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THE BUSINESS ADVANTAGE - Issue 8

ASSET PROTECTION PLANNING:
SHIELDING YOURSELF FROM THE LITIGATION EXPLOSION

There are many circumstances out of your control that could result in your being sued.  Your daughter’s boyfriend wrecks your car.  You own property and a tenant gets mugged. You guarantee a loan for a friend who doesn't pay.

In some circumstances, insurance coverage may provide the first line of defense.  Even then, however, a judgment may exceed the policy limit.  Or, even worse, you may discover that the insurance carrier recently became insolvent.  To further protect themselves, many professionals, property owners, and entrepreneurs are now pursuing deliberate strategies designed to protect against such happenings.

Unfortunately, many others fail to anticipate a calamity until it is too late.  As Mark Twain observed:  When you need a friend most, it is too late to make one.  This is especially true in the context of asset protection planning, where timing is crucial.  Timing matters because protecting your assets in the ordinary course of managing your financial affairs is legal.  Transferring assets after a lawsuit seems imminent, however, may be a fraudulent transfer.

Asset protection planning requires organizing one’s assets and affairs in advance and in a way that will guard against any future judgments.  There are numerous techniques available, ranging from aggressive and specialized measures -- such as Cayman Island trusts -- to measures which are relatively conservative and affordable.  In addition to offshore trusts, the alternatives discussed below include:  domestic trusts, family limited partnerships, post-nuptial agreements, and fictitious name living trusts.

OFFSHORE ASSET PROTECTION TRUSTS (OAPT)

Offshore trusts were once money-hiding gambits preferred by financial criminals and con men.  That has changed.  Today, laws recently enacted in certain foreign countries allow an individual to place cash and securities in the hands of an offshore trustee.  Most notably, the Marshall Islands, the Bahamas, Belize, the Cayman Islands, the Cook Islands, Cyprus, Gibraltar, the Turk and Caicos Islands have such laws.  Today, an OAPT -- when not used to conceal assets or defraud creditors -- is effective and perfectly legal.

The largest drawback of OAPTs is their complexity.  Briefly, an OAPT is a trust created under the laws of a foreign jurisdiction.  That means that American courts generally will honor the trust law of that jurisdiction, provided your trustee resides there.  Typically, this foreign trustee’s powers under the trust agreement are strictly limited.  This is because, in addition to the foreign trustee, there should be one or two domestic trustees, relatives or friends, who actively manage the trust. 

Beyond the domestic trustees, an OAPT often will also have a “trust protector,” an individual unknown in American trust law.  A trust protector (usually friend, relative, or trusted professional) has veto power over actions taken by the trustees, including the power to discharge trustees and amend the trust.

Used properly, an OAPT will protect assets from future creditors.  And, like domestic trusts, it maintains confidentiality and avoids probate.  However, OAPTs often are a substantial investment in time, planning and start-up costs of more than $15,000.

A problem with OAPTs is the risk inherent in placing large sums of money in volatile foreign countries.  Unlike American trust law, the laws of such jurisdictions are not predictable.  In particular, one must consider both the possibility of a military coup and the effect that such a development would have upon the trust property. That is generally why the trusts are located in foreign countries with an Anglo-American cultural background and legal system whose government is stable.

DOMESTIC TRUSTS

Most individuals utilize trusts established under American law as part of their asset protection plan.  Compared with the Cook Islands, for example, domestic trust law restricts the benefit and control one can retain following creation of a trust.  This stems from a maxim of domestic trust law:   One does not place property out of a creditor’s reach if the property has not been placed out of the transferor’s own reach.  In other words, where the creator of the trust maintains too much control, the trust may be held to be invalid.  Obviously, sacrificing control is a substantial tradeoff to shielding assets from future creditors.

Here are two examples of commonly used domestic trusts which serve an asset protection purpose:

Irrevocable life insurance trusts:  This allows you to transfer ownership of your life insurance policy to your spouse or children.  This is a good estate planning tool for anyone with a large insurance policy, because it takes the asset out of their estate and, if done right, avoids estate taxes.  It also protects assets from creditors because the life insurance policy becomes someone else’s property.  Of course, you cannot easily regain ownership of the policy if you change your mind about who should receive your death benefit.

Grantor Retained Income Trust (GRIT):   This allows you to place your home, for example, into a trust for your children or others.  However, you retain the right to use the residence during the life of the trust on a rent-free basis.  Practically speaking, this places your home beyond the reach of creditors for the life of the GRIT.  Of course, this also means you are surrendering nearly all control.  Beyond asset protection planning, there are important estate planning reasons (i.e., tax advantages) to use a GRIT.

FAMILY LIMITED PARTNERSHIPS

Family Limited Partnerships are similar to regular limited partnerships, but typically hold income-producing assets of a single family.  They are frequently used to pass rental properties to children or grandchildren, which saves estate taxes.  The other benefit is that you are able to retain control of your assets by serving as the general partner.  They also provide an asset protection device. Your creditors usually may reach only the income from your portion of the partnership.  If you own 5 percent of the partnership, for example, they can only get the partnership distributions that relate to your five percent.

FLPs are still under scrutiny by the IRS. For instance, in the Estate of Strangi, 115 TC 478 (2000), $10 million worth of assets was exchanged for a 99% interest in an FLP 2 months before the taxpayer’s death. The FLP was upheld for having enough economic substance and thus did not constitute a taxable gift and qualified for the 31% valuation discount.  This effectively transformed a $10 million into $6.9 million for estate tax purposes.

The IRS has appealed and is now arguing that the assets were included under the decedent’s gross estate under §2036.  This appeal demonstrates the Services continued interest in policing exploitation of FLPs. 

Minority discounts have also failed in other situations.  In Estate of Godley v. Commissioner, 286 F.3d 210 (2002), the FLP discount could not apply where options to purchase the decedent’s partnership interest did not affect the contractual stream of income or the decedents control.  In Shepherd v. Commissioner, 115 TC 376 (2002), a discount failed when the donor’s son caused a transfer of land to the partnership to be an indirect gift by signing the partnership agreement the day after it was duly executed with the deed.

Finally, the Tax Court sided with the IRS when it concluded that collective indifference to the sanctity of the partnership agreement caused assets in the decedent’s gross estate to be taxable without the discount. 

Again, like foreign trusts, Family Limited Partnerships are a significant investment and require maintenance.  Initial setup fees can range from $10,000 and up.  Moreover, if you buy new rental properties and want to put them in the partnership, you will require professional advice.  Failure to establish Family Limited Partnership correctly, or to include inappropriate assets, can jeopardize both its estate planning and asset protection functions.  This may also create income tax nightmares.

POST-NUPTIAL AGREEMENTS

A post-nuptial agreement is an agreement entered into after your wedding ceremony.  The purpose of a post-nuptial agreement is often to change community property into separate property.  The reason for this change is to protect the once-community assets.

Post-nuptial agreements avoid California law which makes community property liable for a debt incurred by either spouse before or during marriage, no matter whether one or both spouses are parties to the debt or to a judgment for the debt.  By "transmutating" community property into the separate property of the non-debtor spouse, the asset may not be reached in satisfaction of the debt.  Unless, of course, the debt arose in consideration for the provision of food, shelter, clothing, medical care, or other "necessaries of life." 

One drawback to having a post-nuptial agreement is the possibility of divorce.  In the event of divorce, you will have no claim to the property which has been transmuted into your spouse’s separate property.  Therefore, couples contemplating this step require separate lawyers.

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