ASSET PROTECTION: INSIDE AND OUTSIDE
I’m convinced that the term “asset protection” and the goals of asset protection are misunderstood by millions of Americans and even by the bulk of attorneys. Far too much legal planning is implemented and paid for in the name of asset protection but doesn’t come close to accomplishing what was envisioned.
Simply stated, asset protection is the concept of protecting your assets from the claims of a potential creditor. However, many think that by setting up an LLC, corporation, or estate plan or trust, they are finished planning and are good to go. That is the furthest from the truth.
What I want to do in this chapter is cut to the true core of asset protection and what many attorneys or self-professed gurus don’t talk about. Essentially, I’m going to pull back the curtain and explain what real asset protection means when it comes to potential lawsuits.
Now with that said, I have written two books on asset protection, and this one chapter certainly doesn’t do the topic justice with all the nuances and variations on asset protection. Nonetheless, this summary will give you the basic concepts to measure against your current plan, and at the very least, it will help you understand where to get started. Frankly, when it comes to financial freedom, how can we consider ourselves truly “free,” at least to some degree, if we don’t consider the risk of a lawsuit that could take everything away?
Let me break this down into four core concepts that will provide clarity and by so doing save you thousands of dollars and get you started on the real asset protection you desire.
1. Where’s the Beef?
2. Two Types of Risks
3. Automatic Protection
4. Targeted Strategies
For those that grew up in the ’80s or remember that iconic era, there was a famous commercial I’m sure you haven’t forgotten. It involved a typical fast-food commercial like you would see today with a B-roll of patrons eating their value meals and featured a little old lady (actress Clara Peller) looking at the skimpy amount of beef on the burger and asking the question, “Where’s the beef?” Classic ’80s fodder.
I use this TV commercial as an important example because we have thousands of clients come to our office seeking asset protection out of fear. They want to check the next box off their list in building wealth, and they have a false sense of urgency. As soon as I discover their feverish concern for “asset protection” imposed on them by some company firing them up unjustifiably, I ask them, “Where’s the assets? Where’s the beef? What are you stressed about protecting?”
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If asset protection is such a concern for you, tell me what these assets are that you are trying to protect.
This poignant and direct question accomplishes two important goals:
1. We decide if asset protection is even necessary. If there really aren’t any assets to protect, or they are already afforded protection, with automatic provisions (as discussed below), then we can move on to more important topics like actually building wealth. This is often a break-through moment or realization for the client when they understand that they have been overly fixated on asset protection, rather than spending time on building those assets to protect in the future. I love to turn the conversation to goal setting and practical legal planning to take their ideas to the next level and produce some real income and assets.
2. We determine what assets need protecting and then can hyperfocus on the assets themselves, taking an asset-by-asset approach to targeted protection. For example, we can create a holding company for a specific asset that is just what the doctor ordered for real asset protection.
To better advise and focus your attention on what matters most when considering asset protection, Figure 23.1 on page 248 is a list of assets that will drive the rest of the discussion.
Once we determine there are actually real assets that need protection, we can then start talking about the risks. I have classified risks into two simple categories; I refer to them as “inside” or “outside” risks or liabilities. This principle is at the heart of real asset protection and thus the title of this chapter.
Figure 23.1—Potential Assets
Inside Risk Is the Exposure Created By Doing Business
These risks are created inside your business. For example, if you are going to start a landscaping business, you just created a bunch of risks that if something goes wrong inside your venture (such as an employee or bystander getting hurt), you have just threatened your personal assets or even your home. By doing this specific analysis, we can isolate the issue to a direct correlation we can begin to focus on. See Figure 23.2.
Figure 23.2—Risk to Your Assets
Outside Risk Is the Liability You Create in Your Personal Life
This has nothing to do with your business. It’s outside of your business activity but is still a critical risk assessment we often forget to consider. For example, if you are texting and driving down a road and seriously injure a pedestrian, you have just created a significant risk to your assets, and it had nothing to do with your business. This is when the discussion of real asset protection begins to take form and shape into a constructive conversation.
