Asset Protection
Today, many people are concerned with protecting assets from creditors. They have good reason to worry. Business owners and professionals increasingly find themselves facing large and unexpected claims brought by litigants under expanding legal theories such as malpractice, sexual harassment, hazardous waste, and wrongful discharge.
Insurance has traditionally been used as a protection against lawsuits. However, in today's world, insurance is not always effective protection, as insurance companies are often writing policies to exclude protection from many risks. Also, some insurance companies have proved to be insolvent.
The economic recession has also caused concern. Business owners now realize that an unexpected economic slump can result in the loss of the business, along with the assets pledged in support of it.
Advertisements by attorneys, seminar promoters, and book sellers seek to profit from these concerns by promoting the concept of "asset protection planning." Materials offered provide a variety of strategies, some rather extreme, such as the placement of assets in offshore trusts.
Placing assets overseas is costly, risky, and does not always afford the desired protection. Additionally, placing monies overseas smacks of money laundering and raises images of Tom Cruise in "The Firm."
Attorneys also advise putting assets in living trusts. The public now has the impression that this is a safe way to protect assets from creditors. This is not necessarily true.
Attorneys can provide effective and legitimate assistance to clients seeking to protect their assets. In fact, many attorneys have utilized "asset protection" strategies for years. Traditional legal tools can be used to ethically protect substantial assets. These tools include retitling assets, use of exemptions, retirement accounts, family limited partnerships, and trusts.
Retitling Assets
Changing the manner in which title to property is held may reduce the risk of loss to creditors. Married couples can be counseled concerning the advisability of transmuting community property into separate property.
Community property laws should be reviewed to determine which assets are subject to debts. The general rule is that all community property is liable for the debts of both spouses, including debts incurred before the marriage [Family Code, Section 910].
Separate property of the non-debtor spouse is not liable for the debts of the debtor spouse [Family Code, Section 913]. Additionally, the earnings of a spouse during marriage are not liable for debts incurred by the other spouse [Family Code, Section 911]. The transmutation agreement allows each spouse to retain property as his or her own separate property [Family Code, Section 850]. It permits property held by one spouse to avoid liability for debts incurred by the other spouse.
A more drastic method to protect assets from creditors' claims is to dissolve the marriage. Those assets awarded to the non-debtor spouse are not liable for debts incurred during the marriage by the debtor spouse [Family Code, Section 916(a)(2)].
Disadvantages to using transmutation agreements or dissolving a marriage to avoid creditors' claims are:
- 1. Possible tax consequences. The advantage of a step-up basis on the death of one spouse will be unavailable if the property is held as separate property [I.R.C., Section 1014(b)(6)]
- 2. A change in the marital relationship may cause the asset protection planning to become detrimental to the rights of one or both spouses.
- 3. Counseling dissolution of a marriage to avoid debts is ethically and morally unappealing. [See Marriage of Dajani, 204 C.A.3d 1384 (1988) and See Bus. and Prof. Code, Section 6068(c).]
Retirement Accounts and Exempt Assets
California law provides two sets of exemptions which may be used to protect assets from creditors.
Unfortunately, these exemptions are rather modest and do not provide extensive protection. For example, a married couple is allowed only one vehicle having $1,200.00 equity (C.C.P., Section 704.110) and tools of the trade having a value of not more than $5,000.00 (C.C.P., Section 704.060).
Nonetheless, several important exemptions can be used to protect larger assets. The most commonly used is the homestead exemption, allowing a married couple to retain $75,000.00 in equity in their residence (C.C.P., Section 704.730). The exemption increases to $100,000.00 if one spouse is 65 years of age or older, or disabled [C.C.P., Section 704.730(a)(3)].
Exemptions and anti-alienation clauses protect retirement accounts and annuities. ERISA-qualified retirement plans and annuities are becoming important asset protection planning tools. Properly qualified plans can protect unlimited funds. The United States Supreme Court has upheld the effectiveness of anti-alienation clauses under ERISA-qualified retirement plans to totally protect ERISA-qualified retirement plans from creditors [Patterson v. Shumate, 112 S.Ct. 2242 (1992)].
The ERISA Act specifies that retirement plans implemented pursuant to its provisions must include an anti-alienation clause. Consequently, it is important to determine whether a plan qualifies as an ERISA-approved retirement account. This is not always easy. For example, it is important to note that a one-person plan is normally not qualified for ERISA purposes [29 C.F.R. 2510.3-3(b) & (c)(1) (1988)]; [Kwatcher v. Massachusetts Service Employees' Pension Fund, 879 F. 2d 957 (1st Cir. 1989)].
