Asset Protection Planning for Vulnerable Professionals

By:
Matthew E. Rappaport, JD, Esq., LLM
Published Date:
Aug 1, 2020

America is the most litigious society in the world, and few thoughts strike more fear into the hearts of ordinary people than a protracted lawsuit and—even worse—enforcement of a monetary judgment. Outside of the nation’s capital, New York is home to the most lawyers per capita, so the dangers of litigation loom larger in that state than almost anywhere else.

Professionals are in an especially vulnerable position because New York law prohibits them from using an entity to shield liability for their own malpractice. This policy makes accountants, lawyers, doctors, architects, engineers, and other licensed practitioners prime targets for plaintiffs’ counsel. One wrong move could spell liability in excess of insurance limits, leading to seizure of personal assets and future income.

With this existential peril looming over their heads, what should professionals do to protect themselves? This article describes some strategies that can help and considerations when implementing them.

Timing Is Everything

The first principle to understand about asset protection is that timing matters. The chief timing risk in the asset protection process is enacting a fraudulent conveyance. Despite its name, a fraudulent conveyance doesn’t actually have to be fraud; rather, any transfer meant to hinder, delay, or defraud a creditor could be ruled a fraudulent conveyance.

When determining whether a fraudulent conveyance has occurred, a court will weigh—

  • the balance sheet of the debtor at the time of transfer,
  • the adequacy of consideration from the counterparty,
  • the presence of reasonably foreseeable creditors at the time of transfer, and
  • badges of fraud.

Badges of fraud include—

  • transfers to an insider (e.g., a relative),
  • retention or control of the property after the transfer,
  • concealment of the transfer from outsiders, and
  • timing of debts incurred after the transfer.

Even if one of these badges of fraud or another of the four fraudulent conveyance factors weighs against the transferor, the court might still rule in the transferor’s favor, depending on the remaining facts and circumstances. Advisors should not consider any single factor dispositive in either direction.

If a transfer is deemed a fraudulent conveyance, the transaction is voidable, which means a court may decide to reverse the transfer and render the asset involved subject to attachment by the transferor’s creditors. Contrast this concept with void ab initio, which means the transaction is automatically reversed. A voidable transaction affords the presiding judge discretion, but a transaction that is void ab initio does not.

Besides reversing the subject transfer, a court’s other remedies for fraudulent conveyances include issuing an injunction preventing any further transfers and appointing a receiver to take control of the property in question. Receivership is especially painful because the receiver has sweeping rights to operate and manage the property, effectively leaving its original owner entirely shut out.

Fraudulent conveyances against the government, including regulatory agencies like the IRS, could result in criminal penalties. In fact, both debtors and their advisors could be held criminally liable.

IRC section 7206 imposes a potential penalty of $100,000 and three years of imprisonment. Advisors rendering asset protection advice must be very mindful of these concerns and should conduct thorough due diligence to avoid inadvertently aiding a debtor in enacting a fraudulent conveyance against the government.

Types of Titling

The simplest of all approaches to asset protection is titling assets in another person’s name. When a debtor owns an asset outright, the debtor’s creditors may seize the asset without restriction, unless an exemption applies.

In a tenancy in common (TIC), creditors can recover a debtor’s TIC interest but cannot recover any other TIC interests. Upon seizure of a debtor’s TIC interest by creditors, the other TIC owners typically experience the inconvenience of an action for partition of the property by sale, in which the creditor TIC petitions a court to force the sale of the property.

In a joint tenancy, whether or not with a right of survivorship, each tenant’s proportionate share is subject to creditors, who can sever the debtor tenant’s interest from those of the other tenants. For instance, if two people are joint tenants with a right of survivorship, creditors can typically attach the debtor tenant’s one-half interest in the property.

In a tenancy by the entirety, a form of ownership available just to married couples, creditors can attach the property itself only if both spouses are debtors. If only one spouse is a debtor, the creditor takes a risk. If the debtor spouse dies first, the remaining interest passes to the non-debtor spouse; on the other hand, if the non-debtor spouse dies first, the remaining interest passes to the debtor spouse by operation of law, thereby exposing the asset to creditor attachment.

