Asset Protection Planning – By Jeffrey R. Matsen

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I. Introduction

Asset protection planning has been practiced by attorneys, financial planners and accountants for several decades. Business persons have always had concern over the exposure of their personal assets to claims against the business. The corporate form of business entity with its shield of limited liability has been invoked for centuries. Certainly, protecting one’s assets from the myriad of risk involved in business and personal financial planning is not a novel objective or planning idea.

Since the 1970’s, expanding theories of liability and the proliferation of litigation have given increased emphasis to asset protection planning to the extent that it is now a well recognized area of practice. It certainly comes within the concept of lifetime estate planning involving the protection and conservation of accumulated wealth or asset base.

There is really no recognized body of law called asset protection. Indeed, it is a multi disciplinary practice area that involves estate and tax planning, debtor-creditor law, bankruptcy law and practice, judgments and remedies, business formation and business structuring, contracts and commercial law. A better name for asset protection planning might be risk management planning. Risk management attempts to protect and shield a client from all the various types of risks that the client might encounter whether business or non business related.

II. Fraudulent Conveyance Law

A. Overview

The process of planning for estate preservation and risk management involves the marshaling together of one’s assets in order to protect them from loss or dilution from potential risk and claims to which they would otherwise be subject. One of the biggest obstacles or hurdles an individual faces with respect to implementing a legally efficacious risk management plan is the fraudulent conveyance law. Fraudulent conveyances are conveyances made (or presumed to made) with the intent to delay or defraud creditors. Usually, fraudulent conveyances are characterized by a lack of fair and valuable consideration and/or an attempt by debtors to place their property beyond the reach of creditors. In California, the law of fraudulent conveyances found in the Uniform Fraudulent Transferred Act (“UFTA”) as set forth in Civil Code Sections 3439.01 to 3439.12.

Basically, a transfer made or obligation incurred by a debtor is actually fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation with actual intent to hinder, delay or defraud any creditor of the debtor. A claim means a right to payment whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured. A transfer means any manner of disposing of or parting with an asset or an interest in an asset whether direct or indirect, absolute or conditional, voluntary or involuntary, and includes the payment of money, a release, a lease and the creation of a lien or other encumbrance. Although most cases involve transfers of assets, California applies the fraudulent conveyance law with equal force to obligations incurred by the debtor.

A creditor need not have a judgment or a matured claim against the debtor to enforce the remedies of the UFTA. The relation of debtor and creditor arises in tort cases the moment that a cause of action accrues.

To determine whether transfers were made with actual intent to hinder, delay or defraud creditors, the focus of the inquiry is on the debtor’s state of mind. The court often infers fraudulent intent from the circumstances surrounding the transfer taking into account the so called “badges of fraud”. These badges of fraud include:

  1. A transfer or obligation to an insider;
  2. Concealment of the transfer or obligation;
  3. The debtor’s retention of possession or control of the transferred property;
  4. Transfer of substantially all of the debtor’s assets;
  5. The debtor’s receipt of inadequate consideration for the transaction;
  6. The debtor’s insolvency before or shortly after the transaction;
  7. The incurring of substantial debts shortly before or after the transfer;
  8. Pending litigation or threatened litigation against the debtor;
  9. Transfer of the essential assets of the debtor’s business to a lienor who then transfers them to an insider of the debtor; and
  10. The debtor absconding with his/her property.

Once these badges of fraud are established, then the burden shifts to the transferee to provide a legitimate purpose for the transfers. California, however, seems to say that the presence of badges of fraud does not create a presumption of fraud but constitutes evidence from which an inference of fraudulent intent may be drawn.

B. Transfers

The fraudulent transfer law is primarily aimed at people who try to make gifts to other people or entities to avoid their creditors. In order for fraudulent transfers to be avoided, all transactions should be for “fair value”. In addition, the transfer should have economic substance.

Transfers to trusts are extremely suspect because they are not for fair value and often times do not have economic substance. However, transfers to limited partnerships and corporations may be “for value”. It is much more difficult to force a limited partnership or corporation to pay up than the debtor himself/herself.

