Mention the words asset protection strategy and clients may imagine something out of a John Grisham novel—cunning schemes for stashing money in exotic locations, full of action and intrigue. In reality, these strategies don't usually involve a trip to the Cayman Islands by cover of night, and you can leave the cigarette boat and armed bodyguard at home.
From the basic to the more complex, asset protection strategies have a fairly straightforward purpose: to protect clients against the unexpected creditor. But which of your clients can benefit most from such strategies, and how can you choose the right approach to help protect their net worth? Let's take a look at three potential solutions.
Domestic Asset Protection Trusts
A domestic asset protection trust (DAPT) is an irrevocable trust that a client creates for his or her own benefit. There are generally two primary goals: (1) to protect assets from creditors; and (2) to retain access to the trust assets (at the trustee's discretion).
Currently, 16 states have passed legislation authorizing the use of asset protection trusts: Alaska, Colorado, Delaware, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, and Wyoming. Under DAPT legislation, the grantor can keep assets in the U.S., remain a discretionary trust beneficiary, and receive spendthrift protection from certain creditors.
Although state statutes vary, typical trust provisions include the following:
• The trust must be irrevocable.
• The grantor must be a discretionary beneficiary of the income and principal.
• There must be at least one trustee located in the DAPT state.
• Some of the administration of the trust must take place in that state.
It's important to keep in mind that DAPTs won't protect clients against every creditor. State laws vary, and certain creditors may be allowed access to trust assets, including:
• Divorcing spouses
• A child entitled to child support
• A prior creditor whose claim arose before or on the date assets were transferred to the trust and who files suit within the state's statutory time frame
• A future creditor whose claim arises after assets are transferred to the trust and files suit within the state's statutory time frame
• Claims arising as a result of death, personal injury, or property damage caused by the grantor before the transfer of assets to the trust
Tax considerations. DAPTs may be drafted for asset protection purposes only, or for asset protection combined with overall estate planning. Depending on the client's planning objective, income and transfer tax consequences should be considered. If asset protection is the key objective, irrevocable transfers to the DAPT are an incomplete gift, and the assets are included in the grantor's estate for estate tax purposes. If estate planning is also a key objective, transfers to the trust are a completed gift, and the assets are intended to be excluded from the grantor's estate.
Clients should be aware of income and transfer tax concerns that may be involved in establishing a DAPT.
Third-Party Spendthrift Trusts
Another option is the third-party spendthrift trust, established by a client for the benefit of another individual. Third-party trusts often include spendthrift provisions designed to protect the trust assets from the trust beneficiary's creditors or from the beneficiary's spending habits. Another common planning goal is asset protection in the event of a child's divorce.
Here, trustee discretion is an important benefit. The trust's asset protection is strengthened by the trustee's discretion on how to control and distribute the trust money. Also, the spendthrift trust provision prevents a beneficiary from assigning or pledging his or her interest in future trust assets. Keep in mind that public policy exceptions do exist (e.g., claims for child support), and trust provisions that specify ages for distribution, or give the beneficiary the right to demand assets or terminate his or her interest in the trust, are typically held to be a property right available to the beneficiary's creditors.
Trust assets are managed by the trustee according to directions specified in the trust and statutory guidance. Although the beneficiary may act as a trustee, his or her control over the trust assets should be limited. With this type of trust, appointing an independent or corporate trustee may afford greater asset protection.
Limited Liability Companies
Entities such as limited liability companies (LLCs) have long been used as a strategy to transfer assets in a tax-efficient manner, minimize a client's estate for estate tax purposes, and maintain a controlled ownership transfer. But clients may also use an LLC for asset protection.
With an LLC, the underlying assets are typically protected because the creditor's remedy is a charging order against the membership interest.
• A charging order is a lien giving the creditor the right to receive distributions from the LLC that would otherwise be distributed to the debtor.
• A charging order will not give the creditor access to the debtor's ownership of the underlying LLC assets.
• As the debtor's controlling interest may limit LLC distributions, the creditor may receive little or no payment, making charging orders an unattractive remedy.
When considering an LLC, state law may be a deciding factor. Specifically, many states allow creditors to use more aggressive tactics to force a disposition of the underlying assets or seek a judicial foreclosure. Further, even if the entity's underlying assets are protected, an LLC doesn't protect the member's lifestyle, and a debtor may never enjoy his or her property interest.
Costs and Administration
With any asset protection strategy, clients should work closely with an attorney to structure the plan and discuss the costs (e.g., initial planning and ongoing maintenance). The level of assets to be protected should be considered in order to select the most cost-effective type of planning.
There are also administrative aspects to consider. It's not uncommon for a well-intentioned client to transfer assets, make statements, or take other actions that can undo a plan already in place. This is where you can provide real value for your clients: keeping an open dialogue with the client and his or her attorney can help safeguard the plan.
The Right Solution for Your Client
In deciding on the right asset protection strategy, consider the following:
• What is the client's current financial status? Does he or she expect this status to change?
• Is the client aware of any potential litigation or creditors that may make a claim?
• Does the client have the administrative acumen and willingness to carry the plan forward?
• Does the irrevocable nature of many asset protection strategies give the client pause?
• Is the client prepared to relinquish control? To what extent?
• Will the transfer of assets leave the client in a position to be rendered insolvent or unable to meet future financial obligations?
Engage Your Clients' Other Professionals
Of everything discussed here, the most critical point is helping your client avoid unreasonable expectations. No asset protection planning technique is foolproof. The key is helping your clients balance competing goals and understand the benefits and limitations of any plan. Once a decision is made, be the quarterback—engaging the client's attorney and CPA to keep the asset protection plan on track.
For help positioning yourself as a vital partner in the development of your clients' plans for their estate, download An Estate Planning Blueprint for Financial Advisors.
This post originally appeared on Commonwealth Independent Advisor, a blog authored by subject-matter experts at Commonwealth Financial Network®, the nation's largest privately held independent broker/dealer–RIA. To subscribe, please visit http://blog.commonwealth.com/.
Rose Watson is director, advanced planning, at Commonwealth Financial Network®, member FINRA/SIPC, an independent broker/dealer–RIA. She is available at firstname.lastname@example.org.
Commonwealth Financial Network® does not provide legal or tax advice. Please consult with a legal or tax professional regarding your individual situation.
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