It takes a lot of hard work to reach financial independence (“FI”). Whether you have reached FI or are still striving toward the goal, it’s a good idea to make sure your assets are protected against an unforeseen lawsuit.
None of us like to face the possibility of being sued. And I certainly don’t want to be a pessimist. However, as a bankruptcy attorney I have witnessed first-hand the many ways people get sued unexpectedly. Here are a few examples to consider:
- Guaranty Agreements: A Guaranty Agreement is a business owner’s promise to pay their company’s bank or vendor debts in the event that the business fails to pay. Unfortunately, business owners are often required to sign personal guaranty agreements in order to obtain necessary credit for their business, even if the business has its own assets. Most business owners believe they are protected from personal liability because they formed a Corporation or Limited Liability Company. However, by signing a Guaranty Agreement business owners empower corporate creditors to do an “end-run” around the corporate shield and pursue the owner’s personal assets. Most of my clients tell me they didn’t realize they had signed the Guaranty Agreement until they were served with the associated lawsuit. Some say they just didn’t understand what they signed or didn’t adequately review the fine print.
- Business Disputes: Business partners fast friends in the good times, but when business ventures fail finger pointing sometimes follows. This often leads to lawsuits between partners alleging such things as breach of fiduciary duty, breach of contract, or even unfair and deceptive trade practices.
- Piercing the Corporate Veil: When entrepreneurs start a business they often incorporate by forming a Corporation or Limited Liability Company. One of the main reasons for incorporating is to obtain a corporate veil or corporate shield, which is supposed to protect the owners in the event the business gets sued. Because of the corporate veil, creditors are supposed to be limited to looking to the business for payment or recovery in the event of a lawsuit. However, in many cases attorneys sue the business AND the business owner in the same lawsuit, alleging that they have a factual basis to support “piercing the corporate veil” so that they can pursue the business owner’s individual assets. How can they do that??? The details of such a lawsuit are beyond the scope of this article, but the main reasons such piercing actions are successful are (a) commingling of personal and business funds, (b) lack of corporate formalities (i.e. annual meetings, meeting minutes, accounting records), and (c) insufficient capitalization (to meet the businesses’ reasonably anticipated needs).
- Automobile Accident: This one is self-explanatory. However, this type of exposure may exist whether you, a family member, or another authorized agent is driving your car.
- Injured visitor: There are a variety of ways someone might be injured while on your property. Perhaps you have an aggressive dog who bites the neighbor’s child. Or maybe its as simple as a trampoline injury at a birthday party. You get the idea.
Asset Protection Options
If you’re like me, you don’t lose too much sleep worrying about these and other potential lawsuits. That said, there is no harm in taking precautions ahead of time to make sure you are not an easy target in the unlikely event a lawsuit comes your way. In representing my clients, I have found that most settlements are driven by two components : (1) insurance coverage, if any, and (2) the defendant’s personal financial statement. As I will demonstrate below, you can have a million dollar net worth and still have ZERO assets available for a creditor in a lawsuit while complying with your state’s applicable laws. You see, each state has “exemption laws” that protect its citizens from judgment creditor collection efforts. The public policy behind these statutes is to allow families to start over with certain protected assets, even if they face financial ruin due to an unforeseen legal exposure. With that introduction, let’s jump in to my top 6 favorite asset protection tools:
- Insurance: This is the first line of defense. If you have adequate insurance items 4 and 5 from my previous examples are likely covered. There are at least 3 types of insurance that everyone with meaningful assets should own: Automobile, Homeowner’s, and an Umbrella Policy. The first two are quite common place and usually required. The third — the Umbrella Policy — is substantially underutilized. An Umbrella Policy is a low cost insurance product that stacks on top of your auto and home policies. In other words, it’s an extra layer of protection above the limits of your auto and home policy. You will find that the Umbrella Policy provides substantial protection at a very low cost. Why is it affordable? For the same reason that you don’t stay awake every night worried about my lawsuit examples — it is not likely that the policy will ever be triggered. If you are a business owner, consult your insurance agent to review available policies suitable to your type of business such as an errors and omissions (E&O) policy or business liability policy. These and similar policies can serve as an additional layer of protection to protect you in the event of a business related lawsuit.
- Retirement Accounts: Almost universally, the money you invest in a qualified retirement account — 401K, IRA, Roth IRA, etc. — is 100% protected from the claims of creditors. This is true even if you have $1,000,000 or more. Keep this in mind when you are trying to decide between investing your money in a taxable or non-taxable account.
- Real Estate: Many popular blogs discuss the downside of real estate ownership and promote renting as the preferable option. I think there are certainly valid reasons to chose renting instead of home ownership. However, in the asset protection world real estate offers an outstanding planning option. Roughly half of the states in the U.S. recognize tenancy by the entireties real estate ownership, whereby a husband and wife own real estate jointly. In such cases, the individual (as opposed to joint) creditors of one or the other spouse cannot pursue judgment collection against the jointly held real estate. This is generally an unlimited asset shield no matter how much equity you may have. In most cases, this protection extends to all jointly held real estate and not just a primary residence. (NOTE: this is a good justification for that second home at the beach!! :)) Many states that do not recognize tenancy by the entireties ownership still offer some statutory real estate equity protection.
