Asset Protection 101
In my estate planning practice, many people ask about ways to protect their assets from potential creditors and plan for children and grandchildren. Irrevocable trusts and limited liability companies are useful tools in “asset protection” planning. Asset protection planning is designed to address potential future but currently unknown claims or creditors.
Claims of creditors, whether tenants of rental property, or even family members feuding after one’s passing, can put assets at risk.
How to protect against this very real risk?
Limited Liability Company
When dealing with rental property, transferring the property to a limited liability company (“LLC”) provides liability protection for its owners. What does that mean? Let’s say an event creating liability happens within the LLC. If another party sues based on that event and becomes a judgment creditor, that party would not be able to reach the personal assets (non-LLC assets) of the owner.
What’s more, if the LLC owner is sued personally due to an event occurring outside the LLC, the judgment creditor could not take control of the LLC. Only the LLC itself is liable for the debts and liabilities incurred by the business—not the owners or managers. A creditor of a member of an LLC might be limited to a charging order. A charging order gives a creditor the right to receive any distributions that the owner of the interest would have received. Because the LLCs manager(s) determine if and when distributions are made, a charging order is not an attractive remedy to most creditors. The prospect of a charging order can often convince a creditor to settle on more reasonable terms than might otherwise be possible.
Because of the protection against inside and outside liability, LLCs are effective personal asset protection tools for holding investment real estate and operating businesses.
Irrevocable Trust
When a Grantor puts assets into an irrevocable trust, they are no longer the owner. Instead, the Trustee becomes the legal owner, and he or she must manage the assets according to the terms of the trust for the benefit of the beneficiaries, who are designated in the trust instrument.
Irrevocable trusts provide asset protection by removing control from the Grantor. The rule of thumb is if the Grantor can’t reach the assets, creditors of the Grantor can’t either.
There are many types of irrevocable trusts, and it is possible for the Grantor to retain some degree of control. Depending on the trust and goals of the Grantor, it’s possible for the Grantor to act as the trustee, as well.
Although the Grantor will not be able to access the principle of an irrevocable asset protection trust, the Grantor can retain the right to income.
These irrevocable asset protection trusts also provide estate and capital gains tax benefits, including a step-up in basis equal to the fair market value of the property on the date of death of the Grantor. Because the assets are no longer owned in the Grantor’s name, they may not be includible in the probate estate and not subject to estate taxation.
Irrevocable trusts work great for primary residences of older clients, or for parents or grandparents who’d like to make a gift and want the benefit of a step-up in basis and do not want the beneficiary to have unlimited access to the gifted funds.