By: Frank Armstrong, CFP, AIF
Are you sure you will never be sued? Are you sure that if you are, the courts will be fair? Are you willing to bet your entire financial future on it?
The potential costs of a lawsuit can be devastating. CNN recently reported the following: “Millions of lawsuits are filed in the United States each year, at an estimated cost of about $150 billion, or 2.5 percent of the Gross National Product. The chance of one of these lawsuits being directed at you grows each year. The mean compensatory award exceeds $700,000 and has grown every year since 1991. About 40 percent of compensatory judgments exceed $100,000 and more than 10 percent are above $1 million. These figures do not include punitive awards or legal fees.”
“The biggest misperception people have is that they aren’t going to be sued or that a lawsuit won’t have merit and will be settled for a small amount,” Don Griffin, a director at the National Association of Independent Insurers, said. “But that’s not typical in this day and age.”
Fortunately, you can reduce your exposure. Lawsuits are avoided or settled if there is doubt about either liability, or collectability. Asset protection planning raises a series of defenses that makes collection problematic.
These defenses vary in complexity, cost and effectiveness. Even the most elementary might be enough to deter a frivolous lawsuit, while the most sophisticated defense may not discourage an irrational deep-pocketed litigator. Let’s look at some of the most basic defenses.
Pension accounts are generally out of reach of creditors as a result of Federal legislation (ERISA). However, if a corporation is closely held, the owner’s account may in some cases be considered an asset of the corporation. Protection does not extend to IRS liens, court ordered divorce settlements, or child support. Any distribution from a qualified plan is not covered by federal exemption.
All states have statutory protection for some amount of some classes of property. The best we can do here is give you an idea of the exclusions that might be available to you in your state.
IRA Assets Protection of IRA’s is subject to individual state legislation. Depending on where you live, protection varies from unlimited to zero. Many states that do provide protection have expanded that protection to include Roth IRA’s as well.
Homestead Most states provide some form of protection for your primary residence. Florida, for instance, exempts the homestead without limitation of value for 1/2 acre inside a city limit or 160 acres in an unincorporated area. But California exempts only up to $100,000 in value.
Titling Provisions You may be able to title property (not necessarily real estate) to make it more difficult to attach under state law, or make the property less desirable to the creditor.
“Tenants in Common” is a form of ownership where each owner holds a specified portion of an asset. Because these ownership interests are easily transferable, there is little creditor protection besides the inconvenience of owning an asset with others. Once ownership is transferred, it is often possible for a party to force division of the property.
Property may be held jointly with right of survivorship (JTROS) or tenancy by the entireties. Few investors realize that there is a huge difference between the two.
JTROS may offer a low level of asset protection, especially where assets may not be easily divided, making the undivided interest less valuable to creditors. In some states, the joint tenancy may be “severed”, leaving the interest of the debtor subject to his creditor. Joint tenancies can often be invaded to the extent that a contribution is traceable, and if not traceable, may be entirely subject to creditors of either party. Creation of a joint interest may present gift tax complications where both the parties are not U.S. citizen spouses.
Where available on a state-by-state basis, tenancy by the entireties is reserved for married couples and may offer more complete protection against creditors of one party. But the titling must be recorded exactly correctly to get the anticipated benefits. Beware: Many banks and brokerage houses do not offer account registration as tenancy by the entireties.
Neither JTROS nor tenancy by the entireties is a complete asset protection solution. If both parties are found liable for a debt, it offers no protection at all. Worse yet, if the spouse or joint tenant takes off, the property may be lost, and the debtor worse off than if it had gone to the creditor. Or, if the “wrong” party dies, the debtor could lose the property immediately. Jointly titled property may be subject to lien that will make it impossible to dispose of. Finally, property held as JTROS or tenancy by the entireties may be an estate tax disaster if the estate is large.
Wages Many states provide protection against garnishment of wages of various amounts and for various time periods after received. Where available, the terms of protection may vary as a result of factors such as whether the wage earner is the “head of household” or if the amount covered is “reasonable” for the wage earner and his household.
Life Insurance and Annuities The cash value and/or proceeds of a life insurance policy or annuity are protected by some (but certainly not all) states.
Common Problems with Statutory Exemptions Each of these elementary defenses are subject to problems and attack. State exclusions may not be adequate or may be reduced by the state later. They are always subject to reinterpretation by the state courts, and new “heroic legal theories” arise each day from the fertile minds of the varmint legal class. “Results oriented” judges can find a number of clever ways to get what they want done if property is within their reach.
Of course, most of us rely on insurance to provide an asset protection shield. But insurance may have gaps in coverage, contain exclusions, be cost prohibitive, or may not even be available. Or the award may exceed the limits of the policy.
Insurance companies maintain stables of their own expensive house attorneys busily engaged in finding ways not to pay claims once incurred. This process is euphemistically referred to as “underwriting at point of claim.” The rationalizations and imagination of insurance companies varies directly with the size of a potential claim.
Or, the insurance company may go out of business, or withdraw from a state. The largest malpractice carrier in Ohio recently folded, leaving many physicians suddenly hung out to dry.
Insurance poses some difficult moral problems. As responsible citizens, we want our insurance to cover legitimate claims, but the presence of large amounts of insurance coverage may actually attract fraudulent or frivolous litigation. And, insurance companies often pay simply to make these bogus claims go away for nuisance value. Professionals and others often find their reputations damaged where insurance companies force settlement rather than fight a spirited defense.
While it would be foolish to ignore any available statutory exemptions, it’s very unlikely that they could form the basis of a comprehensive asset protection plan. Next article will examine a far more useful tool: the family limited partnership.
Asset Protection: The Basics
By: Frank Armstrong, CFP, AIF