California exemption laws also provide substantial protection for retirement plans. For example, private profit sharing plans designed for retirement purposes are exempt to an unlimited amount [C.C.P., Section 704.115(a)(2)]. This exemption was used in one case to fully protect a profit sharing plan in which the debtor had an interest worth $1.8 million [In re Witmer, 148 B.R. 930 (Bankr. C.D. Cal. 1992). Note the private retirement plan was not ERISA qualified and the sole plan participant had liberal rights to manage and borrow from the plan.]
Self-employed retirement plans and individual retirement accounts are exempt up to an amount reasonably necessary for the debtors' support at the time of their retirement (C.C.P., Section 704.115). This exemption may be larger than it first appears. Most financial planners believe that substantial savings are required to support a retirement, and actuarial tables can be used to support this claim. Cases supporting this approach are: In re Switzer, 146 B.R. 1, 27 C.B.C. 1680 (Bankr. C.D. Cal. 1992); and, In re Delaimo, 88 B.R. 268 (Bankr. S.D. Cal. 1988).
Unmatured annuities can be used to protect substantial assets. An unmatured annuity is totally exempt regardless of its value [C.C.P., Section 704.100(a)]. An annuity is not mature as long as it provides for periodic payments which begin only after the bankruptcy petition is filed. [In re Moffat, 119 B.R. 201 (9th Cir. BAP 1990).]
Non-exempt assets can be sold and the proceeds used to purchase exempt assets. Many cases have held that this is not an improper transaction. [In re Wilson, 123 F.2d (9th Cir. 1903) and In re Moffat, 107 B.R. 255 (Bankr. C.D. Cal. 1989)]. Courts may object to the transfer of non-exempt assets into exempt assets if the transaction is excessive. See, for example, Norwest Bank Nebraska, N.A v. Tveten, 848 F. 2d 871 (8th Cir. 1988). Also, see language in In re Witmer, 148 B.R. 930 (Bankr. C.D. Cal. 1992).
Limited Partnerships
Family limited partnerships have been used for many years to protect assets. The partnership is usually arranged so that the clients hold a one percent interest in the limited partnership as general partners. The children or other beneficiaries are set up as holders of 99% of the partnership as limited partners.
The advantage of a family limited partnership is that it makes assets unattractive to creditors. Partnership assets are not liable for the debts of a partner [C.C.P., Section 699.720(a)(2)]. The creditor's only remedy is to obtain a charging order, which can only reach the debtor's interest in the partnership as it is distributed [C.C.P., Section 708.310].
These partnerships, however, are not immune to creditor attack. Some case authority allows partnership assets to be sold to satisfy a judgment where a charging order proves ineffective [Hellman v. Anderson, 233 C.A. 3d 840 (1991)]. It is also possible that a court may be reluctant to give full recognition to a partnership used solely as a protection from creditors.
Family Trusts
Family trusts provide limited value in protecting assets because of restrictions contained in the California Probate Code. The most important restriction is that trust assets are subject to creditors' claims if the settlors retain the power to revoke the trust (Probate Code, Sections 18200 and 19001). A spendthrift clause to protect benefits payable to the settlors is invalid (Probate Code, Section 15304).
Family trusts are valid asset protection tools if the debtors do not retain any benefits in the trust assets; consequently, creditors are not entitled to reach the assets. In addition, a spendthrift clause can protect the beneficiaries from their creditors (Probate Code, Sections 15301 and 15303). The downside to a living trust is that the settlors must give up the right to benefit from and control the assets.
Fraudulent Conveyances and Ethical Considerations
Laws governing fraudulent conveyances must be carefully considered. Efforts to transfer assets or set up trusts and/or partnerships may run afoul of this law.
Generally, a transfer made to hinder, delay, or defraud creditors is subject to avoidance [Civil Code, Section 3439.04(a)]. Certain transfers create an inference of fraudulent intent ("badges of fraud"). For example, transfers to family members and transfers which cause a debtor to become insolvent are presumed fraudulent [Civil Code, Section 3439.04 and comments (5) through (7)]. The statute of limitations for fraudulent conveyance can be as long as seven years (C.C.P., Section 3439.09).
