Asset Protection Planning
 
July 15, 2003
 

In an increasingly litigious culture, many individuals are anxious to find some means to protect their assets from potentially ruinous claims of creditors who might arise in the future. Among these individuals are professionals, such as doctors and lawyers, who, despite their best efforts, may find themselves defending enormous malpractice claims. Corporate officers and directors likewise fear that decisions made in the best interests of their corporations will be second guessed and that they will be held personally liable for corporate losses or declines in the value of corporate stock. Business owners worry that they could lose their businesses to a customer who becomes injured on their premises. Some individuals are concerned with preserving a nest egg for retirement, others with safeguarding their children’s inheritance. This article presents a number of asset-protection options.

The Myth of Joint Ownership

It is commonly believed that transferring assets into joint name with another individual can protect those assets from the transferor’s creditors. However, holding assets jointly with another person is generally ineffective for asset protection purposes because each co-owner can unilaterally sever her interest from the other’s. Consequently, a creditor who obtains possession of an owner’s interest in the property can sever that interest from the joint owner’s interest or compel the sale of the property and distribution of the proceeds. One exception is property held as “tenants by the entireties.” This form of ownership is available only to spouses, and in most, if not all, states, it is limited to ownership of real property. Because both spouses must consent to a severance of this form of joint ownership, a tenancy by the entireties does offer a measure of protection for assets held in that manner. However, the protection is limited because, on the death of one spouse, the property will once again be subject to the surviving spouse’s creditors.

Gifts

One simple, but effective method to protect assets from potential creditors is to give the assets away. No one can take from an individual that which she does not own. Gifts are generally effective to shield assets from the claims of future creditors. Although the law varies somewhat from state to state, gifts will not protect assets from current or reasonably foreseeable creditors if the donor is acting with the intent to hinder such creditors or if the gifts render the donor insolvent.

Gifts to Spouse

Giving a substantial sum to a spouse makes sense from an asset-protection perspective, and often it is wise for estate planning purposes. Generally speaking, the creditors of one spouse have no claim on the assets of the other spouse. In a community property state, care should be taken that gifts to a spouse are maintained in that spouse’s sole name and are not commingled with community assets.

It is typically advisable for both spouses to own at least the maximum amount of assets that each individual can give free of federal estate taxes. In past years, this figure has been known as the “credit shelter” or “unified credit” amount or by other similar names. It is now technically referred to as the “applicable exclusion amount,” and in 2003 it is $1,000,000. As the law is now written, that amount will increase to $1,500,000 in 2004, to $2,000,000 in 2006 and to $3,500,000 in 2009. In 2010, the estate tax (but not the gift tax) is repealed, only to reappear with an applicable exclusion amount of $1,000,000 in 2011. Almost certainly, the law will be rewritten before that time.

If each spouse owns assets at least equal to the prevailing applicable exclusion amount, then each will be able to utilize his or her applicable exclusion amount, regardless of which spouse dies first. If one spouse is wealthy and the other has no assets, one of two possible applicable exclusion amounts will be wasted if the poorer spouse dies first. Assets that the poorer spouse might have given away free of estate tax to children, or placed in trust for children and the surviving spouse, will instead be subject to estate tax when the wealthy spouse eventually dies.

An additional advantage of making gifts to a spouse is that such gifts are free of federal gift taxes. They are likewise free of state gift taxes in most or all states.

Gifts to Spouse in Trust

If an individual is reluctant to make a substantial gift to a spouse outright, she could make the gift by means of a marital deduction trust, either a Qualified Terminal Interest Property (QTIP) trust or a power-of-appointment trust. In either type of trust, all of the trust income must be payable to the donee spouse. In a QTIP trust, the assets pass on that spouse’s death to persons of the donor’s choosing, or the donor spouse could give the donee spouse a limited power to distribute the assets among the couple’s descendants. In a power-of-appointment trust, on the death of the donee spouse, the assets would be payable to persons of his choosing. Like an outright gift, a gift to a spouse through a marital deduction trust is free of gift tax. Also like an outright gift, the trust would be includible in the donee spouse’s estate for estate tax purposes, thus permitting him to use his applicable exclusion amount if he predeceases the donor spouse.

Gifts to Children

An individual also can make gifts of as much as $1,000,000 to her children or others without incurring federal gift tax. ($1,000,000 of the “applicable exclusion amount” mentioned earlier can be applied to shield gifts from gift taxes.) A married couple can make gifts aggregating as much as $2,000,000 to their children. In addition, an individual can make gifts of the “annual exclusion amount” to any number of persons without federal gift tax consequences. This amount is in addition to the applicable exclusion amount, and in 2003 it is $11,000 per donee per year. A married couple can give twice that amount.

Hopefully, whether an individual makes gifts to a spouse or to children, he or they would be willing to provide assistance to the donor if ever her own assets were awarded to a creditor. However, an express agreement to that effect would nullify the gifts and render them subject to the donor’s creditors.

Gifts to Children in Trust

As with gifts to a spouse, gifts to children can be made in trust. The terms of such trusts can be quite flexible.

Depending on the specific terms of the trust, a gift in trust for an individual’s children may or may not constitute a “completed gift” for gift tax purposes. By retaining the power to distribute the trust assets among her descendants in accordance with a provision in her will, the donor could render the gift incomplete. Such a gift would not be subject to gift tax on the initial transfer of assets to the trust, but it would remain subject to estate tax on the donor’s death. Although the gift described in this paragraph would be incomplete for gift tax purposes, the donor’s future creditors would be unable to reach the property since the donor would have retained no beneficial interest in the trust. Distributions from the trust would be subject to gift tax, although the donor could apply $1,000,000 of her applicable exclusion amount to gifts and shield that amount of those distributions from gift tax.

Depending on the terms of a trust for children, the donor might be liable for the trust’s income taxes, which can be beneficial for estate planning purposes. In that case, the trust would not be depleted by the payment of income taxes. The payment of those taxes by the donor should not be treated as an additional gift to her children. More information on this topic will be published in future issues.

For more information, contact Mark W. Smith via e-mail at mwsmith@hklaw.com or call toll free 1‑888-688-8500.