An Introduction to Asset Protection
Asset protection refers to a set of legal techniques that protect a person’s property from creditors and judgments. While there have always been protective measures available to persons to protect their assets, there has never been as great an interest in asset protection until recent years. The litigation explosion of the latter part of the last century prompted overwhelming interest in this area. The statistics are overwhelming: Nearly every American business and every American individual will be sued at some point in their life. An even greater number will be threatened with lawsuits. Despite these dismal statistics, only a slim percentage of Americans bother with any asset protection considerations at all. Asset protection planning ranges from simple devices such as transferring assets to a retirement account, to more complex arrangements such as offshore trusts.
The Strange Case of OJ Simpson and His Protected Assets
In 1997, a civil judgment entered against celebrity O.J. Simpson in the amount of roughly $33,500,000 in a civil case brought by the family of his former wife and the family of Ron Goldman following their alleged murders by Mr. Simpson. One might think Mr. Simpson’s property would have to be relinquished to satisfy this enormous judgment. Yet Mr. Simpson lives in a lavish Florida mansion, and enjoys a steady pension. Sure, some assets have been seized, but the bulk of Mr. Simpson’s property remains out of reach of his creditors. In fact, Mr. Simpson has never declared bankruptcy or taken other action to extinguish the liability.
How is this possible? The answer is that Mr. Simpson arranged his financial affairs in a completely legal manner that left his assets out of the reach of creditors. Florida, his new home state, just so happens to be one of the most advantageous states for asset protection. When asked about his choice of domicile, Mr. Simpson responded in an interview that while he intended to move to Florida anyway, ‘an added benefit is some of the laws here in Florida.’
Approaches to Asset Protection
Asset protection planning can be effected in essentially three ways. The first is divestiture, by which an individual transfers his property to another, either by outright transfer or by having liens or mortgages placed upon the asset. This method relies on the simple truth that a creditor cannot have what a debtor does not own. The second way is through exemption planning, where an individual transfers assets to a statutorily protected class of property, such as residential homestead, life insurance, or an IRA. These classes of protected property vary widely by state. The third way is through the use of liability shielding entities such as corporations and LLCs. Hiding one’s assets is not part of responsible or effective asset protection planning. First, it may be against the law, and second, it doesn’t work well.
Asset Protection Issues and Asset Protection Secrets
Several general themes apply in asset protection:
- No asset protection plan can ever give anyone 100% protection from creditors; asset protection planning can only shield most of a person’s assets from creditors. Some assets will always be exposed.
- The proper goal of an asset protection plan is to frustrate creditors by altering the creditor’s economic analysis of a lawsuit (by making it more expensive and uncertain for the creditor). In other words, the plan itself doesn’t give the protection; how the creditor perceives the plan gives the protection.
- Timing is important. An asset protection plan must be put in place well before a creditor or plaintiff emerges. Otherwise, the plan will be exposed as a transparent last-minute effort to thwart creditors.
- An effective asset protection plan can be made even more effective by ‘layering’ applying different legal protections over the same assets.
- Compartmentalization is an effective asset protection planning tool. For example, an owner of rental properties (rental properties generally carry a high risk of liability) can place each separate rental property in a separate LLC or corporation. If one property results in liability, a creditor will be forced to pursue liability against only one entity, and will not reach either the owner and her other properties.
- A simple asset protection plan is generally more effective than a complex plan.
How Plaintiffs Think
The key to asset protection is to step into the mind of the plaintiff. First of all, the plaintiff can’t just go around taking a debtor’s property until the underlying dispute is heard in court. Only after winning the suit can the plaintiff proceed to the collection phase of his suit. The plaintiff wants a quick, inexpensive trial. After that, the plaintiff wants a quick, inexpensive, and productive collection phase. Lawsuits are economic events and require economic analysis. Only a foolish plaintiff would pursue a case without some certainty of recovery. Asset protection seeks to deter lawsuits by confounding the certainty of a plaintiff’s recovery.
Protecting the Family Home With Asset Protection: Homestead Exemption and Liens
For most Americans, the most valuable asset they own is their personal residence. The home offers some of the simplest and most effective asset protection planning. The first device is the homestead exemption, sometimes called simply a “homestead.” We discuss the homestead exemption in a separate article here.”
In states with low homestead protection, mortgages and liens provide a very effective means of protecting the personal residence. This process is sometimes referred to as ‘equity stripping,’ or in some cases an owner of property can put in place a ‘ friendly lien.” A residence with liens on it is essentially owned by the bank. The home’s lienholders have priority over subsequent creditors. Any creditors who levy a home with one or more existing liens take a disadvantaged position behind the lienholders. In the event of a sale, the creditor is less likely to get a recovery. A property owner can lien up his or her own property by increasing the size of an existing mortgage, or by getting a home equity line of credit (HELOC). Most HELOC loan do not require the property owner to ever draw money on the loan, drawing on the HELOC is optional but once the HELOC is in place, it discourages later creditors from pursuing the owner.
Placing liens on property works similarly well for other assets, such as cars, art collections, business inventories, securities, and a wide range of other assets.
Asset Protection Through Property Exemptions
Every state protects certain classes of assets through property exemption statutes. The property exemption statutes serve a dual purpose. First, they denote types and amounts of property that are unreachable by creditors. Second, these statutes also denote types and amounts of property that cannot be lost by a debtor in bankruptcy. A bankruptcy court is a de facto creditor, so a bankruptcy court can only reach what a creditor can reach. This principle applies to homestead laws as well, except for some recent erosion built into the 2005 bankruptcy law revisions. So, good asset protection planning is also effective pre-bankruptcy planning.
So, the property exemptions are plainly valuable. Again, property exemptions differ widely by state. Texas places the full amount of all IRAs beyond the reach of creditors, while California exempts retirement accounts ‘only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor.’ California’s subjective test for retirement account exemption results in frequent disputes. Florida exempts an automobile of up to only $1,000 in value, while Texas exempts one automobile of unlimited value per spouse. Florida and Texas exempt wages from garnishment, which most states do not.
The property exemptions also contain some historical oddities. Texas’ generous property exemptions include ‘two horses, mules, or donkeys and a saddle, blanket, and bridle for each; 12 head of cattle; 60 head of other types of livestock; and 120 fowl.’
In order to take advantage of the property exemptions, one must first investigate the property exemption statutes in one’s state of residence this state’s property exemption statutes will govern. Property exemption planning is simply the process of transferring non-exempt property into exempt property. The simplest and most common example is to arrange and select the most appropriate retirement account. Moving cash into an IRA in most states will shield the asset from creditors. In other states, certain types of retirement accounts are more protected by others. Property exemption planning also means avoiding property transfers that expose protected assets. There have been cases where uniformed debtors cashed out their pensions (pensions are fully asset protected by federal law) and moved the proceeds into non-exempt assets, thereby exposing the asset to creditors.
Asset Protection Through Liability Shielding Entities
Nearly all business owners can protect their personal assets by conducting their business operations through a liability shielding entity, a corporation or LLC. Both forms of entity serve the same liability shielding purpose. LLCs and corporations serve the specific purpose of isolating the liabilities of a business enterprise with the entity. This approach should always be the business owner’s first line of defense in protecting their personal property. A liability arising out of the corporation’s operation attaches to the corporation only, and cannot reach the owner’s or owners’ property. Of course, extreme misuse of the corporate or LLC form can erode that liability protection.