Fraudulent conveyance can occur when assets are transferred (a) between a husband and wife (Civil Code, Section 5110.720); (b) to a limited partnership [Crocker National Bank v. Perroton, 208 C.A. 3d 1 (1989)]; or, (c) to a trust.
It is important to realize that transfers undertaken to hide assets from creditors may be punished as a criminal offense [Cal. Penal Code, Section 154(a)(b)]. Secreting assets can be prosecuted as a bankruptcy crime (18 U.S.C., Section 152). Other criminal statutes may also be used to punish debtors improperly hiding assets [Money Laundering Control Act - 18 U.S.C., Sections 1956 and 1957)].
Attorneys must use caution advising clients how to protect assets. The rules of ethics prohibit participation in illegal or unjust activities (see Business and Professions Code, Section 6068(c) and Rule 3-210 of the Rules of Professional Conduct). Attorneys can be criminally prosecuted for participating in a fraudulent conveyance (Cal. Penal Code, Section 531).
Attorneys have been disciplined for giving improper advice to clients attempting to hide assets from creditors. See, for example, Coppock v. State Bar, 44 Cal. 3d 65 (1988); Yokozeki v. State Bar, 11 Cal. 3d 436 (1974); and, Townsend v. State Bar, 32 Cal. 2d 592 (1948).
Laws governing fraudulent conveyances and improper transfers teach us that asset planning should be done well in advance of the existence of the creditors' claims. It is not improper to engage in transfers made for the purpose of protecting the client's future well being. On the other hand, if assets are being transferred in an effort to remove property from the reach of creditors, then the transaction is subject to attack as a fraudulent conveyance. See Oberst v. Oberst, 91 BR 97 (Bankr. C.D. Cal.) (1988).
Foreign Trusts
Sending assets overseas for administration by foreign trustees is a more exotic way to protect assets. Publications promoting this method include: Spero, Asset Protection (1994); Solomon, Asset Protection Strategies (1993); Margolin, California Asset Protection Planning (1993); and, Professional Education Systems, Inc.
The authors suggest that attorneys become familiar with and utilize the trust laws in such offshore locations as the Bahamas, Barbados, Bermuda, Gibraltar, Cayman Islands, Cook Islands, and the Isle of Man. A trustee in that location is selected to manage the assets according to the terms of the trust.
These locations generally allow the settlor the power to revoke the trust and receive benefits from the trust. Nonetheless, these laws may permit the settlor to retain the control and benefits over and from the trust. Also, some of these locations do not recognize foreign judgments, thus forcing a creditor to litigate claims in the foreign jurisdiction. With the assets in a foreign jurisdiction, where the courts and trustees may ignore California judgments and the costs of litigation are considerable, frustrated creditors may agree to more favorable settlements.
Using offshore trusts can be extremely complex. To recommend this method, the attorney must be very knowledgeable with conflicts of the law and the laws of that country. The costs of retaining an offshore trustee and obtaining legal advice from a local attorney can become prohibitive.
There are no guarantees that a local court will respect the limitations imposed by the offshore laws on the trust and trust assets. Additionally, public policy would not argue in favor of allowing assets to be hidden from creditors in an offshore country. Consequently, a local court might utilize its contempt powers to force the debtor to return the assets to this country. Also, the court may determine that it has sufficient grounds to exercise jurisdiction over the foreign assets and the foreign trustee.
The effectiveness of offshore trusts is unproven. Offshore trusts can be expected to be challenged in the courts by creditors. Even the author of one of the leading books on asset protection acknowledges numerous ways in which the use of offshore trusts may be successfully challenged (Spero, Asset Protection, Sections 7.01[2] and 7.01[5]).
Local counsel are better advised to use traditional tools to protect assets. Legal complexities and uncertainties, along with the high cost of placing assets offshore, is not warranted.
Conclusion
Financial planning is becoming an important service attorneys can provide. Helping clients utilize exempt retirement accounts is a great way to build and protect assets. Transferring assets to trusts may also provide protection if the trust is created when the debtor is solvent and not facing creditors' claims.
Attorneys must use caution not to participate in or encourage the transfer of assets in situations which may be criminally prohibited and subject to the fraudulent conveyance laws. Also, foreign trusts pose tremendous risks, ranging from trustees who may abscond with the funds to unexpected changes in foreign laws and economic instability.
Sufficient legitimate and safe methods are available for protecting and preserving assets. The most important element governing the success of asset planning is to plan early.