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Types of asset protection

Table of Contents

You would have had to be stranded on an island for the past 20 years to miss the evolution of lawsuits in this country. Fast food coffee too hot or the psychic who sues because she loses psychic ability after a CT scan are just two examples. Frankly, the list could cover pages. The resounding theme in all of these court cases is that someone is looking to make someone else responsible for some real or perceived injury, loss, or trauma. Physicians are often targets of such lawsuits. Since our legal system still provides very little downside to filing a frivolous lawsuit, we can expect this problem to get worse before it gets better.

Once an event occurs that ultimately leads to a lawsuit, the window of opportunity for protecting assets is closed. Fraudulent transfer statutes will allow the court to reverse any transfer of assets after an event and make the assets available for recovery. Therefore, it is critical to structure the ownership of your assets in a way that will discourage a lawsuit. Most lawsuits would never have been filed if the likelihood of recovery had been small. Certainly, the existence of medical malpractice liability insurance can make physicians attractive candidates for that type of lawsuit. Therefore, the protection of personal assets is crucial, so personal wealth is not exposed to such a lawsuit threat.

Many people mistakenly believe that asset protection is as simple as putting assets in your spouse’s name. This strategy actually affords little to no protection and may leave the asset owner with a false sense of security.

In general, asset protection involves using the avenues afforded by the laws of the various 50 states, the Federal statues, and the laws of foreign countries to protect assets. For example, many states (i.e. Florida) offer some level of exemption from lawsuits for the primary residence and for life insurance. Federal statutes exempt pension plan assets.

Asset protection is graded on a scale of -5 to +5. Owning an asset in one’s own name would be a -5. Owning an exempt asset such as life insurance or a pension would be a +5. Experts rate joint ownership only slightly higher than the -5 assigned to individual ownership.

Categories of asset protection

Generally, asset protection strategies are divided into the categories of exempt, onshore, and offshore.

As discussed above, some or even all of the primary residence may be exempt from lawsuits. Further, Federal laws exempt ERISA plans from lawsuits in order to protect the pension plan participants. Many states exempt some or all of the cash value and/or death benefit of life insurance. To find out which assets are exempt in any particular state, consult legal counsel knowledgeable in asset protection in your state.

Onshore involves any domestic strategy designed to protect assets that does not include exempt assets. The most common of onshore strategies include Limited Liability Companies (LLCs) and trusts.

LLCs

Creating a single member LLC and transferring investments to it would afford better protection than owning the assets individually. Due to recent court cases that have called into question the effectiveness of single member LLCs, multiple owner LLCs appear to offer a stronger level of protection.

The main reason for the increased asset protection afforded by LLCs is that most jurisdictions only provide a charging order as the means of recovery. Should a charging order be awarded against the defendant’s LLC, the managing member of the LLC would be required to redirect any distribution for the benefit of the defendant to the holder of the charging order. Since the charging order does not require any distributions to be made, the managing member would normally forgo distributions. If the LLC is taxed as a flow-through entity such as a partnership or S-corporation, the holder of the charging order would receive the K-1 form reporting the income from the LLC instead of the defendant. This creates an interesting situation where the defendant (who may also be the managing member) can effectively make the plaintiff pay taxes on the LLC’s income while giving them no distributions.

Likewise, properly setting up an irrevocable trust and transferring assets to it would result in a very high level of protection unless the court ruled that the assets actually were under the control of the grantor.

Offshore LLCs

Offshore strategies are very similar to onshore, however, the LLC or trust is set up in a country selected because it makes it extremely difficult to access the funds without winning a second lawsuit in the host country. There have been many negative items in the press concerning offshore tax evasion strategies. The use of offshore entities for asset protection has nothing to do with these schemes. US citizens must fully declare their offshore income and pay all taxes due on that income. Additionally, the existence of the foreign accounts requires a certain schedule disclosing the detail of the accounts.

The reason that offshore strategies can be so effective in asset protection can be illustrated through a description of the laws affecting Nevis LLCs. Nevis is a small former British Commonwealth nation located just below the Virgin Islands. The local language is English and their legal system is based on British Common Law, just as is ours. Like most U.S. states, Nevis law allows a charging order as the only remedy for recovery.

What makes Nevis different is that Nevis does not recognize U.S. judgments. Therefore, the plaintiff would have to file suit in Nevis and win the lawsuit again there. Further, Nevis legal counsel must be used (they do not work on a contingency fee basis) and a significant bond must be posted since Nevis is a “loser-pays” jurisdiction. All of this adds up to a very unfriendly climate for the plaintiff.

Debt shield

Debt shield is an interest strategy that can protect real estate but can also result in significant increases in after-tax retirement income. Under the debt shield strategy, the property owner mortgages as much of the property value as possible. This often means a mortgage of 100 percent of the property value. Interest-only payments are made on the mortgage so that no equity is grown on the real estate other than the increase in market value. This strategy also improves the cash flow to the point that often the interest-only payments on the 100 percent mortgage may be close to the same payment being made for a conventional mortgage.

The idea with debt shield is to move the equity into exempt assets while protecting the real estate through the high level of financing. Every five years or so, the property would be refinanced to remove the additional equity that was available through the increase in market value. As was illustrated in a recent Forbes magazine article, as long as the after tax return on the exempt assets is  greater than the after tax interest cost of the mortgage, the strategy will generate a positive benefit for the property owner while protecting the real estate. While this is a critical strategy for states where the primary residence has little to no statutory protection, it can be a very valid strategy even for states like Florida where the home is completely protected due to to the potential net positive spread between the after-tax borrowing rate of home mortgages vs. the after-tax return that the borrowed funds might conservatively achieve. Additionally, it should be considered for second homes, office buildings, and other real estate.

These are a few creative ways to protect your assets. Consult with your CPA to decide which are most useful to you based on the nature of your assets and the laws governing your state.

David B. Mandell, JD, MBA is an attorney, lecturer, and the author of Wealth Protection, MD. He is also a co-founder of The Wealth Protection Alliance (WPA). Beryl N. (Sandy) Stokes, III, CPA, MBA is the president of Stokes Accounting & Business Consultants, PA and provides sophisticated business planning to physicians around the country. Both authors can be reached via email: info@wealthprotectionalliance.com.

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David B Mandell, JD, & Beryl N. Stokes, III, CPA

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