What is Asset Protection?

By Paul Deloughery, J.D., August 2019

Definition.

‘Asset Protection’ can be defined as the organization of one’s financial affairs and assets in advance of any pending, threatened, or expected creditor claims, in order to shield the assets from future liabilities to which they may become subject.

Asset protection is a defensive strategy, like knowing karate. It doesn’t guarantee that you will be able to completely avoid paying future creditors. Rather, the goal is to significantly reduce the amount that a creditor would be allowed to get from you. In a similar way, just because you know karate doesn’t mean you won’t get bloodied up in a street fight. But hopefully it means you’ll survive and come out much better than you otherwise would.

Purpose.

Put briefly, there is a lawsuit for every three adults in the U.S. each year[1] The general rule in the U.S. is that each side pays his/her own lawyer. This is known as the American Rule. Compare that to the United Kingdom and Germany, where the loser pays the winner’s legal fees (which makes each side think seriously about the validity of its legal claims or defenses). The American Rule has led to the creation of contingency lawyers who will take a case in the hopes of pressuring the defendant (or his insurance company) to pay to settle the case.

Contingency lawyers are more incentivized to go after people with assets, because they have better chance of getting paid. For that reason, successful professionals and business owners (or anyone with assets for that matter) are more at risk of being the target of frivolous lawsuits than others. If you want to be able to defend yourself against lawsuits, you need a plan – an Asset Protection Plan.

Basic Concept.

What you own can’t be taken from you. Or as John D. Rockefeller once said, “Own nothing, but control everything.” You can’t take the Eiffel Tower from me because I don’t own it. However, if you could get a civil judgment against me and then have the court issue a Writ of Garnishment to seize the money in my personal bank account. This is the fundamental rule of asset protection. Absent a fraudulent transfer, assets not owned by you cannot be reached by your creditors. So, if asset protection is a key goal in your estate planning, you must somehow remove the assets from your ownership. The best way to remove assets from your ownership is through the use of a properly crafted irrevocable trust.

Philosophy

The philosophy that underlies Asset Protection is that all people are entitled to life, liberty and the ability to acquire and keep property. This is what the English philosopher John Locke wrote about around the time of the American Revolution and it is what ultimately got memorialized (with one change) in the Declaration of Independence. According to Locke, it’s a basic right (going back to the dawn of mankind) to be able to find a piece of land to grow your own food. This is natural law. However, when Thomas Jefferson wrote the Declaration of Independence, he didn’t want to include the reference to ‘property’ because he know that the southern slave colonies would eventually use this as a justification for continuing their practice of slavery.[3] Thus, the Declaration of Independence refers to our God-given rights to “Life, Liberty and the Pursuit of Happiness.”

Other historical figures have also weighed in on the need for a person’s basic right to be able to own property and not have it confiscated. “Property must be secure or liberty cannot exist,” wrote the American founding father John Adams.  “The right to be left alone is the most comprehensive of rights and the most valued by civilized men,” wrote Justice Louis D. Brandeis in 1928.[4]

Related Concepts

Risk Management.

This is the forecasting and evaluation of financial risks together with the identification of procedures to avoid or minimize their impact. It’s a main concern of wealthy families who want to maintain their wealth for multiple generations.

This is one of the main purposes that successful families form (or join) family offices. They want a method of (a) picking profitable investments, while (b) avoiding loss of capital. Risk management is complicated, which is why wealthy families will hire one or more full-time people for this purpose. It encompasses all the myriad ways that wealth can be lost, such as:

  • Theft and embezzlement
  • Poor investment choices
  • Poor management by current generation
  • Failure to preserve capital and resources by future generations
  • Spending more than the family can afford
  • Risk of all family members dying in a single plane crash
  • Risk of family assets being awarded in a divorce
  • Risk of older person changing estate plan to benefit someone other than family members
  • Risk of kidnapping (with ransom demand)

Estate Planning.