While tenancy by the entirety is almost always the preferred form of ownership for personal residences, which typically don’t produce income, advisors should note that creditors can attach the debtor spouse’s share of any income derived from property owned as tenants by the entirety.

Retitling assets has collateral consequences, and advisors need to plan around them to avoid adverse consequences. Examples include blended family and remarriage issues; estate, gift, and generation-skipping transfer (GST) tax issues; matrimonial issues; and exposure of assets in a different spouse’s name to their creditors.

Qualified Plans

Plans qualified under the IRC are generally exempt from all outside (i.e., non-family) creditors. This includes all IRAs, 401(k)/403(b)/457 plans, and Keogh plans. The federal government (but not New York State) also requires plans to be qualified under the Employee Retirement Security Income Act (ERISA) to enjoy protection from outside creditors. Single-participant non-IRAs (e.g., a “Solo-K”) are generally not qualified under ERISA.

Qualified plans don’t enjoy protection from all creditors in all circumstances: exceptions include claims by the federal government for tax liabilities, restitution, or other judgments held by a federal instrumentality; equitable distribution in divorce proceedings; and payments of alimony and child support. But excluding family and troubles with the government, creditors will have no luck attaching qualified plan assets—making qualified plans excellent asset protection vehicles.

The Supreme Court of the United States clarified in its 2014 Clark v. Rameker decision that non-spouse beneficiaries of qualified plans cannot enjoy protection of the plan assets from any creditors at all. Naming properly drafted trusts as beneficiaries of qualified plans can remedy the asset protection issues for non-spouse heirs.

Trusts

Trust assets are generally off-limits from creditors of settlors, trustees, and beneficiaries under the following conditions:

  • If the trust is irrevocable.
  • If the trust has a spendthrift clause.
  • If the trust was not funded via any fraudulent conveyance.
  • If the debtor does not have unilateral ability to distribute assets to himself or herself, either directly or indirectly. This means the debtor can’t serve as the sole trustee and can’t exercise any influence over trustees responsible for exercising discretion over distributions of income or principal.

The types of irrevocable trusts include:

  • Medicaid asset protection trusts, the asset protection of which is usually limited exclusively to Medicaid as a creditor.
  • Family trusts, wherein the beneficiaries are a class of persons that may or may not include a spouse; if administered correctly, these trusts protect assets from the creditors of all parties, but they may afford the family unit less access to the trust corpus.
  • Spousal life access trusts (SLAT), which can protect assets against the creditors of both spouses if drafted and administered correctly.

The beauty of SLATs is their flexibility. Consider the many ways a SLAT might be customized:

  • Tax features, such as adding qualified terminal interest property (QTIP) eligibility or planning into the Delaware Tax Trap.
  • Adding a general or limited power of appointment, which can be further modified by adding a formula requiring approval of a third party or stipulating whether exercise is valid during life or upon death.
  • Adding a co-trustee to allow the beneficiary spouse better asset protection.
  • Customizing the class of eligible beneficiaries.
  • Using a single-member LLC to allow the grantor spouse greater management and administration powers.

SLATs do come with two main risks. The first is death of the beneficiary spouse, which can be mitigated in two ways:

  • If the beneficiary spouse is insurable, life insurance works well (and especially well in a separate trust).
  • If the beneficiary spouse is uninsurable, a power of appointment could allow the assets to pass back to the grantor spouse, but advisors must carefully navigate estate and gift tax consequences.

The second risk is divorce, which is best addressed through a post-nuptial agreement.

New York doesn’t allow for the protection of domestic asset protection trust (DAPT) assets from creditors, but as of this writing, 20 other states do. The unresolved question is whether a New York resident can set up a DAPT in one of these 20 states and protect the DAPT’s assets from a creditor holding a New York judgment.

DAPTs only came about in the United States in 1997, so the case law on the subject is relatively undeveloped. Where a New York resident might have more success is with an offshore asset protection trust, but courts might frown on their use. These trusts also require significant annual capital outlays to maintain, and they come with tax and financial system compliance obligations, so clients might view the endeavor as too much of a headache.