I realize this can seem complicated, but this is truly the core of asset protection planning. Some see it as a fresh look compared to the advice of traditional advisors. Let me give an example that will make sense of this unique approach to analyzing your risks and assets.
CASE STUDY
A few years back, I had a client with a teenage driver in the house. (Yes, you know what is coming.) There was an accident one weekend, and two third-party individuals were terribly injured. It was a devastating situation for everyone involved. Of course, a lawsuit followed, and my clients scheduled a meeting with me to assess the potential damages and risk to their assets. Early in the meeting, the parents said something I’ll never forget and initiated my quest to teach this inside/outside concept. They stated confidently, “Well, at least we set up LLCs for our rental property that is paid off, so at least that is protected.” I regrettably had to tell them that the LLC didn’t protect them from this type of lawsuit. They were shocked and confused. I said that the LLC protected them from the rental, but it didn’t protect the rental from them getting into a lawsuit. I went on to explain further that the LLC protected their home and a number of assets from a lawsuit inside the LLC or from the rental (like a tenant gone bad), but the LLC didn’t protect the property and them from a personal lawsuit—something that happened outside the LLC (like a teenage driver). This reality is a shock to many people when they realize that the typical LLC protects them but doesn’t protect the asset. It sounds odd, right? Please read on further.
The good news is that there are structures—and yes, LLCs—that will protect the asset and not just protect you and your personal assets from the business. This type of LLC is called a COPE entity or Charging Order Protection Entity, and I discuss more fully below as one of my targeted strategies. This could be a perfect fit for your family if you have equity or assets other than your personal home worth protecting.
Sometimes, you get lucky, and you have asset protection already built into a plan or product that you are using. This means you are already covered—to some degree—in case creditors come after you.
Once you have made a list of your assets that need protection and identified your inside or outside risks, it’s important to understand which assets may already have automatic protection. Our federal and state government has felt it’s critical to our economy and the American way that certain assets are protected from most lawsuits. We, as a society, have generally decided that we don’t want to throw people to the curb with no assets at all when they go through a debilitating lawsuit. Thus, we have created certain classes of assets that are excluded from a creditor’s reach in a lawsuit.
This topic of automatic exclusions is a big one and difficult to do justice to in one section, of one chapter in this book; however, I want to summarize the “Big Five” exclusions, as I have come to call them, and how they may impact a client’s asset protection analysis.
Homestead Exemption
Retirement Plans
Life Insurance
Tenancy by the Entirety
Garnishment Limits
Homestead Exemption
This concept is one of the bedrock principles of debtor protection outside of bankruptcy, the concept being that a creditor can’t take every last penny of value from your home if you lose in a lawsuit. If there is equity in your home, you get to walk away with a few bucks to start your financial life over again after settling the claim. Interestingly enough, state governments dramatically vary on how much that exemption should be for your home after a lawsuit.
Retirement Plans
Many Americans don’t realize how protected their retirement plan really is against any type of lawsuit. This includes every type of retirement plan, from an IRA, to a Roth, SEP, 401(k), and even an HSA. There are only two people that can get into your retirement account without some sort of creditor exclusion, and it’s the IRS (federal government) and your ex-spouse in a divorce.
Now, you may not think this is a big deal, but everyone I explain this to seems to be able to relate to this concept with an aha moment when I explain how through all the ups and down of O.J. Simpson’s legal problems, he has kept his NFL 401(k) from creditors.
States can sometimes have the ultimate say about the exemption amount and how certain retirement accounts are protected. Regrettably, IRAs aren’t as protected as 401(k)s, but it’s still pretty amazing the protection you can get. In this asset protection context, there are really two types of retirement plans: those that are covered by ERISA (aka the Employee Retirement Income Security Act of 1974, which set minimum standards for protection for most voluntarily established pension and health plans in private industry) and those that are not. For example, a 401(k) is covered, but non-ERISA plans (such as IRAs, SIMPLEs, SEPs, and KEOGHs) vary from state to state when it comes to having automatic protection. The bottom line is if you are relying on your retirement plan as an asset protection vehicle, make sure you understand the rules in your state.