Estate planning is the act of preparing for the transfer of a person’s wealth and assets after one’s death. Assets, life insurance, pensions, real estate, cars, personal belongings, and debts are all part of one’s estate. It also includes preparing for one’s incapacity (or inability to make personal, healthcare and financial decisions). A good estate plan is always the foundation of a sound asset protection plan. The reason is that one of the most common ways creditors seek to unwind an estate plan is to claim that the debtor engaged in a fraudulent transfer.[2] Actual fraud is when a transfer is made (from one’s personal name to a creditor protected structure) or an obligation incurred with the actual intent to hinder, delay, or defraud creditors is fraudulent. Constructive fraud is when a transfer is made or obligation incurred without adequate consideration or other specified elements. Thus, it is to a debtor’s benefit to be able to honestly say that a primary purpose implementing the legal structures and transferring assets to appropriate legal entities was to (a) reduce taxes, (b) plan for one’s incapacity or death, (c) prevent family squabbles, (d) avoid probate, (e) prevent assets from being lost to children’s divorces, and (f) generally structure the family and business(es) for ongoing success.

Asset Protection Example

Here is one Asset Protection example:

As much as this looks like some sort of contemporary art, it’s actually a visual blueprint of seven legal entities.

Visual illustration of an asset protection plan

Here is an illustration of a typical asset protection plan. If you are using a DAPT or Foreign Asset Protection Trust, that would be used in place of the Asset Vault Trust.

Revocable Trust: The red triangle in the upper left represents a revocable trust (colloquially called a ‘living trust’). As mentioned earlier, a good estate plan is always the foundation of a good asset protection plan. And a revocable trust is a basic component of a well-drafted estate plan. The purposes for a revocable trust include (a) avoiding probate upon the person’s death, (b) avoiding the need for guardianship and/or conservatorship court proceedings if the person becomes incapacitated (such as by dementia, Alzheimer’s disease, or just plain old age), and (c) allowing one to specify how and when the loved ones receive their inheritance. The revocable trust will own personal assets, such as the personal bank savings and checking accounts, household goods, and the 1% General Partner interest in the Limited Liability Limited Partnership.

Limited Liability Limited Partnership: This is the green oval in the upper center of the above blueprint. The LLLP will typically own cash accounts, such as Consolidated Liquid Asset Management Accounts (CLAMA accounts) at a brokerage house, plus “non-dangerous” investments such as stocks, bonds, and notes receivable. The LLLP is treated like a family bank that can issue loans and manage investments. It’s the main vehicle that holds the family’s wealth in a consolidated fashion. As such, the family sure doesn’t want creditors to go after it. For this reason, assets held in the LLLP should be “safe,” meaning that they won’t injure someone or incur a legal liability. For example, an apartment building could injure an occupant, so it should go into its own limited liability company (which could be owned by the LLLP). Airplanes, motor vehicles, active businesses, and boats are other examples of things that should be owned by their own limited liability companies (which may or may not be owned by the LLLP depending on tax and other considerations).

Asset Vault Trust: In the upper right is another red triangle that represents a unique type of trust. It’s not an asset protection trust and it’s not a standard irrevocable trust. In our example, the Asset Vault Trust owns a 99% limited partnership interest (non-managing) in the LLLP.

An Asset Vault Trust has the following characteristics:

  • It is designed to take advantage of Section 541(b)(1) of the U.S. Bankruptcy Code.  That section of the code is quoted below and defines what property is included and what property may be excluded from the bankruptcy estate.

11 U.S. Code § 541 – Property of the Estate

(b) Property of the estate does not include –

(1) any power that the debtor may exercise solely for the benefit of an entity other than the debtor;

What this means is that the Bankruptcy Estate does not include a power to ‘appoint’ (i.e., give an instruction to the trustee to transfer now or at a later time) an asset to someone other than the debtor.  An Asset Vault Trust provides that the settlor retains a Special Power of Appointment, which is one of the ways it provides flexibility for future planning by the settlor.

  • You do not own the assets in the Asset Vault Trust, so they can’t be taken from you. (Remember the John D. Rockefeller quote above.)
  • In you want access to the assets in the Asset Vault Trust in the future, there are various ways to make this happen. You can borrow from the trust using proper documentation and paying an appropriate interest rate as determined by the IRS. This is discussed in more depth here. LINK
  • It can be a Grantor Trust, meaning that it is disregarded from a tax standpoint. This is where careful planning is necessary. If you treat the Asset Vault Trust as a disregarded entity for income tax purposes, then upon your death your heirs get a step up in basis on any appreciated assets. However, if your goal is primarily to reduce your income tax burden now, then it may make sense to have the transfer to the Asset Vault Trust be completed for income tax purposes so that your heirs are responsible for paying the tax on the income at their lower tax bracket.
  • It may or may not be a completed gift for gift and estate tax purposes.
  • It is built upon a foundation of generations of proven legal precedent. The only type of trust that has withstood the test of time as a proven method of asset protection is a non-self-settled trust, aka a third-party trust. In comparison, DAPTs and foreign trusts have a horrible record in terms of court decisions.

