Protecting Assets in a Volatile Economic Climate
In representing closely held businesses, the topic often turns to how to protect assets from creditors’ claims to ensure that collateral claims for assets not secured by a bank or other creditor do not become available for attachment as a result of other obligations coming due.
Although I am not a bankruptcy attorney, the most egregious circumstance I see in failure to protect assets is taking exempt assets and using them to pay debts. In other words, avoid using assets—that would not be subject to payment of creditors’ claims in a bankruptcy—for living expenses or payment of creditors’ claims. These assets may include retirement benefits such as 401(k) monies, IRAs, profit sharing plans, cash value of life insurance, and second mortgages on homes that already qualify for the exemption. If you are past the point of having any reasonable likelihood of paying back the amounts you owe, it is time to seek the advice of bankruptcy counsel.
There are instruments you can use to protect assets from creditors’ claims, even if you are not a candidate for bankruptcy. All of these, however, are a balancing act between the rights you can retain and whether those rights rise to the level of making the assets available for creditors. Often, transfers into entities or to third parties may be a fraud on creditors.
There is also a 90-day preference period, meaning any payments you make 90 days before filing bankruptcy for services that are not currently rendered become property of the bankrupt estate. This often happens with my clients who are owed large sums of money for past orders, which are paid prior to the debtor company declaring bankruptcy. The trustee in bankruptcy can require, and usually does, that those payments be made back to the bankrupt estate for the satisfaction of debts of all creditors.
The easiest way to protect assets is to give them away. If you are not currently subject to a judgment or security interest in an asset, the asset can be given to children, friends or a charity. If you give the full right of the asset away, no one can claim you somehow retained an ownership interest that would give rise to a right to collect. Obviously, the downside is that you have no legal rights in the property. This often is the case with recreational properties that owners have accumulated and paid for over the years and wish to keep in the family. If you give those assets away to your children, you rely on their good graces in allowing you to continue to use the property. In addition, any child who receives benefit of the property through title transfer has that property as an asset of their estate; it is subject to their financial situation.
It is also important not to confuse estate planning for death with estate planning to avoid creditors. Sometimes both of those issues can be dealt with. For instance, a charitable remainder trust could be established wherein the owner transfers money to a trust that retains and invests the money for the life of the grantor, and the grantor usually retains an income beneficiary’s interest. The grantor can put limitations on what the income can be used for or how it can be distributed. Be aware that the charity for whose benefit the property is ultimately given may have restrictions on how the assets can be administered. This type of trust can be used as both estate planning for a current situation and a future situation.
Another vehicle is an irrevocable trust, wherein assets are placed in the trust administered by a third-party trustee. The grantors, who are trying to avoid the claims of creditors, give up all rights to control the property and retain only a certain benefit. Revisiting our example of a vacation property, it may be the right to live in the property and pay the bills associated with the use of the property, while locking in for whom is the benefit of the property (i.e. children or grandchildren) and ensuring that title of the property is no longer held by the grantor—thus keeping it from being available to creditors’ claims. An irrevocable trust must be drafted in such a way that none of the terms allow control by the grantors to such a degree that the assets are available for them. The grantors must give up the right to mortgage, use as collateral or security, any form of income including rent, or extraction of benefits like minerals and timber. The remaining use(s) for the grantor must be so limited that a creditor cannot argue that a beneficial interest of the grantor rises to the level of an actual ownership interest.
A caveat to this is that it is not estate planning. If you retain the right to live in a property to your death, the value of your interest in the life estate will be an asset of your estate for estate planning purposes.
Another easy technique that can be utilized to avoid creditors’ claims or interests for businesses is to transfer a majority interest to a minority group. In a family business, this can be Mom and Dad transferring a greater than 50% ownership interest to the children and retaining a minority interest. Typically, a minority interest has no market value to speak of, since third parties will not pay for a minority interest due to its lack of control. This is one instance where it also helps with estate planning because the federal government will recognize a minority discount up to 40% of the value as of the date of death of a minority shareholder’s interest in a closely held business.
Protecting your assets from creditors’ claims is something that must be considered throughout the estate planning process. It must be well thought-out, given the points of lack of flexibility and control. Often those decisions are very easy—for instance with a vacation home that is used seasonally as opposed to year-round—but other decisions such as taking a majority interest and converting it to a minority interest in a family business can be very difficult. Your business and estate planning attorney, if not an expert in bankruptcy and credit solvency rules, should work hand-in-hand with your accountant and an experienced bankruptcy attorney to ensure any vehicle you desire to utilize does not create unintended consequences.
Consult an attorney regarding your specific situation.
This article first appeared in the Ellenbecker Investment Group In Touch quarterly newsletter, the 4th Quarter 2010 issue. Past newsletters can be viewed at Ellenbecker.com.