31 May A Primer on Legal Asset Protection
What is asset protection? First, it is the tried and true strategy that everyone is familiar with – insurance. For individuals, the most common types of insurance protection are for: (1) auto accident collisions and injury, and (2) damages to the insurer’s home. Most businesses also have insurance covering exposures like fire, damage, “slip and fall” and work-related employee injuries. But the most important asset protection for a business owner is the creation of a limited liability company (LLC).
The main goals of this article are to: (1) explain just how LLCs provide asset protection and (2) introduce the reader to Domestic Asset Protection Trusts (DAPTs), the penthouse suite of estate and asset protection planning.
LLCs insulate their owners’ personal assets from claims arising from the business. Without such protection, it would be too dangerous for entrepreneurs to invest capital in businesses with inherent risks. This concept, called internal protection, goes back to the industrial revolution and is a foundation of our commercial system. Traditional “C” corporations also provide internal protection, but they suffer from the double taxation of income. Contrarily, LLC income is directly passed through to its member owners and taxed only once. LLCs are also simpler to operate. Consequently, most entities formed today are LLCs.
Just as important, LLCs can provide external protection. Suppose you host a Christmas party for friends and an inebriated guest leaves the party and becomes involved in a car accident where someone is injured or killed. As a “deep pocket,” you could be sued and, although you are certain it was not your fault, suffer a judgment for millions of dollars. This is where knowledgeable asset protection planning comes into play. The plaintiff’s attorneys will find the task of seizing assets owned by a properly structured LLC in a legally-favored state considerably more difficult.
LLC protection works like this. Generally, when a creditor obtains a personal judgment against a defendant, it becomes the creditor’s responsibility to identify the defendant’s assets adequate to satisfy the judgment, and then obtain a court order to seize those assets. But, if properly planned, the LLC members’ interests will not be treated like other assets. The creditor’s legal remedy will be limited to obtaining a lien, called a “charging order.” Charging orders allow the creditor to obtain a court lien against distributions made to the member’s interest; but they do not allow the creditor to step into the defendant’s shoes and become a member of the LLC, with rights to its assets. Thus, if the LLC chooses not to distribute assets or income to its members, they will not be available to the judgment creditor. Moreover, only the member owners are entitled to determine whether or when distributions will be made.
The majority of states’ laws do not include the language needed for optimal LLC protection. For an LLC to be truly effective, it should be formed in a state with favorable LLC laws. Also, clients should be aware that, if the LLC owns real property located in the client’s domicile state, a local court may try to exercise jurisdiction over the property, notwithstanding its out-of-state LLC ownership. Whether this in rem jurisdiction will play a part in the outcome depends on the case’s specific facts and the LLC’ structure; therefore, knowledgeable counsel should be consulted before creating or transferring assets into an LLC.
Domestic Asset Protection Trusts (DAPTs)
DAPTs have a strong appeal to clients concerned about future unanticipated claims. But, these trusts also offer a wide range of other benefits, including: insuring privacy, tax savings, flexibility to modify the trust if circumstances change and avoidance of intra-family quarrels.
The most significant feature of DAPTs is that they are irrevocable. But, most forms of irrevocable trust provide asset protection. The distinction is that the other types mandate that the client permanently lose use and control of the assets transferred into the trust. Some clients view this as an unacceptable result. The solution is to create a DAPT in one of the four leading states allowing such trusts armed with two core provisions: (1) the trustee’s distributions are “discretionary,” and (2) the client is designated as a permissible trust beneficiary. The desired result is that creditors will have greater difficulty seizing the assets, while the client will have access to the assets in an emergency.
Although Georgia does not yet allow DAPTs, Georgia residents still may enjoy the benefits by establishing a DAPT in one of the states that has enabling statutes.
The legal sustainability of properly structured and implemented out-of-state DAPTs is untested in court; however, a preponderance of the evidence and commentary point toward their survival. When appropriate, DAPTs clearly are more prudent than taking no action at all. And, from a practical viewpoint, a DAPT will have proven its worth if it provides real benefits to the client and either: is upheld, or if a dispute arises, leads to an attractive settlement.