Common fatal flaws of asset protection planning, Pt. 1
By Ike Devji
PRO ASSET PROTECTION
For the last seven years, the sole focus of my legal practice has been asset protection and estate preservation planning that touched literally thousands of clients representing billions of dollars in personal assets. During that time, I have seen the best and the worst of the planning available to the American public, as well as the most common flaws evident in both self-directed planning and plans executed by professionals who do not practice primarily in this area. Here is a short summary of issues to keep in mind when addressing this crucial issue — please bear in mind that the information included in this article is written in the broadest terms and is never a substitute for consulting with an experienced professional:
1. Failing to act – Asset protection is best analogized to “net worth insurance” and, like insurance, you have the best, most effective and legally supportable options available to you when you implement the planning before a crisis exists. Transfer of assets into plans after you have specific exposures is costly, ineffective and in some cases illegal (fraudulent conveyance). The best time to act is always now, and every day that passes makes your planning stronger.
2. Thinking you're not rich enough – This is a sin I see committed on a weekly basis, often by professionals like lawyers, CPAs and financial advisors. These advisors often tell clients that they are not rich enough to do any planning and that that they must have a net worth north of $5 million or even $10 million dollars to consider it. Nothing could be further from the truth, especially if you are in the “fall” of your earning career. Of course high-net-worth individuals must implement this kind of planning and always have, but there are precautions that can be taken at any net worth level. When should you start? There are many simple ways to analyze this but here is an easy one. Answer these questions:
- If you lost what you have today — or some significant portion of it — are you at an age, earning level and financial condition that will allow you to maintain your family’s goals and expenses?
- Do you have assets that would be difficult or impossible to replace given your age, health and economic conditions?
- Are you financially and legally prepared for a lawsuit that is either uncovered by liability insurance or which often produces verdicts above the limit you are carrying?
3. Relying on your traditional estate planning — Not a week passes when I don’t talk to someone who says, “I’ve got this covered, I think. I have my home, cars and investments all titled in my trust.” A little more probing on my part reveals what I expected; that the layperson I am speaking to feels that a transfer of these assets to a vehicle like an estate planning trust — commonly a revocable living trust — is effective protection. It’s not. The first word in the trust is “revocable” and in most cases, a judge will simply order you to revoke the trust and tender the assets for a judgment. I’m all in favor of estate planning — the huge new looming estate tax exposure is one of the issues on my client exposure checklist we address every day — but that is death planning. What has been done about your life planning and the exposures you face every day practicing your profession, driving a car, having children (some driving your car) or having employees?
4. Too many eggs in one basket — Others do take initiative and implement a good tool like an limited liability company (LLC) as a barrier between themselves and their investments, but fail to adequately segregate and subdivide assets so that they are protected from the owner and each other. A common example is the case of the residential rental property owner who has a single LLC that is legally and financially responsible for a wide variety of properties that have different levels of liability, equity and use. If you call and say you have $5,000 to $10,000 down on four new short sale properties in a single LLC, it’s probably OK, because your total exposure is theoretically limited to $20,000 to $40,000, the value of the LLCs assets. On the other hand, if you call and say that you have seven pieces of real estate with a total equity position of six or seven figures, some paid for, some all debt, including a triplex, a lot and a commercial strip mall, I’m going to start sweating on your behalf. Primarily because any exposure at a new, zero equity property could wipe out your entire portfolio of paid for or partially paid for properties. Assets must be divided based on use and equity, as well as into the right kind of legal vehicle, among many other factors, as explained below.
5. Square peg, round hole: Using the wrong tool — Another flaw I often have to untangle is the “funding” of assets into the wrong vehicle. Certain vehicles have great uses for specific business functions supported by statute, tax law and case history. You and your planner must have a good handle on these issues and know what pros and cons each entity presents, what the effect on your liquidity will be, and what it will take to maintain and support that stated business purpose as a start. Beginning to see the detail required? One good example is the common misuse of family limited partnerships (FLPs) to own the client’s personal residence. What is the legitimate business purpose of using a vehicle that is most often created for “family investment management and wealth transfer” to own the house you personally live in? If you’re not paying commercially reasonable rent, you don’t have one. In this case, the plaintiffs will successfully argue that you are using the FLP as a personal piggy bank that is not legally distinct from you and your personal assets and liabilities, and the IRS won’t find it cute, either.
6. Dragging liability into your plan — Similarly, we often see dangerous articles of personal property like personal vehicles moved into an FLP, or others like an LLC or S-Corp. that is a primary business. Or equally dangerous, they are moved into an entity like an FLP that is holding safe and attractive assets like cash, stocks, bonds and other liquid assets. Think about it: If you lease or own your vehicle through your business, you have taken the most dangerous activity you likely perform on a daily basis — driving a car — and linked it to either the source of your wealth, your business or, in the case of your FLP, the place you keep your wealth.
7. Relying on gifting to relatives — Transferring all of your assets to your spouse and/or children, especially after something has happened, will not protect your assets from a lawsuit. Even if it did protect you from lawsuits, transferring your assets to your spouse and/or children opens up another Pandora’s Box. Keeping in mind that there are thousands of lawsuits filed daily due to employment grievances, slip and fall, and auto accidents, consider this scenario: Let’s suppose that you transfer all of your assets to your 18-year-old son, who causes an auto accident. Several other cars are involved in the accident, and several injuries are incurred. Chances are high that the other parties will come looking for the driver with the deepest pockets. If your son “owns” your house and business, a sympathetic jury will undoubtedly take the possession away from your son in order to teach him a lesson for his reckless driving. The same holds true for spouses, parents and even friends. Also, gifting is limited to about $13,000 annually, per spouse, per donee. Gifts over that amount must be documented with a gift tax return. Failing to do so will result in you having to answer the question, “Are you lying now regarding the date and validity of this transfer or did you cheat the IRS?” A bad place to be in a time of need.
8. Using unproven, poorly-structured tools or scams like "friendly liens" — Another common scam I see is promoters of LLC mills setting up LLCs that you or a friendly party own, and then having that entity record a “lien” against some valuable asset, typically real estate. While validly recorded and executed liens do have great deterrent power against creditors, they have to be backed by a real exchange of value. So, if your brother-in-law owns a Nevada LLC that holds a lien on your home for most of its value, there should have been some exchange or “consideration” roughly equal to the amount of the lien. “Your sister has a $300,000 lien against the $400,000 home you live in? Uh, OK … Then where’s the $300,000 she gave you, as a bank would have in a real home equity loan? She didn’t give you anything in return? Great, we’ll take the house.”
9. Relying on insurance alone or failing to adequately insure. Why can't we simply insure our way to safety? — This is a reasonable and common question we get from clients and advisors alike. In the most egregious cases of armchair quarterback misinformation, we actually see uninformed advisors telling their clients that the only asset protection they need is a good umbrella policy. This is flat out wrong for the kind of successful people we protect. Why? Because they are successful, visible and typically have assets above and beyond just the insurance policy itself — they are good targets from a net-worth perspective.
Our position on liability insurance — as distinct from life insurance — is pretty simple: Buy as much liability insurance as you can afford, assume it won’t be adequate, and have a plan B.
The second part of this series examines the liability insurance model, the role of "umbrella" policies, and the best way clients can ensure that they're properly covered.