The fact that the Asset Vault Trust only owns a limited partnership interest in the LLLP, which is therefore cannot manage or control the limited partnership, is important. The beneficiaries of the Asset Vault Trust may be your irresponsible teenage kids, or your alcoholic sister. You don’t want them to have control over your legal and financial affairs. At some time in the future, your kids may become responsible or your sister may sober up. And at that time, the trustee could distribute assets out of the Asset Vault Trust to them. However, there is flexibility, and at least for now they are not in control.

Trust Protector. Behind each of the red triangles (trusts) is a symbol of a knight. This represents the Trust Protector, which is a person (or entity) that serves as a check and balance to the trustee. If the trustee proves to be irresponsible or dishonest, the Trust Protector can remove and replace him/her. The Trust Protector can direct the trustee in matters relating to the trust. The Trust Protector can also have additional powers ranging from simple veto powers to very broad powers allowing the addition or removal of beneficiaries and even rewriting some or all of the trust. This allows for more flexibility and for adapting the trust to changing circumstances and changes in the law. The Asset Vault Trust is an “irrevocable trust” and may not be able to be changed by the settlor, but that doesn’t mean it can’t be changed.

Limited Liability Companies (LLCs). The three orange rectangles in the lower right represent limited liability companies. These are business entities created pursuant to state statute. In many states, these are advantageous for holding “dangerous” assets that could be the target of lawsuits because they could incur legal liabilities. In the above example, one LLC holds rental properties, another holds a speed boat and another owns the rights to the name of the ophthalmology practice, plus that business’s internet domain name and future equipment.

In real life, rather than having multiple rental properties in the one LLC, it would probably make sense to have a separate LLC own each property. The reason for this is that if a tenant gets injured in the shower of one property, that tenant could sue the owner of the building (the LLC), get a judgment and then seek payment from the assets inside the LLC. If there are multiple rental properties inside a single LLC, then the tenant has more assets to collect against. On the other hand, if each rental property is inside its own LLC, then an injured tenant (judgment creditor) could only go after the one building and bank account owned by the particular LLC that signed the lease with him/her.

Corporation. To the lower left is a rectangle that represents the business entity that owns an active business (in this example, it’s an eye clinic). Limited liability companies have become the standard for forming new businesses. However, in some parts of the country lawyers still set up corporations because they are “tried and true” in their minds. This is technically true. New York was the first state to enact a corporate statute in 1811. Other states followed suit. By contrast, the first LLC statute was adopted in Wyoming in 1977, and most other states did not adopt them until the 1990s.

One issue with corporations is that the owner’s stock (which represents what portion of the corporation that the owner owns) is an asset that can be seized by creditors.

The corporation is owned by the revocable trust rather than the LLLP because it is being taxed as a subchapter S corporation.

Lease Agreement. The blueprint shows a lease agreement from an LLC to the professional corporation. This would be a lease of valuable assets that are being kept out of the professional practice (so they are not available to future creditors of that corporation). Commonly leased items could include a commercial office building, the trademarked name, the website domain, office equipment, and other equipment.

Management Agreement. Another way of getting money from the professional corporation to a separate entity would be to have a management agreement. In the blueprint above, there is only a single LLC that is both leasing equipment to the corporation as well as managing the professional practice. This is elegant and simple. But it is also somewhat risky. Someone injured by the professional practice could easily claim that the practice was being mismanaged, and therefore sue the LLC that was managing it. Thus, all the work of extracting valuable assets out of the professional practice was of no effect. It would be better to have yet another LLC that is managing the professional practice. (Just as there is a tradeoff between asset protection and freedom, there is also a tradeoff between protection and simplicity. The best protection is usually somewhat complicated.)

