5th Apr 2016
Asset protection planning is the process of organizing assets and property to safeguard and preserve them from loss or attack by creditors. Individuals may seek asset protection for a variety of reasons:
- Financial uncertainties from engaging in a business or profession.
- Financial risk from being an entrepreneur or property owner.
- Threat of litigation.
- Unavailability of affordable, adequate, or appropriate insurance.
- Other economic and social factors.
Similar to choosing a business entity, when planning for asset protection, specific goals and objectives must be determined. Depending upon those goals and objectives, an asset protection plan can be developed and the proper methods can be utilized and implemented.
There are various methods to accomplish asset protection. Some traditional methods are as follows:
Gifts: Outright gifts provide asset protection because “if you don’t own it, it can’t be taken away from you.”
Irrevocable Trusts. A gift to an irrevocable trust can accomplish the same asset protection as an outright gift where no interest has been retained by the grantor.
Offshore Trusts. Foreign situs trusts, depending upon the jurisdiction, provide various levels of asset protection by disregarding foreign judgments and/or protecting assets from seizure.
Business Entities. Business entities (corporations, limited partnerships, limited liability partnerships, limited liability companies, etc.) can provide protection for owners from creditors of the business by limiting the owner’s liability. Some of these entities (limited partnerships, limited liability companies, etc.) can also provide protection for the business from creditors of the owners by limiting a creditor’s rights against the business.
ASSET PROTECTION ASPECTS WITH A BUSINESS ENTITY THE LIMITED LIABILITY COMPANY
There are two facets to the asset protection afforded by the use of a business entity. The first commonly known component is the “inside out” protection available to the owners of certain businesses. The second asset protection component is provided by the “outside in” protection afforded by the charging order concept which is only available to members of LLC’s and, depending upon the jurisdiction, to partners of the various types of partnerships (i.e., L.P., L.L.P.). In most jurisdictions, this second prong is available to members of the LLC but not partners of a partnership, nor shareholders of a corporation.-However, several states allow “outside in” protection to partners of a partnership.
“Inside Out” Protection
The first component, which most people are familiar with, is the “inside out” protection, commonly referred to as the “limited liability shield.” This asset protection aspect is generally available to corporate shareholders, limited partners in a limited partnership, members of an LLC, and partners in an LLP, etc. Generally, under this facet, an owner’s personal exposure for the debts of the company is limited to his or her investment in the company. Thus, a creditor of the company cannot execute upon the personal assets of the owner in order to satisfy the company’s debts. The extent of the “inside out” protection for an owner will depend upon the type of business entity and will vary from state to state.
“Outside In” Protection: The LLC
The second asset protection component is provided by the “outside in” protection afforded by the charging order concept. In most jurisdictions, this second prong is available to members of the LLC but not to shareholders of a corporation or partners of a partnership. The reason for this is because a member of an LLC does not have any specific rights in the property of the LLC and the LLC statutes are drafted so as to limit the rights of creditors.
Under the charging order concept, which is applicable in some states, such as Utah, company assets (“inside”) are protected from judgment creditors (“outside”) of owners of the business entity. A charging order is an order that allows a creditor with the means of getting at a debtor’s interest in a business entity (such as a limited liability company) and is often the “exclusive remedy” for a judgement creditor of an owner of a business entity.
A judgment creditor of a member of an LLC interest has the right to apply to a court of competent jurisdiction for a charging order. On application to a court of competent jurisdiction by any judgment creditor of a member, the court may charge the LLC interest of the member with payment of the unsatisfied amount of the judgment with interest. To the extent so charged, the judgment creditor has only the rights of an assignee of the LLC interest This does not deprive any member of the benefit of any exemption laws applicable to his or her LLC interest. Unless provided to the contrary in the operating agreement, as assignment of an LLC interest does not entitle the assignee to become, or to exercise rights of, a member.
The charging order only entitles the creditor to receive the distributions the debtor member would have been entitled to, if, as, and when such distributions are made. If no distributions are declared or issued to the member, then the creditor will not receive any monies. In a large company where distributions are regularly made, the charging order is an effective tool for a creditor to receive the money owed him or her. However, in a company where the interests are closely held or held only by family members, the charging order will not be as effective.
It is important to note that since the LLC owns the assets, a creditor has no right to obtain possession of any LLC property. Also, a charging order against a member of the LLC, nor will it affect the LLC’s licenses or permits because the creditor does not have any right to participate in the management and affairs of the LLC or to become, or exercise any rights of, a member. The LLC need not be made a party when a creditor is applying for a charging order against a member of the LLC.
A charging order should be obtained in the state where the LLC was organized. A member’s LLC interest, which is personal property, is located in the state where the LLC is formed. Thus, creditors who are seeking a charging order should bring the action in the state where the LLC filed its articles of organization. However, a creditor of a member may be able to obtain a charging order in another state under the Full Faith And Credit Clause of the U.S. Constitution if the LLC has an interest, or conducts business in that state.
Creditors can generally avoid charging orders with closely held LLC’s or family LLC’s for two reasons. First, the creditor has no right to participate in the management of the LLC unless all or a majority (depending upon the operating agreement or state statute) of the other members consent. Since in a closely held LLC the other members will not consent to the creditor participating in management. the creditor will not be able to force a distribution. Second, the charging order, which makes the creditor an assignee of the LLC, bestows upon the creditor a pro rata share of the income tax liability for profits retained by the LLC, even if the creditor does not receive any distributions.
This consequence becomes more meaningful in an LLC whose members include only the client and his immediate family. In that situation, a creditor of a member of a family-owned LLC could be worse off by obtaining a charging order against the LLC interest. The creditor will be worse off because the creditor will be required to recognize and pay taxes on income earned by the LLC, but will not receive any distributions from the LLC to pay for those taxes. Consequently, the creditor of a member of a family-owned LLC should think twice before obtaining a charging order against the LLC interest.
Additional asset protections can be implemented in the operating agreement. For example, a provision in the operating agreement can state that no member has the right to a return of capital, or a provision in the operating agreement can require that all members must unanimously consent to any distribution. With these two provisions, a creditor of a member or partner is effectively defeated from recovering any money from the LLC.
It is important to note that a charging order is only applicable to LLC’s, not corporations. Thus, for this reason, LLC’s are superior to corporations for asset protection purposes against personal creditors.
THE SELF-SETTLED SPENDTHRIFT TRUST
A self-settled spendthrift trust, is a spendthrift trust in which the Settlor is the Trustee and the Beneficiary. A “spendthrift trust” is a trust which, by its terms, attempts to create a valid restraint on the voluntary or involuntary transfer of the interest of the beneficiary. Thus, normally, in most states, under the common law, an individual cannot create a valid trust whereby he or she is the Trustee (i.e., in control of the assets), he or she is the Beneficiary (i.e., can use the assets), and the assets are protected from creditors.
However, some states, such as Nevada have enacted statutes which, if certain requisites are met, allows an individual to create a valid trust whereby he or she is the Trustee (i.e., in control of the assets), he or she is the Beneficiary (i.e., can use the assets), and the assets are protected from creditors.
THE NON SELF-SETTLED IRREVOCABLE TRUST
The non self-settled irrevocable-trust can be-used for asset protection for a beneficiary who is not a. settlor. Thus, it is useful for a grandparent to set up such a trust for the benefit of a grandchild or grandchildren during their minority. Since the child has no right to any of the income or corpus during the term of the trust (until the child reaches certain specified ages) a creditor of the child has no asset to seize, i.e., no vested interest. Such a trust is usually subject to a gift tax, and if properly established, is not a grantor trust and therefore the trust must pay an income tax adjusted for inflation.