III. Marital Planning

Prenuptial agreements and marital property agreements can be effectively utilized for risk management purposes. In California, one spouse may transmute his/her separate or community property by written agreement specifically setting forth the intent to transmit the property to the other spouse as his or her separate property. This transfer can be either outright or in trust. This process becomes important because a creditor of a married debtor may reach not only the separate property of that debtor, but the community property of the debtor and his/her spouse. On the other hand, the creditor cannot reach the other spouse’s separate property except to the extent the debts were incurred for the necessities of life. Accordingly, one very fundamental risk management planning tool to attempt to allocate separate property to the spouse with the least risk. Care needs to be taken in evaluating and implementing the strategy, however, because the fraudulent transfer laws are applicable to marital property agreements, even those entered into in the context of a formal marriage dissolution proceeding.

IV. Use of Trusts in Risk Management Planning

A. Traditional Domestic Trusts

Trusts can be among the useful of asset protection tools. However, many trusts that are created for estate planning purposes are not properly structured to provide protection from creditors. The typical revocable living trust wherein the trustors are the lifetime beneficiaries and retain the power to revoke, amend and invade the principal of the trust provides no protection whatsoever against the creditors of the trustors. Certain spendthrift trusts can provide protection for risk management purposes. Care must be taken in the setting up and drafting of these trusts, however, in order to account for the estate and income tax consequences as well as for asset protection planning.

B. Domestic Asset Protection Trusts

As was stated previously, most self settled trusts are not protected from creditors. However, recently, several states have provided various degrees of asset protection legislation for a self settled trust. The legislation of these trust in Alaska, Delaware, Nevada, Utah and Rhode Island are similar in many respects to the asset protection trust legislation found in several offshore jurisdictions. It should be noted, however, that the courts have not had an opportunity to pass muster on this type of legislation because of its recent enactment and because the statute of limitations in most cases has not expired. Depending on the timeline involved with respect to when the claim has arisen, these trusts can be and should be considered in appropriate circumstances, but only by an attorney who understands all of the ramifications.

V. Transmutation by Utilization of Charging Order Business Entities as it Effects Both Limited Partnerships and LLCs

A. Introduction

A charging order is a court order available to a judgment creditor directed to the partnership or LLC of which the judgment debtor is a partner or member which grants the judgment creditor the right to whatever distributions would otherwise be due to the debtor partner or member whose interest is being charged. The charging order has its origins as part of the English Partnership Act of 1890. The relevant provisions of that act are very close to similar provisions later adopted in the United States in the Uniform Partnership Act in 1914 and Uniform Limited Partnership Act in 1916. The purpose of the charging order was to prevent the judgment creditor of an individual partner from access to the partnership assets while at the same time, giving the creditor some relief relative to distributions from the entity to the partner. The charging order then became the exclusive remedy of the judgment creditor of a partner denying him direct access to the partnership assets and limiting the creditor exclusively to collection of the income or distributions which the partnership assets might engender for the benefit of the judgment debtor.

B. Foreclosure of the Charging Order

Many states now allow a judgment creditor to foreclose on the charged interest. However, it appears that the purchaser at the foreclosure sale becomes at most an assignee of an economic right to the judgment debtor’s income distributions. As such, the judgment creditor is still not a substantive partner and not entitled to participate in partnership or LLC management. A judgment creditor who forecloses may also face adverse tax consequences as he may be considered a partner for federal tax purposes. The income tax consequences to a judgment creditor who has foreclosed are to be differentiated from a judgment creditor who is a mere holder of a charging order. Most likely, the mere holder would not be considered a partner for tax purposes.

C. California Law

Section 15522 of the California Corporations Code deals with charging orders for California limited partnerships subject to the California Uniform Limited Partnership Act. Section 15673 applies for California limited partnerships governed by the California Revised Limited Partnerships Act (“CRLPA”). Limited partnerships formed after July 1, 1984 are governed by the CRLPA. Section 15673 makes it clear that a judgment creditor with a charging order only has the rights of an assignee. The relevant LLC charging order statute is found in Section 17302 of the California Corporations Code. In addition to giving a judgment creditor the right to a charging order, the legislation provides that the charging order constitutes a lien on the judgment debtor’s assignable member interest and the court can order a foreclosure on the member interest subject to the charging order. However, it is pointed out that the purchaser of the foreclosure sale has only the rights of an assignee. This Section is the exclusive remedy by which a judgment creditor can satisfy a judgment against a judgment debtor’s membership interest in the LLC.

