Although “asset protection” may not be a phrase you are used to seeing, most people engage in asset protection to some degree. For example, liability insurance is the most basic form of asset protection: you want to make sure if you have a home or automobile accident, your creditors will not take your residence or bank account. So, you pay for insurance in order to ensure your most important assets are not at risk for the most likely forms of accidents.
Asset protection can range from those basic forms of insurance to extremely complex plans utilizing a complex web of entities and trusts in various jurisdictions. Here is a brief overview of various levels and descriptions of asset protection:
- Insurance: Ensuring you have appropriate amounts of insurance for the types of activities you regularly engage in is one of the simplest things most people should do to protect their assets. Home and auto insurance is a given, and most professionals can also purchase insurance policies for malpractice issues. Umbrella policies can also be a good idea once a certain level of wealth is achieved.
Insurance is important, and should not be foregone even if more complex strategies are also used. However, it is important to realize that it would be impossible to insure against every lawsuit, or every level of liability. Other strategies can be used in conjunction with insurance for more comprehensive coverage.
- Exempt assets: There are some forms of assets that are automatically protected by law from creditors. For example, a retirement plan that falls under the purview of ERISA cannot be taken by creditors. In a few states, the primary residence is exempt from creditors no matter the value. In other states, a certain dollar amount of equity in the residence is protected (as of 2021, California protects between $300,000 to $600,000 of equity, depending on the county and average home value). Some states protect annuity contracts, and some protect the cash value of life insurance policies, usually up to a particular limit.
To the extent that you can transfer your non-exempt assets (like cash savings) to exempt assets (like protected retirement plans), you are protecting those assets from your creditors.
- Entities: Using business entities is another level of protection, meant to isolate your business activities from your personal assets. Corporations were first used to shield shareholders’ personal assets from liabilities within the business, and still serve this purpose. Now, there are a variety of different kinds of entities that individuals can use depending on their business and tax needs.
- Limited liability companies: Limited liability companies, or LLCs, have risen to prominence in the last several years as an ideal structure for many smaller businesses. As the name suggests, this type of company limits the liability for its owners, who are called members. If there is liability incurred at the company level, the creditors involved will not be able to reach the members’ assets; the creditors will be limited to collecting from the company itself (provided the members have followed corporate formalities; see item (d), below). This is sometimes referred to as “inside out” protection – liability “inside” the LLC will not reach out of the LLC.
LLCs in many states also provide “outside in” protection: if a member of an LLC faces liability, the creditor will not be able to fully take over the membership interest. Instead, the creditor will be limited to taking a lien against the member’s distributions from the LLC. This is called a “charging order.” This means if the LLC never makes a distribution to the member, the creditor will receive nothing. Note that sometimes charging order protection is not available to single-member LLCs (including LLCs owned by a husband and wife).
- Partnerships: Like LLCs, partnerships can provide “inside out” protection – liabilities incurred at the partnership level will not affect the partners’ personal assets. However, in many cases, a partnership is required to have a general partner, who does have personal liability for partnership liabilities. Also similar to LLCs, in some states personal creditors of a partner will be limited to receiving a charging order, or lien, against the partners’ distributions, providing “outside in” protections.
- Corporations: Corporations were the original form of business entity, structured to provide protection to shareholders from the business’s liabilities. Unlike LLCs and partnerships, corporations do not provide “outside in” protection – a creditor of a shareholder can take the shareholder’s shares and step into the shareholder’s shoes.
- Piercing the corporate veil: All of the above structures are subject to having the corporate veil pierced if corporate formalities are not followed. For example, if someone sets up an LLC to conduct business through, but pays personal expenses from the LLC bank account, a court may decide the LLC has not been used as the law intended and allow a creditor to “pierce the veil” – meaning, the creditor will be able to access to member’s personal assets.
- Trusts: You have probably heard of living trusts, or revocable trusts, and you may even have one. A living revocable trust is a trust that you set up in your lifetime, transfer your assets to, and control during your life. The trust contains provisions about what should happen to your assets when you are incapacitated or after you have passed away. This type of planning is very important to ensure your family does not have to go through the probate process, and can provide your heirs with asset protection, but importantly, living trusts do not provide asset protection to the people that set them up.
Living trusts do not provide asset protection because of two features: (1) you are the trustee and beneficiary, so you retain both legal and beneficial ownership; and (2) you retain the right to revoke and amend the trust in any way you wish. Since you have full ownership and full control, your creditors can access those assets.
There are other types of trusts that do not result in your retaining full ownership and control, and in turn, can provide asset protection. These are irrevocable trusts – once you set them up and fund them, you cannot change them (although attorneys have come up with ways to include flexibility in these trusts even while they remain irrevocable). Moreover, for the best asset protection, you should not be both trustee and beneficiary of any asset protection. So, if you want to retain beneficial use of the assets, there should be a third-party trustee; or, if you are prepared to gift away assets during your life to beneficiaries, like your children, you can name them as beneficiaries (and you must respect that this is a binding gift, and you cannot use the assets for your own benefit without appropriate loan documents).
While there are a number of different types of trusts, too numerous to discuss in full, a few of the most popular types of trusts in recent years that can result in asset protection, if properly structured, include the following:
- Spousal lifetime access trusts (SLATs): This is a type of domestic trust wherein you make a gift of assets to your spouse in an irrevocable trust. This trust is popular because it allows for both asset protection planning and estate tax planning, while the estate tax exemptions in the United States are very high. It is also popular because it allows the person gifting assets to retain “indirect access” because their spouse can access assets and use the assets to for both spouses, if needed. Because the trust is irrevocable, and the settlor is not a beneficiary or trustee, the assets within the trust are protected from creditors.
- Domestic asset protection trusts: “Asset protection trusts,” meaning a trust that you set up for your own benefit while enjoying asset protection, were not possible to set up in any United States jurisdiction until the late 1990s. After seeing the increasing popularity of offshore asset protection trusts through the late ‘80s and ‘90s, some states elected to pass legislation allowing these types of trusts in order to draw business and investments to their states. Now, 18 states allow these asset protection trusts to some degree. The trusts function like this: the Settlor sets up the trust and names themself as beneficiary, meaning they remain entitled to use the assets. A third party is named as trustee, or the legal owner of the assets. Because the Settlor/beneficiary is not the legal owner of the assets, and assuming the trust is drafted correctly, the Settlor/beneficiary’s creditors cannot reach the assets, because the Settlor/beneficiary is not the legal owner. For residents of states that have passed legislation allowing this type of trust, these are good vehicles for asset protection. Whether or not the trust will hold up for residents of other states is a gray area. California does not have a domestic asset protection trust law.
- International Asset Protection Trusts: International trusts remain the most comprehensive form of asset protection, simply because of the complexity involved for a creditor to try to bust an offshore trust. Structurally, international asset protection trusts are set up similarly to domestic asset protection trusts – the Settlor sets up and funds the trust; the Settlor is the beneficiary; and a third-party trustee is the legal owner of the assets. The third-party trustee is integral to the offshore asset protection trust – because the trustee is not in the United States, and has no ties to the United States, no court in the United States will have jurisdiction over the trustee. Even if a creditor discovers the trust exists, in order to try to bust it, they will have to go to the offshore jurisdiction, hire counsel there, post a bond (typically at least $100,000), and try their case again in the offshore jurisdiction. Any United States case will have no effect on the offshore trustee or court. Offshore jurisdictions also typically have short and stringent statutes of limitations, meaning most creditors are barred from bringing any claim at all.
What form of asset protection is appropriate for you will depend on a number of factors, including your risk profile, the size of your estate, your liquidity, and your personal risk tolerance.