RANDY LUEBKE
In general, I feel that most people make too big of a deal over asset protection. So many people are afraid of the bogeyman or the proverbial “slip and fall” guest at your rental. The odds of something happening to you or your business that would be catastrophic are very small. That, by the way, is why insurance is such a bargain. For a small fee, you can protect yourself from catastrophe. That said, I also feel that most people do not truly understand risk or the risk of their particular situation. Remember, risk is like oxygen. It’s everywhere and all around us. You cannot see it, smell it, or taste it, but it’s there. You cannot survive without it, but too much risk, and you can explode.
Aside from business risk and market risk, the biggest risk that most of us ignore is our ability to earn an income. Financial plans look great when one spreadsheet lays out 20 to 30 years into the future the future earnings, savings, and compound growth. But what if you don’t get 20 to 30 years? What if you can’t work due to health-related issues or you are laid off and unable to find a replacement job? Oh, yes, then there is that one absolute certain risk, as we will not be around forever. Once again, often the best “asset protection” can be as simple as having an adequate long-term financial plan that involves your business and every possible option.
Life Insurance
Life insurance can be used for asset protection as well as for investing and estate planning. Essentially, life insurance is afforded some protection under federal bankruptcy exemptions, but protection across the states varies drastically. Some states give blanket protection of all the accrued cash value inside an insurance policy. Others may give just a limited dollar amount of protection. There are even limitations on the ability of the IRS to collect against the cash value, or the proceeds, of life insurance. Of course, if you have term life insurance, which does not build up liquidity inside the policy but simply pays out a death benefit upon your passing, there is no cash value to worry about protecting.
I still don’t think the primary reason to purchase life insurance should be for asset protection. It can be expensive, and you should have other important goals you want to accomplish if you are going to make such an investment. Therefore, I don’t recommend that anyone rush out and buy life insurance just to protect their cash in the bank. Rather, I encourage my clients to make the wisest possible decision for the investment of their liquid assets and real property. In sum, be cautious about being oversold on insurance for the purposes of asset protection.
Tenancy by the Entirety
If your state allows it, you can title your personal residence as “tenancy by the entirety,” which offers unique a protection: if one spouse is sued, the property cannot be attached or bifurcated by the lawsuit. Essentially, tenancy by the entirety holds that if a husband gets into a terrible lawsuit, it’s not fair that the wife loses the house when the lawsuit had nothing to do with her (or vice versa). There are approximately 15 to 20 states that have this law on the books, including Hawaii (as if you needed another reason to move to the Aloha State).
Garnishment Limits
Garnishment limits are imposed by state law to limit how much a creditor can withhold from a paycheck so people can still make enough money to live.
After analyzing your asset list for any automatic protection, you will likely determine that you still have risks and assets that are exposed to these risks. We can then implement targeted strategies that are effective and affordable. Moreover, we can use strategies that make sense so as not to overdo our asset protection.
Many times, nonlawyers, coaches, gurus, and document prep companies will oversell one-size-fits-all strategies that don’t actually protect anything. To add insult to injury, they will accuse your lawyer of being a liar and then charge excessive fees for their silver bullet protection that costs far more than what a skilled asset protection attorney may charge. (This issue alone was the impetus for my first book Lawyers are Liars: The Truth About Protecting Our Assests (Life’s Plan Publishing, 2007) and later chapters in my book The Tax & Legal Playbook: Game Changing Solutions for Your Small-Business Questions). In both of these books, I have appendices that list how the various states treat your retirement accounts, life insurance, or primary residence in regards to asset protection.
I want to propose three targeted strategies that a competent asset protection attorney can at least present and discuss, then tailor them to a client if it’s a good fit for their situation and will work in the state in which their client resides. Again, state domicile and where the asset is can play a big part in the planning.
