Asset Protection Planning for Those 40 and Older

Imagine this scenario: you and your spouse are in your 40s, 50s or 60s, and you both have good-paying jobs that have allowed you to start building a nest egg for future retirement. You have maxed out on your 401(k) contributions and have been able to open a nice securities account with a financial advisor. You also have a few rental properties that have performed well. You were presented the “opportunity of a lifetime” to invest in what appears to be a great real estate investment in Arizona, and it looks good on paper. The opportunity includes a modest cash investment, but you must guarantee a large mortgage loan to finance the remainder of the investment. Things go fine for awhile, but then the market becomes overbuilt and suddenly the amount of the mortgage exceeds the value of the property. The mortgage company forecloses and the property sells at the foreclosure sale for much less than the amount of the loan, leaving a large deficiency. What does the mortgage company do? They sue you on your guaranty, get a judgment and come after you. Your 401(k) account is probably exempt, but your securities account and rental real estate are not. Suddenly, your “nest egg” becomes a “rotten egg.” What could you have done to prevent this horrible result? The answer: start asset protection planning at an early stage.

The term “asset protection planning” may conjure up thoughts of quasi-legal offshore trusts in the Cayman Islands or illegal Swiss bank accounts; but this article is about perfectly legal entities that can shield a person from many liabilities. Two of these entities have similar characteristics, limited partnerships (LPs) and limited liability companies (LLCs). Both of these entities can be created pursuant to Arkansas law.
Here is how an LP or LLC typically works: a husband and wife (or single person) will transfer some of their assets, such as business interests, real estate and securities, to an LP or LLC in exchange for an ownership interest in the LP or LLC. The transferors, or an entity controlled by them, will be named as the general partners (if an LP) or the managers (if an LLC) and will make all business decisions related to the LP or LLC assets. Over a period of time, the transferors may transfer some of the LP or LLC units to their children or grandchildren, but will always retain control over LP or LLC decisions.

So just how does an LP or LLC protect against claims of creditors? Under Arkansas law, a creditor of a limited partner or LLC member cannot attach the LP or LLC units owned by the limited partner or member. The creditor can only obtain a “charging order,” which means that the creditor is entitled to receive any distributions if and when they become payable to the limited partner or member. Guess who makes the decisions regarding LP or LLC distributions? Distributions from the LP or LLC are only made if the general partners or managers make that decision. Therefore, the creditor with a charging order cannot force distributions from the entity. It gets even better … even though the creditor cannot force distributions, the IRS may decide that the creditor holding the charging order should be taxed on its pro rata share of partnership or LLC income — even if no distributions are made to the creditor! That is what we in the South call a double whammy: the creditor has to come out of pocket to pay income tax on the share of partnership or LLC income the creditor did not receive. Most creditors will avoid a charging order like the plague.
Another great technique for creditor protection is a trust. In a trust arrangement, a donor establishes a trust for one or more beneficiaries. Assets of the donor are transferred to a trustee, who administers the assets for the benefit of the beneficiary. There are many different types of trusts, some of which qualify for creditor protection and some of which do not. To qualify, the trust must be irrevocable and must contain what is known as a “spendthrift clause.” The spendthrift clause states that the beneficiary cannot sell or pledge his or her interest in the trust, and the trust assets are exempt from the claims of the beneficiary’s creditors. These clauses have been around since English common law and are readily accepted by the courts except in very unusual situations.

In most situations, a trust established by a donor for himself or herself (sometimes called a “self-settled” trust) will not protect against the claims of the donor’s creditors. But a trust set up by a parent for a child or grandchild either during the parent’s life or at death will protect against the claims of the child’s creditors. Today, more clients are setting up trusts for the lifetime of the children, to protect not only against the claims of creditors, but also the claims of a current or future spouse if the marriage goes bad.
It’s important to note that any asset protection planning must be commenced before creditors come calling. Transfers to avoid existing creditors will be set aside as a fraudulent transfer. So the best time to start is now. Contact your attorney, and see if asset protection planning is right for you.

John Peace practices tax and estate planning law with the Little Rock law firm of Dover Dixon Horne PLLC and is listed as a Best Lawyer in the 2010 edition of Best Lawyers in America. This article is for information only and is not intended to be specific legal or tax advice.