing about "asset protection."

            I heard on the radio recently that for the modest cost of the audio tapes and the home study program, I can earn thousands of dollars every month as an "asset protection consultant."  I learned from those ads that last year "$167 billion was paid to settle frivolous lawsuits,” and that IRS tax liens are “up 400%.”  All this, of course, must be true, since it was on the radio. 

            The “asset protection” industry is huge.  I did a Google search of “asset protection” and got over 2.5 million hits. 

            All the hype and hysteria aside, asset protection planning is an important part of wealth management.  In the past year I have had many clients, mostly doctors, other professionals, and businessmen, ask about insulating their assets from lawsuits, ex-spouses, the IRS, and creditors.  

            In this memo I'll summarize your choices and tools for protecting assets.   I think you will find that we can do many things, some of them with little or no cost, to provide all the protection we realistically need.

            Asset protection techniques fall into two general groups.  The first group includes basic steps that everyone should consider.  They are simple, inexpensive, and flexible.  The second group includes the exotic techniques with limited application for most of us. 

Basic Protection Steps

            Use Qualified Plans      A client's first line of defense is his qualified retirement plan, such as a pension, profit sharing, or 401(k) plan.  However, the protection of a qualified plan from a participant’s creditors is not entirely bulletproof.

            The protection comes from ERISA, the federal pension law.  A participant's money in a qualified retirement plan cannot be taken by his creditors, even in bankruptcy.  There are several important exceptions.

            First, the IRS can seize the participant's retirement plan for unpaid taxes.  I have recently heard that other federal agencies are portraying their claims against individuals as a "taxes" in order to sneak in under this exception.  They are putting a saddle on a cow and calling it a horse.

            Second, if the qualified retirement plan is established by a sole proprietor, or the owner of a one-person corporation, and there are no employees other than the owner and his or her spouse, there is no ERISA creditor protection whatsoever.  This was confirmed by the U.S. Supreme Court in Yates v. Hendon   a few months ago.  So, a small businessman must have some other employee, other than his spouse, to get creditor protection for his qualilfied plan under ERISA.

            Third, a qualified plan is not protected from domestic relations claims in cases of divorce and child support.

            Fourth, the ERISA protection does not cover IRAs.  However, protection for IRAs may be available under state law.  New York, South Carolina, Florida, and North Carolina all have statutes that protect IRAs.  But, that protection in not necessarily complete, as each state has special rules and exceptions.  Also, state law may treat conventional IRAs differently from Roth IRA, SEPs, education IRAs, and SIMPLE IRAs.  

            Make Transfers to the "Low Risk" Spouse    Putting assets in the name of the "low risk" spouse is another first line of defense.  (My wife loves this one.)  For example, if the husband is in a high risk business, putting the home, investments, and bank accounts in the name of his wife alone insulates them from his creditors.  Transfers to spouses are free of gift tax.  In the event of divorce, title to assets is not controlling under the "equitable distribution" rules.

             The timing of transfers to the spouse is critical because of laws on "transfers in defraud of creditors."  All states have rules that disregard asset transfers if they were made with the intent to avoid creditors.  These laws are complex, and attorneys for creditors are smart and aggressive in using them.  As a broad general rule, however, a transfer to a spouse might be challenged by an existing creditor, but it would probably withstand attack from a future creditor.   So, re-title assets sooner rather than later.  If the creditor is already out there, you’re probably too late.   

            Get "Umbrella" Insurance       Again, this is a first category defense that everybody should have.  "Umbrella" insurance is the nickname for "excess liability insurance."  This type of insurance will protect you from huge judgments arising from home ownership, auto and boat accidents, and the like. 

            You may have automobile liability insurance of $300,000.  If you cause an accident that results in a $500,000 judgment, the insurance company will cover the first $300,000 (i.e., the limits of your policy), but you're on the hook for the $200,000 excess.

            An "umbrella" policy covers the excess.  Umbrella insurance is cheap.  You can buy $1 million excess liability coverage for a few hundred dollars each year.  Umbrella insurance is generally purchased from the same company that insures your home and auto.  I recommend at least $3 million of umbrella coverage, and more if it is available. 

