The term "asset protection planning" is often used to describe the variety of planning steps that can be taken to protect assets from the claims of creditors. This type of planning ranges from having adequate liability insurance to the funding of an asset protection trust. Asset protection planning does not involve hiding assets, implied agreements between family members or fraudulent transfers. Rather, asset protection planning consists of the use of deliberate and legitimate planning techniques that insulate assets from the claims of creditors.
Basics Asset Protection Planning
When most clients hear the term "asset protection planning," thoughts of foreign trusts and exotic, surreptitious techniques come to mind. In reality, the basic steps of asset protection planning are undertaken every day by most people.
A basic asset protection planning step is to have adequate liability insurance with a deductible you can afford to pay. Liability insurance for automobiles and homes serves to protect individuals from claims of creditors related to negligent conduct. In addition to general liability insurance, umbrella insurance may be purchased to provide additional coverage.
For people who are married, a simple way of shielding assets from the claims of creditors is the joint ownership of property as tenants by the entirety. Property held as tenants by the entirety is unique to spouses, as in In re Gallagher's Estate, 43 A.2d 132, 133 (Pa. 1945). The "individual debt of a spouse cannot be satisfied by seizing property owned as tenants by the entirety," as in Madden v. Gosztonyi Savings & Trust, 200 A. 624 (Pa. 1938).
Although tenancy by the entirety ownership of property provides protection to spouses, the U.S. Supreme Court decision in United States v. Craft, 535 U.S. 274 (2002), carved out a considerable exception to this rule. The court in Craft held that the Internal Revenue Service may attach a lien to property held as tenants by the entirety to satisfy the tax obligation of one spouse. The court reasoned that the individual rights of each spouse qualified as "property" or "rights to property" with the meaning of the Internal Revenue Code (tax liens attach to "property or rights in property" as provided for by 26 U.S.C. § 6321). The effect of Craft, at least for federal tax obligations, is to weaken the protections of joint ownership by spouses.
An often overlooked asset protection strategy is fully funding a 401(k) plan. Under the Employee Retirement Income Security Act, with limited exceptions, assets held in a 401(k) plan are not subject to claims of creditors. State law governs whether an IRA is subject to a creditor's claim. Pennsylvania law provides that contributions of less than $15,000 in any year to an IRA are safe from creditors; however, a rollover from a 401(k) to an IRA does not count against the $15,000 exemption amount, so a direct rollover from an employer plan to an IRA will avoid the claims of creditors. The protections provided by ERISA and Pennsylvania law only apply if the debtor is not in bankruptcy. Under current bankruptcy law, the first $1 million of retirement funds (401(k), IRA, etc.) are protected from claims of creditors. This amount is adjusted every three years for inflation.
Use of Entities
For certain clients, forming entities such as family limited partnerships and limited liability companies is a good step to take along the path of asset protection planning. Generally speaking, so long as the entity is not a sham and the formalities of organizing and operating the entity are respected, the individual owners of the entity are shielded from the liabilities associated with the property owned by the entity.
The use of an entity for property ownership can be as simple as establishing an LLC or limited partnership to own one asset, such as a rental property. The entity, of course, should have its own liability insurance. The benefit of the entity is to protect the owners of the entity from any liabilities associated with the property, such as a personal injury action or a breach of contract action.
The use of an entity cannot always provide protection for the entity's owners. For example, a creditor may require the debts of the entity be personally guaranteed by its owner or owners. Likewise, in many cases, the creditor will require a personal guaranty from a spouse who is not an owner of the entity to put at risk the property of the spouses owned as tenants by the entirety.
Ultimately, an entity only provides protection to its owners if the organizational and operational formalities of an entity are respected. Prior to the recent escalation of the exemption amount for the federal estate tax, practitioners often faced disputes with taxing authorities over whether the property of an LLC or limited partnership was part of a decedent's taxable estate. The disputes often focused on whether the decedent expressly or impliedly controlled the entity, the entity owned personal use assets or the entity engaged in less-than-arm's-length transactions with its owners. Practitioners likely will be involved in fewer disputes given the increased estate tax exemption amount. However, there is still a risk that a creditor could attack the validity of an entity on the same theories.
Although there is a strong presumption against piercing the corporate veil in Pennsylvania, Pennsylvania courts will allow the veil to be pierced if the entity is undercapitalized or corporate formalities are not followed, as in Lumax Industries v. Aultman, 669 A.2d 893 (Pa. 1995). The concept of piercing the corporate veil has been considered by courts in the context of LLCs, as in Advanced Telephone Systems v. Com-Net Professional Mobile Radio, 846 A.2d 1264 (Pa. Super. 2004), but there are no reported cases involving limited partnerships. However, bad facts can make for bad law, so it is conceivable that limited partners could have liability if the limited partnerships are undercapitalized, formalities are not followed, personal use assets are owned by the limited partnerships or other negative facts exist.
Trusts are the cornerstone of many estate plans. Trusts can take the form of providing a benefit to the grantor, such as a domestic asset protection trust (DAPT), grantor retained annuity trust (GRAT) or charitable remainder trust (CRT). Trusts may also benefit a spouse and other family members.
A simple form of asset protection planning is to transfer property to a trust that benefits another person, such as a surviving spouse, child or grandchild, either at death or during the grantor's lifetime. In the absence of a fraudulent conveyance and as long as the property is not otherwise encumbered, the property funding the trust should be safe from the claims of the grantor's creditors and the creditors of the beneficiary.
Transfers to trusts that benefit a spouse are not as important for tax avoidance planning under the current estate tax laws. Nonetheless, a surviving spouse may desire the creditor protection provided by a trust. Likewise, intergenerational transfers of wealth are a common form of estate planning, particularly since many states, including Pennsylvania, have repealed the rule against perpetuities.
Some clients may be reluctant to strip themselves of the economic benefit of property that is transferred to a trust. In these cases, a self-settled trust may be advantageous. Thirty-five states, including Pennsylvania, do not protect a self-settled trust from the grantor's creditors. Fifteen states, in varying degrees, provide that self-settled trusts, such as DAPTs, GRATs and CRTs, are exempt from the claims of creditors. These states are Alaska, Delaware, Colorado, Hawaii, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia and Wyoming.
If a client is interested in a self-settled trust, then consideration should be given to establishing the trust in one of the 15 states that protect these trusts from creditors. A complete discussion of DAPTs and other self-settled trusts is beyond the scope of this article. However, the basic concept is that these jurisdictions protect self-settled trusts from creditors unless the transfer to the trust is a fraudulent conveyance and the creditor asserts the claim within a proscribed time period (generally two to four years). The grantor is a discretionary income and principal beneficiary of the trust and may maintain certain rights, such as the right to remove and replace the trustee, serving as an investment adviser and a limited power of appointment. A self-settled trust, therefore, may be an attractive planning option for clients that need to benefit economically from the transferred property but have an uninsurable risk.
Asset protection planning takes many forms and is engaged in by clients and practitioners, intentionally or not, in a variety of ways. For most clients, simple steps such as adequate insurance coverage, owning property as tenants by the entirety and taking advantage of retirement accounts will suffice. For other client, more advanced planning may be warranted. As with all estate planning, each client and family is unique and practitioners should utilize the available planning tools that best suit each situation.
Vance E. Antonacci is the chair of the asset planning and federal taxation group of McNees Wallace & Nurick. He concentrates his practice in the areas of estate planning and estate and trust administration with an emphasis on representing family business owners, executives and professionals.