Corporate Entities

Most corporate entities exist for the sole purpose of protecting the equity owners from liability, so they work as very good asset protection vehicles. There are two types of asset protection for corporate entities: upstream protection and downstream protection.

Upstream protection is when liability arises from activities within the entity itself and a plaintiff is going after the owners personally in a lawsuit. The main concern here is “piercing the corporate veil,” which is a legal doctrine allowing a plaintiff to pursue the personal assets of an entity’s owner.

Upstream protection requires observing simple but important formalities:

  • Keeping adequate books and records.
  • Always acting in a corporate capacity and not a personal one.
  • Keeping personal and corporate assets separate from each other and avoiding commingling.
  • Adequate capitalization to carry on the entity’s regular activities.
  • Keeping adequate insurance for all reasonably foreseeable risks, including malpractice liability in a licensed profession.

Downstream protection is when liability arises from activities outside the entity itself and the plaintiff is going after the owners’ equity interests. Downstream protection is heavily dependent on the quality of drafting and observance of the entity’s governing agreement. The essential provisions include:

  • New equity holders must be admitted by unanimous vote.
  • Unadmitted owners are “mere transferees,” meaning they hold economic rights, but no governance rights.
  • The only permissible remedy against a current equity holder is a charging order, which limits creditors to seizing distributions payable to the debtor from the entity and not seizing the assets the entity owns.
  • Any distributions must be declared by the managers and/or members, as opposed to being automatic or mandatory.
  • Automatic buyouts upon certain triggering events with a set mechanism for determining price (usually a valuation by a predetermined professional); mandating payment via long-term installment note buyout deters creditors even further.

Each type of entity comes with its own protections from upstream and downstream liability; the following chart assumes general observance of formalities.

 

Entity Type

Upstream Protection

Downstream Protection

Sole proprietorship

None

None

General partnership

None

Creditors of a single partner generally can’t seize the partnership’s assets.

Limited partnership (GP)

None

The GP’s creditors can’t seize the assets, but a poorly drafted agreement might allow a creditor to seize the equity and exercise the GP’s powers, which are normally extensive and could be absolute.

Limited partnership (LP)

Complete

Complete

Corporations

Complete

Complete, but a creditor of a single shareholder could seize all of the equity and make a play to liquidate the corporation

Single-member LLCs

Complete

Unresolved; in New York State, the answer is likely to be “none,” but the issue would at least be uncertain enough to attempt litigating.

Multi-member LLCs

Complete

Complete

 

For professional entities (PCs, LLPs, LLLPs, and PLLCs), all protections from the same nonprofessional entity type will apply, but unique rules govern professional liability. In a professional entity, professional malpractice typically results in personal liability for the professional performing the malpractice and any of the professional’s supervisors, but the other equity owners enjoy upstream protection. Protection from nonprofessional liabilities and the professional liabilities of others serves as the main draw for establishing professional entities.

Downstream liability in a professional entity is almost never an issue because a creditor needs to be licensed in the entity’s profession to hold equity. But a creditor is typically not interested in a professional entity’s assets, other than its accounts receivable, because capital isn’t a material income-producing factor. Rather, professional entities make all of their income from services, and creditors usually seek a charging order for the cash flow the services produce.

Insurance and Annuities

In New York State, life insurance (both death benefit and cash value) and nonqualified annuities are generally exempt from creditors if acquired without making a fraudulent conveyance, but the rules are complicated; protections are stronger when the beneficiary is an immediate family member (especially a spouse or a child). New York State law also extends these same protections to the proceeds of disability insurance. The federal exemption, however, is much narrower and only meant to protect interests of the beneficiary rather than the owner.

Besides mitigating creditor risks, life and disability insurance helps insure against key person risk, and offering these policies as an employee benefit could help retain top talent. One of the crippling risks for any business is the death or disability of an owner or top manager, and keeping insurance to cover the risk could mean the difference between failure and survival if the risk manifests.

Put simply, property and casualty insurance are a must for everyone. Any business failing to secure insurance against its reasonably foreseeable risks will allow plaintiffs to better argue piercing of the corporate veil and will leave itself vulnerable to calamity without warning. Not only does insurance provide good protection against unforeseen events, but the insurance companies themselves will give their clients helpful tips about how to further mitigate the insured risks; after all, keeping insureds out of trouble is in the issuer’s best interest.

