Wealth Protection Strategies
The objective of family wealth protection is risk management. The goal is protection against "torts." A tort is an injury (physical, financial, emotional, or psychological harm or damage to one's personal reputation) to one person for which the person who caused the injury is legally responsible. Wealth protection does not prevent injury to another, but is designed to discourage law suits and to promote a favorable and inexpensive settlement to all parties to the injury. Wealth protection is not intended to avoid payment of one's contractual obligations such as a bank note for which an individual is personally liable, or legally imposed debts such as taxes. These strategies are not "bullet proof" and are likely to be of no value in bankruptcy.
Adequate liability insurance protection may be one of the simplest and most cost effective means of family wealth protection:
Both state and federal laws statutorily exempt certain individually owned assets from attachment by creditors. Appropriately, these assets are typically referred to as "exempt property." These laws vary significantly from state to state. A few states have unlimited homestead exemptions which may encompass a residence, the land underlying the residence. In most states, however, the homestead exemption is much more limited and may be of little value as a wealth protection strategy.
Insurance policies are generally protected assets. The degree of protection varies significantly from state-to-state. We do not advocate the purchase of life insurance or annuities solely for wealth protection against creditors. These products are intended to fulfill other financial, tax, and estate planning needs; creditor protection is simply a by-product these contracts afford. Life insurance policies held by irrevocable life insurance trusts (discussed elsewhere on this website), and the cash held by the trust to pay premiums, may also be protected property.
Annuities may be protected assets. Commercial annuities (those widely sold by large insurance companies), may offer more wealth protection than do private annuities. A private annuity involves the transfer of property, generally to another family member, in exchange for a future stream of payments. The assets subject to the annuity payments may be considered assets of the transferee and subject to his creditors, even though the transferor may be protected. Monthly or annual annuity payments to the annuitant may or may not be protected from creditors. Like life insurance policies, annuities should be purchased for financial, tax, or estate planning purposes. They may, however, offer an additional level of family wealth protection.
Qualified retirement plans, though perhaps not IRAs, are generally protected assets, at least to some degree, by both federal and state laws. The Employee and Retirement Income Security Act (ERISA) prohibits an employee from transferring his interest in a qualified retirement plan to a third party. As such, assets held by a qualified plan are unfavorable targets for a creditor. Federal law provides, however, that an employee's interest in his or her qualified plan may be transferred, tax-free, to a spouse or dependent under a Qualified Domestic Relations Order (QDRO). QDROs are frequent components in divorce settlements.
Nonqualified retirement plans, common for highly compensated employees, are unfunded contracts between the employer and the employee. Being unfunded, amounts under these contracts are subject to the creditors of the employer and not the employee. To the extent an employee becomes "vested" in his nonqualified plan, those assets may, depending on state law, be subject to his creditors not withstanding the fact that those assets are still held by the employer or a trust established by the employer for that purpose.
One of the most common wealth protection strategies in the transfer of wealth over generations is the use of appropriate trusts. Not every trust affords wealth protection to the person who establishes the trust or to the trust beneficiaries. The very common revocable trust (also know as "living trusts") is an appropriate tool for asset management in certain circumstances, and provides probate cost savings in some states, but offers the creator(s) no protection against claims by third parties. The assets held within the trust are considered by state and tax law to be owned by the trust maker.
Other types of trusts in which the grantor gives up most or all rights to the trust property generally offer legal protection of those assets. These are "irrevocable" trusts and may be created and become effective during the grantor's lifetime or may be created in a grantor's will and become effective only upon his or her death. Irrevocable trusts carry with them giving up control of trust assets to a trustee; an act that a trust maker may find uncomfortable. There are many types of trusts:
We believe that the use of trusts is generally limited only by the ability of the trust maker to articulate his or her desires and objectives. Because trusts need to be tailored to the specific outcomes defined by the maker, they should be drafted to meet the unique needs of the individual and his or her family. Transferring assets into trust (called "funding" the trust) typically has transfer-tax implications. Therefore, trusts should only be drafted by legal counsel knowledgeable of both the legal and tax consequences. Choice of trustee is important. Trusts are not for every family, but properly structured they can offer a virtually unlimited range of alternatives for family wealth protection.
Limited liability entities such as corporations (including "S" corporations), limited liability companies (LLCs), professional corporations, and limited partnerships offer a high degree of family wealth protection to business owners again torts asserted against the business. Properly structured and operated, family limited partnerships (discussed elsewhere on this website) may offer some degree of family wealth protection. One important caveat, however; families should not allow all of their wealth to accumulate within an entity. Business failure or a law suit against the entity can eliminate a family's principal assets. Removing wealth from a limited liability entity has important tax consequences, however, and should be carefully planned considering both the needs of the entity and the family.
One closing note; this site does not condone fraudulent "asset protection" attempts to hide assets from other family members, creditors, or the Internal Revenue Service. Scams abound and must be avoided at all costs. Widely touted "offshore asset protection trusts" are frequently ineffective, illegal, and may result in criminal, rather than civil, legal action. We neither promote nor tolerate family transfers with fraudulent intent. Wealth protection is a function of state and federal law and should only be undertaken in consultation with ethical and knowledgeable legal counsel. Those caveats having been stated, the goal of preserving and protecting an individual's or family's wealth is a legitimate objective.
Outright gifts to children or spouses provide no protection whatsoever for the beneficiaries' creditors, or ensure that the assets will be used in the manner anticipated or desired by the person making the gift. The choice of wealth protection strategies is vast. Typically, no single technique is sufficient and the interplay of various strategies can be complex.
Working with knowledgeable legal counsel, we have assisted clients in designing workable, legal, and appropriate family wealth protection strategies including the use of liability insurance, protected property, retirement planning, various forms of trusts, and the selection of an appropriate type of liability protected business entity. We are prepared to work with your family to achieve the same objectives.
©2008 Ronnie C. McClure, PhD, CPA