Line of Credit. Our example includes a line of credit from the LLLP and the revocable trust (and the client himself/herself personally). Why would you want to incur a $1 million debt obligation? Because in this case the creditor is your “friendly” LLLP. If your LLLP extends the line of credit to you, it is perfectly entitled to act like a common bank and require collateral to ensure that the loan gets repaid. This justifies the LLLP in securing the loan by all of your personal assets, including your general partnership interest in the LLLP.

Here is a sample secured line of credit promissory note:

An “Event of Default” will occur if:

(f) The BORROWER (i) commences any case, proceeding or other action (A) under any existing or future law of any jurisdiction, domestic or foreign, relating to bankruptcy, insolvency, reorganization or relief of debtors, seeking to have an order for relief entered with respect to it, or seeking to adjudicate it bankrupt or insolvent, or seeking reorganization, arrangement, adjustment, winding-up, liquidation, dissolution, composition or other relief with respect to it or its debts, or (B) seeking appointment of a receiver, trustee, custodian or other similar official for it or for all or any substantial part of its assets, or (ii) is the debtor named in any other case, proceeding or other action of a nature referred to in clause (i) above which results in the entry of an order for relief or any such adjudication or appointment and remains undismissed, undischarged or unbonded for a period of sixty (60) days, or (iii) takes any action in furtherance of, or indicating its consent to, approval of, or acquiescence to, any order, adjudication or appointment of a nature referred to in clause (i) or (ii) above, or (iv) shall generally not be paying, shall be unable to pay, or shall admit in writing its inability to pay its debts as they become due, or (e) shall make a general assignment for the benefit of its creditors; or …

 Remedies. At such time that an Event of Default has occurred and is continuing, then Holder, by written notice to Issuer (the “Notice”), may declare all amounts hereunder immediately due and payable in cash and Holder will be entitled to reimbursement of its reasonable costs and expenses related to collection of all amounts owing in connection thereof. Except for the Notice, Holder need not provide, and Issuer hereby waives, any presentment, demand, protest or other notice of any kind, and Holder may immediately and without expiration of any grace period enforce any and all of its rights and remedies hereunder and all other remedies available to it under applicable law. Such election may be rescinded and annulled by Holder at any time prior to payment hereunder. No such rescission or annulment will affect any subsequent Event of Default or impair any right consequent thereon.

To secure the LLLP’s ability to be repaid, the LLLP would also require the borrower (the client / beneficiary of the revocable trust) to sign additional collateral documents, including a Collateral Assignment of Limited Partnership Interest, Collateral Assignment of Personal Property, Collateral Assignment of stock in the corporation. The LLLP would also file UCC-1 financing statements with the state’s Secretary of State, thereby perfecting its security interest in the collateral.

Footnotes

1: According to http://www.courtstatistics.org/, more than 95% of U.S. cases are filed in state courts. In 2016, there were approximately 84 million cases filed in state trial courts. There are an estimated 255 million adults in the U.S. Thus, you have approximately a 1 in 3 chance of being involved in a lawsuit. State appellate courts had 257,000 appeals filed. 

U.S. Supreme Court Justices decide which cases they will hear, and it’s roughly 80 each year. They decide another 50 without hearing arguments. The cases they choose usually address constitutional issues or federal law. The Supreme Court gets about 7000 requests to hear cases per year, so there are many cases that don’t get heard. 

Statistics for the year ending in March 31, 2017 found that U.S. Courts of Appeals filings rose 10% that total was 58,951—an increase of 5,303 appeals. Civil appeals remained nearly unchanged with just five more cases.  

2: The Uniform Fraudulent Transfer Act (UFTA) is a model Act adopted in 1984 to replace the Uniform Fraudulent Conveyance Act (UFCA). The UFTA has been enacted in 43 states (including Delaware), the District of Columbia, and the US Virgin Islands. While there are certain differences, both the UFTA and the UFCA share the same underlying principle that title to assets conveyed to a third party for the purpose of placing such assets beyond the reach of creditors is fraudulent. Both statutes provide creditors with a remedy when debtors hide or transfer assets that would otherwise be available to satisfy legitimate debts.

3: Harvey, Ray Forrest (1937), Jean Jacques Burlamaqui: A Liberal Tradition in American Constitutionalism. Chapel Hill, N.C., p. 120.

4: Louis Dembitz Brandeis (November 13, 1856 – October 5, 1941) was an American lawyer and associate justice on the Supreme Court of the United States from 1916 to 1939.