Charging Order Protection LLCs
In a nutshell, a Charging Order Protection Entity (COPE) protects your assets from personal liabilities that arise outside your entity holding the asset. Now, the Limited Partnership (LP) in most states and a limited number of states give this COPE protection to the Limited Liability Company (LLC).
I’ll talk about LPs in the next targeted strategy because LLCs and LPs have one major difference when doing COPE planning. The IRS treats the LLC much more favorably when it comes to rental property—no matter what type of rental property. Essentially, you are going to get far better tax treatment with an LLC when it comes to rentals and flow-through depreciation, something you don’t get with an LP. Discuss with your attorney and tax advisor the types of assets that are best for an LP.
Now, the COPE is exactly the protection I was talking about at the beginning of the chapter that will protect you from an outside liability. Many times, we structure a COPE to own all the other sub-LLCs or assets when we have a client with significant assets. Again, be careful of getting oversold this strategy when you are just starting to invest.
The legal principle of the COPE was developed in courts and then codified under some state laws, and allows you, the owner of an asset, to protect its equity inside an entity such as an LLC or limited partnership (LP). Thus, by putting an asset like a real estate property or an investment account in the right type of COPE, you have protected the asset from an outside liability.
The effect of this law is that a judge will give an order charging a debtor to pay creditors from the revenue of an entity but not allow the creditor to foreclose on or dissolve the entity to get at the asset. However, this protection isn’t provided in every state. Approximately 13 states have COPEs for LLCs, while 40 or more provide the same protection through an LP. Again, your tax and legal advisor should collaborate to determine if and when you should utilize this strategy.
Domestic Asset Protection Trusts
This is one of the hottest structures in asset protection today. It’s great for protecting your primary residence, and you should consider this to be the best use for a Domestic Asset Protection Trust (DAPT).
Essentially, a DAPT is an irrevocable, self-settled trust created and protected under state statute. Once you place your assets in the trust, after a certain amount of time (which will vary by state), the assets are protected indefinitely from future creditors. What makes DAPTs so popular is that they don’t require you to file a separate tax return, nor do they have gift tax consequences. They are relatively affordable and easy to set up and maintain. A DAPT can hold your personal residence, stock brokerage accounts, or LLCs that own your rentals. Moreover, it is ultimately coordinated with your revocable living trust and enhances your estate plan (but doesn’t replace it).
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The more assets and wealth you have, the more asset protection you need.
While a DAPT can own rental property LLCs, I typically have concerns when they are used for this structure because of the third-party trustee requirement and steps that need to be taken for distributions. For example, if you want money or assets out of the DAPT, you need to request the distribution from your trustee. This will typically be a friendly trustee who looks out for potential creditors against you before making a distribution, but it’s an extra step that can be cumbersome.
Rather, I recommend a DAPT for assets that you will have for a very long time or make few changes to—such as a personal residence, farm, cabin, etc. In those cases, managing a DAPT and its assets can be simple, affordable, and straightforward. Moreover, you can be designated as the investment trustee, allowing you to make decisions regarding the sale and acquisition of assets within the DAPT.
Yes, in the end, the DAPT could ultimately fail when challenged in your home state by a creditor. At that point, it would be unlikely you could keep a creditor from reaching the assets held in your DAPT. But one of the key strategies of a DAPT is that the amount of time, money, and resources needed to reach the assets could potentially dissuade creditors from pursuing them.
TAKEAWAY 1—Before going to great lengths and spending a lot of money protecting assets, make sure you have assets that are worth protecting.
TAKEAWAY 2—Make sure you understand which of your assets may already be protected under an automatic exemption. Review how such protection works (or whether it counts) in your state.
TAKEAWAY 3—Consider a Charging Order Protection Entity (COPE) or a Domestic Asset Protection Trust (DAPT) as a targeted asset protection structure if you have an asset mix that warrants it.