By Mark Papalia, CLU, CFP
In today’s litigious society, few physicians dare wield a scalpel or stethoscope without ensuring that the premiums on their medical malpractice insurance are paid up. The risk that a single lawsuit might cost them and their families everything they’ve ever earned is too great. Buying insurance protection is just good business. Yet many physicians don’t realize that there are other steps they can take to protect their personal assets from the claims that might surface in their professional lives. The process is called asset protection planning, and it’s never too soon to begin.
Start with Your Insurance
Before you embark on any complex asset protection attempts, which may involve a restructuring of your investment portfolio or your business holdings, take some time to review your insurance portfolio. Naturally, you carry insurance policies on your home, cars and recreational vehicles. Each includes personal liability coverage in the event you injure another person or damage property. But the limits are typically low compared to what a court might award a seriously injured plaintiff. Absent any other form of relief, the plaintiff may try to recover the difference by forcing the sale of your home or other personal property. You may be able to forestall that if you also carry an umbrella policy for personal liability, which kicks in when the limits of your other policies are exhausted. A typical umbrella policy might provide coverage of $3 million to $5 million.
A Valuable Next Step
It is important to recognize that asset protection planning is not something you do to avoid paying legitimate debts when you have the financial wherewithal to do so. It is, rather, a way to shield your personal assets from frivolous lawsuits or unreasonable jury awards related to medical malpractice or even personal liability claims (e.g., automobile accidents).
Also be aware that you need to start asset protection planning long before any creditors are knocking at your door. If you wait until you’ve been sued, or even until you’ve done something that might trigger a suit, laws against “fraudulent conveyance” will likely quash any asset protection strategies you implement, on the theory that their only purpose was to deny creditors their claims. All of the strategies discussed here have legitimate tax-planning and estate-planning purposes, but their value as asset protection tools depend on timely implementation.
Exemption is the Best Protection
Many of the simplest asset protection strategies revolve around placing assets out of reach of potential, future creditors by holding them in forms that are exempt from attachment. One common example: qualified retirement plans regulated under the Employee Retirement Security Income Act. These include traditional pension plans, profit-sharing plans, Employee Stock Ownership Plans and retirement savings plans such as 401(k)s. By federal law, assets held in those plans can’t be attached by creditors. While Individual Retirement Accounts don’t enjoy the same federal protection, many states exempt them from creditors’ clutches, too, including Pennsylvania. One wrinkle: Pennsylvania does not exempt SEP-IRA contributions in excess of $15,000 in any one year.
The lesson in all this is that it makes far more sense to shelter assets you don’t need today in a retirement plan, where, it’s worth noting, they also enjoy tax deferral advantages, rather than in a taxable bank or brokerage account. If you don’t have access to a qualified plan, or if contribution limits are a hindrance, consider purchasing an annuity or a life insurance policy that accrues cash value. In most states, including Pennsylvania, assets held in these instruments are provided some protection from creditors.
Some states, notably Florida, also exempt your personal residence from attachment by creditors. That’s not the case in Pennsylvania, but even here you can make it hard for a future creditor to take your house if you are married and you title the home appropriately. The key is to hold the property in “tenancy by the entirety” rather than the more common “joint tenancy” form. Both forms provide that if one spouse dies, ownership automatically passes to the survivor. However, joint tenancy offers weaker protection against creditors because it allows one party to unilaterally terminate the survivorship rights of the other and force a sale of the property. In a worst-case scenario, a creditor who successfully sues you could claim your share of the house and then force its sale. Tenancy by the entirety, by contrast, requires the agreement of both spouses to terminate survivorship rights and sell the property. That means a creditor of yours would find it difficult to force the sale of your home, as your spouse could block it, and vice versa.
Incidentally, the opposite is true when it comes to cars. You and your spouse should title your motor vehicles in your individual names rather than jointly. That way, if one of you is involved in an accident, an aggrieved party would find it difficult to claim that just because your car was titled jointly, your other jointly owned assets are recoverable, too.
Family Limited Partnerships and Limited Liability Companies
If you have enjoyed a successful career or inherited money, your assets may include business ventures, rental properties, a vacation home or even an art collection. To help protect them, and for estate planning reasons, consider holding them in a legal form that clearly separates them from your personal property. One way to do so is to form a limited liability company to own the property. Another increasingly common strategy is to create and use a family limited partnership. In a typical FLP, you and your spouse retain only a small minority ownership in the partnership, but also function as the general partner. The latter distinction allows you to retain operating control of the partnership and its assets. Meanwhile, your children or other heirs own the bulk of the partnership in the form of limited partnership units. If they cannot afford to purchase their interests up front, you can gift them over a period of years. These structures can be costly to create and complex to manage – the LLC or FLP will have to file its own tax returns, for example. However, they not only help to shield assets from creditors, but may also offer significant tax advantages when passing assets on to your heirs.
Asset Protection Trusts
Trusts are legal entities in which one person holds assets for the benefit of another (the beneficiary). While some trusts have been inappropriately created and/or over-promoted, legitimate trusts can play a reliable and valuable role in the asset protection plans of high-net-worth individuals, especially medical professionals who could face losing their personal and family assets from catastrophic malpractice awards.
It is important to note here that we are not talking here about the type of offshore trusts that U.S. courts and the IRS have been challenging. The offshore trusts that have been in question are primarily those in which money is taken offshore so that it is not subject to United States income taxes.
There are two types of valid asset protection trusts, both of which are subject to U.S. income tax; neither is a tax avoidance scheme. One type of trust is called the domestic asset protection trust. The other is an offshore asset protection trust.
Over the past several years, Alaska and a handful of other U.S. states have enacted legislation that allows for the creation of the “domestic asset protection trust” which some companies are marketing as a type of self-settled spendthrift trust aimed at the asset protection market. These trusts have several advantages over their offshore counterparts, starting with the fact that you get to keep your money in the United States rather than a country where economic or political stability may be suspect. Equally important, many of these domestic trusts also allow you to name yourself as a beneficiary, which is prohibited with most other types of trusts. In essence, you get to have your cake and eat it too: your assets are owned by the trust and are likely protected from creditors, but are still available to you.
The valid offshore trust is considered by many as providing “bullet-proof protection” from creditors and lawsuits. There are two ways of setting up this type of trust. The first option: you set up a grantor trust with a non-U.S. trustee. Because your assets are then held outside of the U.S., in the case of a lawsuit or a bankruptcy, a U.S. Court likely cannot tap those assets. The disadvantage is that your assets are not here and your control is at the discretion of your foreign trustee. The second option, which gives you more direct control, is to combine several asset protection strategies into one plan. While they are fairly complicated to develop, in essence you set up a limited partnership or a limited liability company to allow control through the managing partner relationship and protect the assets through a foreign trustee arrangement.
Realize, though, that asset protection trusts, and especially offshore ones, can be costly to create and complex to manage. But for individuals with several million dollars or more at stake, they can be a vital part of a broadly configured asset protection strategy.
While there is no sure-fire way to shield all of your assets from future creditors, the strategies described here can help. But this article is not written to suggest that you now consider self-directed solutions. To create a viable plan that will work for you, you must consult a qualified advisor who can help you secure meaningful protection without unwarranted cost or complexity.
Mark Papalia, CLU, ChFC, CFP, is founder and president of Papalia Financial in Danville, Pa.