- Cash Value Life Insurance: At the outset let me say that I am not a fan of cash value life insurance products. Outside of the asset planning arena, I recommend low-cost term life insurance that does not have a cash value component. I prefer keeping my insurance products and investments separate. That said, many states allow you to exempt cash value within a whole life or universal policy so long as a spouse or child is the named beneficiary. We have a saying in my profession: “pigs get fat, hogs get slaughtered”. Keep that in mind if you decide to use cash value insurance as an asset protection vehicle. I personally wouldn’t consider putting more than $50,000 to $100,000 in such a policy for asset protection purposes.
- 529 College Savings Plans: One great thing about asset planning is that it often lines up nicely with your current savings goals. That is certainly the case with the 529 account. States have varying laws on this asset protection device so, as with all of these options I am discussing, check with your local attorney if you need detailed information. In North Carolina you may contribute up to $25,000 per child and protect those funds from the reach of creditors. However, you must either (a) contribute those funds more than one year before a judgment is entered or (b) any contributions made in the year preceding entry of judgment must be part of a demonstrable pattern of regular contributions.t
- Health Savings Accounts (HSAs): HSAs are tone of the most popular retirement savings vehicles in the FI world for good reason. They allow you to reduce your taxable income dollar-for-dollar and you never pay taxes on the money so long as it is taken out for medical purposes. As most of you know, the trick is to invest your HSA dollars in low-cost index funds, pay your medical expenses out of pocket, then keep your receipts stored so you can later withdraw the HSA funds tax free against a matching receipt. While the HSA is an amazing investment vehicle, it has yet to be widely treated as a protected asset by state legislatures. At last check, Florida, Mississippi, Oregon, Tennessee, Texas, and Virginia have exemptions available to protect HSA accounts. Because HSA accounts are such great investment vehicles it is certainly worth your time to check your state-specific exemption laws on this one.
Options to Avoid
Now that you’ve read the top 6 options for protecting your hard earned assets, I’d like to list a few asset protection ideas that I don’t recommend. These are also known as the top four “bright ideas” I have shot down during client interviews:
- Trusts: Nearly every time I meet with a client that is facing an impending judgment they ask me “is it okay to just put all of my stuff in a trust for my kids?” Although self-settled trusts are a great estate planning tool that can help you save on taxes and carry out the directives in your Will, they are usually not good asset protection vehicles. Why is that?? Two primary reasons. First, all but a handful of states have adopted the Uniform Fraudulent Transfer Act (“UFTA”). Generally, this statute allows creditors to set aside any transfers made to a trust within 4 years of a judgment collection effort if either (a) the transfer was made with the actual intent to hinder, delay or defraud creditors, or (b) the transfer was made while the debtor was insolvent and for less than reasonably equivalent value. Second, there are two main types of trusts: revocable and irrevocable. As the names suggest, revocable trusts can be undone while irrevocable trusts cannot. Bottom line on trusts: if you can get to the trust assets (i.e. revocable), then so can your creditors. Further, even assets transferred into an irrevocable trust will likely be exposed to creditors if they are transferred within 4 years of judgment entry.
- Offshore Accounts: Do I even have to say anything here? My favorite story on this one is the debtor who appeared before a bankruptcy judge claiming that his offshore account was outside the jurisdiction of the Court. Without missing a beat the learned bankruptcy judge directed the marshals to put the debtor in jail, stating “I may not have jurisdiction over the account but I have jurisdiction over you.” Needless to say, the debtor became motivated to move the assets back to the U.S. in short order!
- Annuities: Annuities are a popular investment option used to guarantee a stream of income to retirees under certain defined contractual terms. Generally, courts have not recognized these products to be protected from the reach of creditors.
- Gold Coins and Cash: You saw this one coming. My clients call this one the “cash money” protection device. Although you can certainly bury some cash or stash gold coins in a safety deposit box, you run the risk of making a bad problem worse. When a judgment creditor seeks to collect from a debtor, they serve papers giving them the opportunity to both disclose and claim protections over their assets. Debtors are required to disclose (under penalty of perjury) any assets that are not protected(that the judgment creditor can take to satisfy the judgment). When debtors fail to list the cash or gold, they run the risk of civil or criminal contempt problems before a judge or worse.
I hope this post gets you thinking about asset protection for your FI assets. You’ve worked hard for your money, and with a little advance planning you can have a great nest egg that is not exposed to unanticipated legal troubles should they arise. I look forward to your questions and comments. Please consult your local professional for state-specific advice. Enjoy the rest of your week!