D. Conclusion

The charging order seems to be the exclusive remedy for a California creditor when it comes to both a limited partner’s interest or an LLC’s member interest. However, the LLC charging order can constitute a lien and can be foreclosed upon. It would appear that a foreclosure only transfers the economic rights of the judgment debtor, but does not give the judgment creditor any right to participate in the management or to control the partnership or LLC entity. The greater fear from an asset protection standpoint is the implications of the Albright case decided on April 4, 2003 by the United States Bankruptcy Court for the District of Colorado which allowed a bankruptcy trustee to take any and all necessary actions to liquidate property owned by a single member LLC. The holding in the Albright case was based on the fact that the charging order limitation serves no purpose in a single member LLC because there are no other party’s interests affected. In a footnote, the Court indicates that in a multi member LLC, the charging order provision of Colorado state law would govern, although bankruptcy avoidance provisions and fraudulent transfer laws would come into play with respect to the setup of a multi member LLC intended to delay or defraud creditors.

E. The Charging Order Entity

1. Introduction:

The asset protecting planning concept of conveying assets to a limited partnership or limited liability company is simply that assets that would otherwise be attractive to a creditor are shielded from creditor attachments by transferring them to the entity in exchange for general limited partnership interest and LLC member interest. After the transfer, the assets are owned by the entity and not the transferor. Accordingly, the creditor’s claim must be satisfied as against the entity interest of the transferor. If the charging order is the exclusive remedy for the creditor, the creditor is precluded from actually having access directly to the assets. Instead the creditor in effect steps into the shoes of the partner or LLC member with respect to the right of distribution. As an assignee, the creditor is only entitled to receive the distribution to which the assignor would be entitled. What this means is that a creditor who has obtained charging order only has the right to receive distributions from the entity when and if such distributions are ever made even though the entity itself may have substantial income.

2. Charging Order Erosion:

Over the last several years, several state courts including California had a lot of judicial foreclosure sale of limited partnership interests. The trend in California begin with Cocker National Bank v. Perroton, 255 Cal. Rptr. 794 (Cal. Ct. App. 1989) wherein the California Court of Appeals allowed a judgment creditor to attaché and sell and partnership interest where the debtor demonstrated that the charging order it had obtained was insufficient to satisfy its judgment. Subsequently, in Hellman v. Anderson 284 Cal. Rptr. 830 (Cal. Ct. App. 1991) the California Appellate Court, adhering to the precedent set in the Perroton case, allowed a judgment creditor to foreclose on a partnership interest when foreclosure of the interest would not unduly interfere with the business of the partnership. In Prestly, 193 Br. 253 (Bankr. D.N.M. 1988), the Federal Bankruptcy Court in New Mexico determined that the bankrupt’s interest as a general partner and limited partner in several limited partnerships were assets of the bankruptcy estate and the bankruptcy trustee had the power to sell them.

It should be pointed out that there are several reasons why a court may refuse to order foreclosure with respect to a limited partnership or LLC set up. Moreover, even if foreclosure is ordered, it still does not mean that the creditor actually will get control of the assets within the entity. See Section V. B., above.

F. Asset Protection Structuring

With respect to the asset protection strategy and planning relative to limited partnerships, it is important to understand that both the limited partner interest as well as the controlling general partner interest need to be protected. In a limited partnership the general partner is personally liable and does not have the charging order protection. Therefore, the general partner should have the smallest possible interest. But this interest also needs to be protected because if the creditor obtains control of the general partner interest, it can possibly order distribution of the assets to the creditor by dissolving the partnership. Accordingly, to protect both the general partner and the limited partner interest, it may be appropriate to form a corporation to act as the general partner and have an offshore asset protection trust hold the limited partner interest. Since the general partner makes all partnership decisions including the right to make or not make distributions and the right to dissolve the partnership, it is important that the creditor of a limited partner not have the ability to gain control of the general partner. Therefore, normally, the transferor client should not be the general partner. It would seem that the best method of protecting the general partner interest is to form a new corporation, LLC or even another Limited Partnership and have it act as the general partner. Preferably, the client should not own the stock of the corporation general partner or the member interest of the LLC general partner. The general partner corporation can be domiciled in an offshore debtor friendly jurisdiction. An election can be made with the IRS to have the offshore corporation treated as a domestic entity in order to avoid negative foreign corporation tax consequences. It may be even possible to have a partnership of offshore corporations be the general partner so that a creditor would have to penetrate more than one offshore jurisdiction at the same time.