            Move to Floridaand Buy a Home    Some states have a "homestead" exemption that protects a principal residence from creditors.  North Carolina and South Carolina have very limited homestead exemptions, and New York has none.  Florida, on the other hand, has an unlimited exemption for a primary residence.

            Use an LLC for Real Estate    If you own rental or recreational real estate, putting it into a limited liability company, or "LLC," affords another level of protection over and above insurance.  In the event of a disaster with the real estate, only the LLC assets are at risk, not the other assets of the LLC owners.  LLCs are easy to set up, and because they are "pass through" entities, they pay no separate income taxes.  LLCs are preferable to corporations for owning real estate.

More Complicated Protection Measures

            Let’s take a look at the more complicated, and expensive, assets protection techniques.

            Family Limited Partnerships     The "family limited partnership" ("FLP") is a popular estate planning technique.  FLPs are complicated and expensive, but they work very well in the right circumstances.  One of the features of the FLP is that it gives some, but not complete, creditor protection.

            Recent favorable tax cases have made FLPs an even more popular estate planning tool.  Creditor protection is generally an extra benefit of the FLP, but not the principal reason for creating one.  FLPs should be used only after a great deal of analysis and thought.

            "Self-Settled" and "Spendthrift" Trusts    A "self-settled trust" is a trust created by someone for himself.  If I put my assets into a trust for my benefit, it is "self-settled."  On the other hand, if I put my assets into a trust for the benefit of my children, it is not "self-settled."

            A "spendthrift trust" is a trust that, by its terms, cannot be taken by the creditors of a trust beneficiary.

            As a general rule, a self-settled trust will not protect the person creating it.  I cannot create a spendthrift trust for my benefit to protect my assets from my own creditors.  Many asset protection scams use self-settled spendthrift trusts, which do not work. (However, see the discussion below on domestic asset protection trusts.)

            If I wish to protect my adult children from their creditors, I can fund a trust for their benefit with "spendthrift" provisions.  These kinds of trusts are quite common, for example where a client wants to protect a child who is in a bad marriage.

            Domestic Asset Protection Trusts    Some states, to compete with off-shore trusts and attract new business, have passed special laws authorizing self-settled spendthrift trusts.  These are known as "domestic asset protection trusts" ("DAPTs").  The states that allow them include Alaska, Delaware, Nevada, Rhode Island, and Utah.  These trusts have a legal advantage over their off-shore cousins because under the U.S. Constitution, each state must give "full faith and credit" to the laws of the other states.  So, the theory goes, my New York creditors cannot grab the assets I put into my Alaskan asset protection trust.

            These trusts may sound better than they are.  They are generally irrevocable and require a bank trustee in the state authorizing the trusts.  The client gives up most of the control of the assets.  These trusts are expensive.  They can protect against the client's future creditors, but not past creditors.  Further, because they are so new, there has not been much experience in whether these trusts will, in fact, give the protection they advertise. 

            Off-Shore Asset Protection Trusts    Now we are on the fringe.  Many countries, some of which you may have even heard of, have laws that encourage financial privacy and hiding assets.

            Off-shore trusts work, but they are very expensive.  I am told that start up costs are in the $50,000 range, and annual expenses thereafter may be one half of that.  You would need a minimum of $5 million for an off-shore trust to justify the expenses.

            The off-shore locations include the places you've heard of --- Bermuda, Isle of Man, Liechtenstein, and the Cayman Islands.

            There are also some newcomers, such as the Cook Islands, the Turks and Caicos Islands, and Nevis.  Nevis?  Nevis a 5 mile by 7 mile island in the West Indies, 200 miles south of Puerto Rico.  Prior to its jumping into the asset protection business, Nevis was famous for two reasons.  First, Columbus sailed passed Nevis in 1493 (not stopping, one presumes, because he had no assets to hide).  Second, in 1757 Nevis was the birthplace of Alexander Hamilton, our country's first Secretary of the Treasury.  I suppose it is only fitting that Nevis enter the financial services arena.    

            Conclusion     Asset protection planning is a part of estate and wealth planning.  For most clients, the steps in the basic category should provide all the protection that is necessary.  For others, where the risks are greater and the stakes are higher, a more complex approach --- including a trip to Nevis --- may be the answer.