Examples of insurance policies every business needs include general liability insurance, cybersecurity insurance, employment practices liability insurance (EPLI), insurance covering heavy equipment and vehicles, and business interruption insurance.

Even on the personal level, insuring one’s auto, home, jewelry, and other valuable assets is a no-brainer. On top of regular insurance policies, umbrella insurance is a lifesaver in the event of a tragic accident, and it’s the cheapest dollar-for-dollar insurance available on the commercial markets.

One popular property and casualty insurance solution is captive insurance companies. These vehicles have become especially popular in recent years because of their tax benefits. But clients must be careful: many promoters have chosen to abuse captive insurance companies, and the IRS has taken notice.

Generally, if a captive insurance company is designed to address an insurance need, tax problems are unlikely, but if conversations with a vendor lead with the tax or asset protection benefits, clients should stay away. Captive insurance companies do offer excellent asset protection on two levels: they provide insurance solutions not available on, or significantly cheaper than, the commercial markets, and the assets they hold are insulated from the creditors of both the insured company and its owners. But no asset protection strategy is worth the wrath of the federal government, so proceed with caution.

Protecting Assets from Spouses

Two of the most common asset protection scenarios involve impending marriage and impending divorce. The latter is much harder to plan for than the former. Planning for an impending marriage usually involves keeping separate property isolated and avoiding commingling. A good solution for this is a DAPT, which serves as a “synthetic pre-nup” for anyone afraid to have a tough legal conversation with their betrothed. Parents can typically provide even stronger asset protection by gifting or bequeathing property through trusts.

Impending divorces are much more sensitive. New York has a strong public policy against spouses alienating property in anticipation of a marriage ending. Family trusts for the exclusive benefit of children might stand up, but depending on facts and circumstances, courts may view family trusts with a skeptical eye.

Spouses can also attempt strategies that don’t change their net worth but greatly decrease their liquidity, such as qualified plans, deferred annuities, or alternative investments. Trusts drafted during the marriage can include a “floating spouse provision,” in which the document refers to a spouse as “the person to whom the grantor is married from time to time,” but advisors should be careful about both the tax and non-tax issues this strategy raises.

Considerations

Done right, asset protection can add tremendous value for professionals and their clients. Navigating the world of asset protection techniques is tricky and requires staying mindful of other areas of the law. Collaboration with allied professionals will always improve the efficacy of any asset protection plan. As a guiding principle, timing is critical when implementing asset protection strategies, and both clients and advisors should carefully evaluate what strategies make the most sense.


Matthew E. Rappaport, JD, Esq., LLM, is vice managing partner of Falcon Rappaport & Berkman PLLC, and he chairs its Taxation and Private Client Groups. He concentrates his practice in taxation as it relates to real estate, closely held businesses, private equity funds, and trusts & estates. He advises clients regarding tax planning, structuring, and compliance for commercial real estate projects, all stages of the business life cycle, generational wealth transfer, family business succession, and executive compensation. He also collaborates with other attorneys, accountants, financial advisors, bankers, and insurance professionals when they encounter matters requiring a threshold level of tax law expertise. Mr. Rappaport graduated from Washington University in St. Louis in 2007, cum laude, with an undergraduate degree in political science. He received his Juris Doctor and Master of Laws in Taxation from Georgetown University Law Center in 2011. Mr. Rappaport is licensed to practice in New York and is an active member of the American Bar Association Section of Taxation, where he serves on the Sales, Exchanges, and Basis committee. Mr. Rappaport has authored articles for Thomson Reuters’ Journal of Real Estate Taxation, The Tax Adviser, Bloomberg BNA’s Tax Management – Real Estate Journal, and the Journal of Taxation of Investments. He has spoken at the request of the American Bar Association, the National Conference of CPA Practitioners, Strafford Publications, Brooklyn Law School, the School of Accounting at LIU Post, and a wide variety of law, accounting, and wealth advisory firms.

 
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