VI Foreign Asset Protection Trusts (“FAPTs”)

A. Introduction and Overview

A FAPT is a trust that is set up in an offshore jurisdiction which has enabling trust legislation providing for substantial protection against creditors of the trustor. One of the greatest advantages of the FAPT is the fact that by its very nature any legal attacks against its assets are transferred abroad to a different legal system. The FAPT is generally much more expensive to set up and create than a domestic trust and requires a certain willingness on the part of the Trustor to deal with offshore jurisdictions and trust entities. The FAPTs’ greatest value is for asset protection planning well in advance of any potential creditor problem. Moreover, many times FAPTs are only used when the client already has some international connections and networking. Recent cases have emphasized the need for careful planning in the structuring of the FAPT if it is to be legally efficacious and successful in meeting the purposes and objectives of the trustor.

B. Purposes and Advantages

Although some clients may have concerns about involving offshore trust entities in the asset protection and estate planning process, a properly established FAPT provides a much more substantive degree of asset protection than a domestic trust. Normally, it is more expensive and it requires more sophisticated and competent advisors because of the increased legal and tax complexities involved. The major advantages and purposes of the FAPT are set forth below:

1. No Comity of Law in Foreign Jurisdictions:

Most foreign jurisdictions do not recognize US judgments. This may force a trial de novo on the merits under the laws of the foreign situs trust in order for the creditor to impose liability on the trustor and reach the assets of the FAPT. Obviously, the fees and expenses of this trial de novo and the burden of having to select offshore counsel can be substantial. Moreover, the FAPT jurisdiction, generally, requires plaintives to employ attorneys who are licensed in that jurisdiction.

2. More Favorable Law:

Most foreign situs jurisdictions require that the burden of proof in challenging asset transfers to a FAPT is always on the creditor and does not shift to the trustor. Moreover, many foreign jurisdictions impose a higher standard of proof upon civil litigation plaintiffs such as the “beyond the reasonable doubt” standard. This is in sharp contrast to the “preponderance of the evidence” principle utilized in US domestic civil cases.

3. Statue of Limitations:

The FAPT legislation of many jurisdictions establishes a statute of limitations for challenging asset transfers to an FAPT that begins to run on the date of transfer. . This is contrary to US law where the statute may begin to run from the date the transfer is “discovered” by someone with a claim against the trustor. Additionally, the statue of limitations of many FAPT jurisdictions is much shorter than the typical four year statute found under US law.

4. Fess and Expenses Litigating in Foreign Jurisdictions:

Manifestly, it is going to be much more expensive and inconvenient to prosecute a claim offshore. Think of the inconvenience of having to pursue a claim out of state and then multiply that by two to three times the cost to pursue the matter in a foreign jurisdiction. Many foreign jurisdictions prohibit contingency fee arrangements forcing the claimant to finance a litigation process entirely on his/her own. Creditors may think twice about having to deal with a completely different legal system out of the country and, this unfamiliarity, plus the additional expanses and costs, and the entire uncertainty with respect to the process, adds a substantial element of protection to the FAPT.

5. Non Asset Protection Purposes:

The FAPT may assist the trustor in achieving several other objectives and planning goals independent of asset protection planning. Traditional estate planning issues such as the orderly transfer of property at death, the avoidance of probate, the strengthening of spendthrift provisions, greater privacy than under US law, the management of offshore assets and businesses and premarital planning can all be addressed by FAPT.

VII. Equity Stripping

Real property assets should have at least two layers of protection. First, property should be placed into an asset protected structured that features charging order protection. Second, the property should be debt financed so that little equity in the asset remains for creditors. The combination of the property being in an asset protected structure and having no, or very little, equity, acts to deter creditors from attempting to pierce the protective structure in the first place, since there would be no equity left for even a successful creditor.

It normally does not make much sense from a business standpoint to place a residence in an entity structure. Therefore, the client can utilize the home equity line of credit technique to substantially encumber the residence and make it more unattractive to creditors. There are other planning steps that can be taken, but one has to be very judicious in dealing with the protection of residences.

