by Stephen A. Drake, Ph.D., CPA and CFP
Stephen Drake has been advising individuals and industries for 25 years. He advises clients in domestic and foreign asset protection techniques and assists them in tax, financial and investment decisions. He has affiliated offices throughout the US and certain foreign countries.
Asset protection is a concept that is gaining appreciation by a growing number of concerned individuals and companies. If asset protection is properly structured, it is a perfectly legal way to organize your affairs. You have every right to protect your assets and if you do not protect your assets then no one else will do it for you.
Let’s define asset protection. My definition is that it is the structuring of one’s assets in such a way to insulate them from uninvited parties or circumstances. Asset protection is necessary as a result of unbalanced divorces, future judgments, creditors and overzealous plaintiff attorneys.
There are many types of asset protection. Some techniques are more complicated then others and some are more effective then others. The most common asset protection device is the use of insurance. Liability insurance is a necessity for all companies. But insurance covers only certain situations and has limits to coverage. For instance, most insurance including umbrella insurance, does not cover certain acts such as sexual harassment or fraud. Thus, do not think that since you have insurance that you are completely safe. Even if you can get plenty of insurance, situations that are not covered can be very expensive. Thus, to a certain extent, all companies self-insure whether they want to or not. As a result, clients ask what they can do to insulate themselves in the event of a major liability or threat to their assets.
Since this question is complex and depends on each situation it is difficult to give a simple answer but let’s try to cover some basic general concepts.
Some background on asset protection:
1/ Your living trust is not an asset protection device. It provides a way to avoid probate (the process where a judge rules on the legalities/details of the will) but this is not considered asset protection except in a very simplistic sense.
2/ Insurance helps and is necessary but it has its limitations as we discussed above.
3/ Corporate operating structures can help but there are limitations particularly with corporations that have been loosely managed. In this case, the legal system can “look through” these corporations and target the individual.
4/ Limited liability companies (LLC’s) and family limited partnerships (FLP’s) are effective asset protection entities. They provide excellent gift and estate benefits to you and your family. We will discuss LLC’s/FLP’s later in this article.
5/ Irrevocable trusts can provide benefits in the US but the concept of “irrevocable” puts fear into the minds of many.
6/ Foreign asset protection trusts, if properly structured, provide the best asset protection. They are often combined with some of the other asset protection techniques discussed above depending on the type of assets in question and their location.
LLC’s and FLP’s:
These asset protection tools are probably the most talked about estate- planning techniques with asset protection features. The terms LLC’s/FLP’s are going to be used interchangeably for purposes of this short article. There are significant differences between them but there are also many similarities. They are similar enough to be used interchangeably for our immediate purposes.
LLC’s are generally established to include your children and spouse to control certain family assets. LLC’s are also effective in reducing values for estate and gift (E&G) purposes. Further, they provide some asset protection.
When values are computed for E&G purposes, they are based on fair market values (FMV). In other words, what a willing buyer and seller will accept. As you can imagine, this definition has brought about many ways to compute FMV. This is the job of the competent advisor to guide you through this planning.
Consider this: If real estate is placed into an LLC by an individual it is now converted from an outright ownership in real estate to a membership interest ownership in an LLC. This membership interest is valued for E&G purposes for less then what the real estate would sell for if it were not in the LLC. This may seem illogical but let me explain. A membership interest is subject to various restrictive parameters in the LLC agreement such as no one can sell their membership interest unless the managing member (you) says it is OK. That is a restriction on the ability of the other members (children or creditors that have become a quasi-member) to have a salable asset. This reduces value for E&G purposes.
Example: You place real estate worth $1M into an LLC with the children. Let’s assume that you now own 80% of the LLC and the kid’s own 20%. How much is your 80% membership now worth? Do not think it is $800,000. It is worth less then that. Far less. In fact most appraisals for E&G purposes would put this 80% value between $400,000-$600,000. The end result is that you can control the real estate in the LLC and when you die, the value for estate purposes is $200,000-$400,000 less then you thought. The result is an estate tax savings to you of $100,000-$200,000. There are ways to enlarge these tax savings which we will discuss in a later article.
The benefit of an LLC, from an asset protection point of view, is that a creditor is limited to a “charging order” against the member’s interest in the LLC. This means that the creditor will only be able to get at a distribution that the LLC would normally make to you. If the LLC does not make a distribution to you then the creditor will not be able to get anything from the LLC. Since you, as the managing member of the LLC, control the LLC you can decide when, if ever, to distribute. Further, you will create a taxable income for the creditor since he will get his pro-rata share of income from the LLC (whether or not distributed) and he must pay tax on it. You have just created a situation where you can often negotiate a settlement for less then the judgment amount. This is an effective creditor deterrent.
Foreign asset protection trust:
This is a trust formed in a foreign jurisdiction (outside of the US). The principal purpose of this arrangement is to provide asset protection from future creditors. Please note the word, “future.” If you have existing creditors or liabilities then moving assets abroad and setting up a foreign trust will not thwart these creditors. The trust must be established before creditors or liabilities exist. The key is early planning and early action on your part.
The reason that many individuals and companies are using foreign trusts is that they are more difficult to penetrate by creditors then asset protection devices in the US. The US courts are often far too generous in their awards to a plaintiff. With a foreign trust, the plaintiff will often have to completely re-litigate his claim in the foreign country even if they have won in the US. Most foreign countries do not allow contingent attorney fee arrangements thus making it costly for a plaintiff to litigate again. Further, some countries have a limited time for creditors to file an action against you in that country. The shortest period of time is typically one year once the trust is in place. All of these factors allow you the opportunity to potentially negotiate a lower settlement with the plaintiff.
A foreign trust is US tax neutral; thus you report income/expense as you would on your US tax return if there was no foreign trust. Estate tax planning can be done effectively with a foreign trust just as with traditional US estate tax planning. In this case, the use of LLC’s and FLP’s are often used.
You can be the trust’s investment advisor or choose another. The trustee of the trust is usually a foreign trustee. This is normally a bank or trust company. There is also a trust “protector” which is someone or company that can remove the appointed trustee(s) if they are not doing their job. You cannot do this directly or you will be considered as owning and controlling the trust. There are many other trust provisions that work in your benefit. These trusts are not for everyone but they are for a growing number of concerned individuals and companies. The details of location of the trust, trustees, protectors and language of the trust instrument must all be discussed. If these details are in place then the foreign trust will be the effective asset protection device you are seeking.
In conclusion, no one asset protection device is for everyone. Each circumstance must be looked at in view of specific circumstances. Further, the above discussion is only very brief and should not be relied on without competent, professional advice. If you or your advisors have any questions then please contact me.