VIII. Exemptions

A. Homestead Exemptions

Generally, homestead exemptions vary from state to state. Florida, Texas, Kansas and Minnesota have very favorable and generous homestead exemptions. The Texas homestead exemption includes an unlimited amount on up to 200 acres of land if the residence is not in town or up to 1 acre of land if the residence is in town. In Florida, the exemption includes an unlimited amount up to a 160 acres if the residence is not in town or up to one-half acre if the residence is in town. In California, the homestead exemption is $50,000 for a single person, $75,000 for families and $125,000 if over 65 or disabled. In California, the creditor can force the property to be sold to satisfy his debt with the debtor of being awarded the homestead exemption amount out of the sales proceeds. In may be then that asset protection planning includes changing domicile to a more favorable homestead exemption state. In a reasonably recent Florida Supreme Court Case, the Court held that the debtor’s residence is protected under Florida’s homestead exemption even if the debtor purchased the residence with the intent to protect the value of the residence from his pre-existing creditor. See Havoco v. Hill 790 So. 2nd 1018 (Fla. 2001).

B. Other Exemptions

Florida law exempts the entire cash value of the life insurance policy and most annuities from creditor’s claims. California, on the other hand, has a very limited life insurance and annuity exemption. The Bankruptcy Code specifically excludes from the bankruptcy estate property that is deemed to be subject to a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non bankruptcy law. In this regard, the anti alienation provisions required by ERISA in retirement plans is such a restriction on transfer. Moreover, since federal law preempts state law, where state law might otherwise subject an ERISA retirement plan to creditor’s claims in a state court judgment enforcement proceeding, the protection afforded by ERISA supersedes state law and, arguably, the ERISA retirement plan assets are protected. The plan must be within the purview of ERISA, however, and its anti alienation provisions.

IX. Sophisticated Planning Methods

A. Introduction

In the right context and for the right client with sufficient property to warrant in depth planning, more sophisticated planning steps are available. It should be kept in mind that it is good practice to fragmentize the risk management process so that not all of the client’s eggs are in one basket.

B. The Modular Concept

Often times it is appropriate to plan an asset protection program that is modular in nature. For example, a domestic asset protection trust or offshore trust can be formed by the client’s parents or a relative for the benefit of the client’s heirs. The trust would then not be a self settled trust and the client would really have no outright interest in the trust. This control trust can then be the owner of some management type entities (LLCs) that can be utilized to provide management services for other types of charging order protected entities. The client can then set up a self settled trust which, in turn, would establish charging order limited entities in which to place the client’s assets. The management entity owned by the control trust would be the manager of these other entities.

C. Private Annuity

In the appropriate circumstances one of the most effective estate and risk management planning techniques is the private annuity. Simply stated, a private annuity is a legally binding agreement between two parties (neither of whom has to be in the business of selling annuities) under which one party transfers property to the other party in exchange for an unsecured promise to make periodic payments in a fixed amount for the transferor’s life or term of the years. The annuity can really be considered a sale wherein the transferor sells the property to another individual or entity known as the obligor in exchange for the transferee’s unsecured promise to make periodic payments to the transferor for the balance of his or her lifetime. The amount of the annuity is computed upon the fair market value of the property conveyed, the annuitant’s life expectancy and the applicable federal fund rate at the time of the sale. The annuity transaction can also be structured to provide for the life of the individual and his or her spouse. A private annuity is something like an installment sale except that instead of specifying an exact number of payments, the obligor promises to make payments to the transferor for the rest of his or her life. The annuity payments may begin immediately or they may be deferred for some period of months or years.

D. Other Techniques

There are a multitude of other techniques that can be utilized including advanced life insurance and annuity strategies, collateralization and structured financial products. These techniques should only be implemented under the guidance of an experienced and qualified attorney who practices in these areas.

Jeffrey R. Matsen is a partner with the Orange County, California firm of Bohm, Francis, Kegel & Aguilera, LLP. Over the past 30 years, Mr. Matsen has provided legal services to a myriad of individuals and business entities and has an extensive background in estate planning, business transactions and formations and asset protection law. He has lectured extensively before professional and lay groups and has authored several legal syllabuses for continuing education including “Asset Protection Techniques in California” published by the National Business Institute.

Let our Costa Mesa law offices help you get started by contacting us today.

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