COMMENTARY

10 Ways to Protect Your Assets From Potential Lawsuits and Creditors

Syed Nishat, BFA; Aadil Zaman, MBA

Disclosures

February 03, 2021

An infectious disease physician in California has been treating patients with COVID-19, and although he knows that he's doing important work, he's also worried about someday facing a lawsuit for potential wrongful treatment, given that medical understanding about COVID is changing almost daily.

We hear similar worries from other clients as well. Other physicians are similarly concerned about protecting assets in the event of a lawsuit, even though they have liability insurance in case of a large judgment.

Although typically lawsuit awards or settlements are within what is covered by a physician's liability insurance, there are some instances where a plaintiff attorney goes after a physician's personal assets to cover a judgment in excess of the insurance available.

Physician practices have the same concerns as hotel owners and restaurant owners, in that they may get sued by patients who claim that they contracted COVID while visiting their practice. The recent stimulus bill passed by Congress does not include protections for businesses against COVID-19–related lawsuits.

There are other potential threats to personal assets. Many physicians invest in rental properties for passive income. If a rental property is owned in a physician's individual name and there is a tenant lawsuit, personal assets could potentially be exposed. On the other hand, if the same property is owned under a limited liability company (LLC), then in the event of a tenant lawsuit, the liability of the physician is limited to whatever is held inside the LLC and personal assets are off-limits.

Several asset protection strategies are available that can help you address this major concern and put you and your assets in the best possible position for yourself, your business, and your beneficiaries.

Irrevocable Trust

Many asset protection strategies make use of trusts, but what exactly is a trust? A trust is a legal agreement in which property is held by one party for the benefit of another.

A revocable trust allows for easy amendments that can move assets in and out of the trust at will. Because these changes can be made simply, assets in a revocable trust are not protected from lawsuits.

In contrast, an irrevocable trust has stipulations that mean it cannot be easily amended, altered, or revoked. The way in which an irrevocable trust is set up keeps creditors from having access to the assets held within the trust.

A potential disadvantage of an irrevocable trust is that once an asset is in the irrevocable trust, you no longer have direct ownership of it. Should changes need to be made, such as changing a trustee or beneficiary, it is not impossible. Therefore, the grantor of the trust, also referred to as the settlor, cannot be made to modify things by a judge's order.

However, alterations can be made by a third party. The "third party" is a trust protector appointed to exercise powers affecting a trust and the interest of the beneficiaries. Having a protector allows the trust to be more flexible and adapt to changes.

Qualified Personal Residence Trust

Your primary house is a key asset to keep in mind when looking at what exactly to protect. A residence is not protected in every state, and some states do not have strong homestead protection like that in, for example, Florida and Texas. It can be beneficial to set up a qualified personal residence trust (QPRT), which is a type of irrevocable trust that removes the grantor's personal home from the estate.

The general purpose of QPRT is to reduce estate taxes, but because the trust is irrevocable, the assets are protected from creditors. QPRTs allow the owner of the residence to live in the property, so the creator of this type of trust does not have to vacate the premises.

401(k) or Defined Benefit Plan

Another way to protect your assets is to keep them in a 401(k) or defined benefit plan. These and other pension plans provide substantial federal protection against creditors. Because assets held in these plans are technically held in trust for the investor, they do not fall under the category of assets that creditors can pursue. Solo 401(k)s do not receive the same protection under federal law, although they do have some protection under state law, which varies by state.

In the event of the account owner's death, the assets in the 401(k) can be passed to the named beneficiary. The primary beneficiary of the 401(k) or defined benefit plan should be the spouse, and the secondary beneficiary should be a living trust that becomes an irrevocable trust upon death of the account owner.

Alternatively, the assets can be transferred to an inherited individual retirement account (IRA), but this does not have strong asset protection. To ensure maximum asset protection, the assets should be distributed via an irrevocable trust after the owner's death. The advantage of this approach is that creditors cannot access the assets in this type of a trust.

When evaluating whether to contribute to a 401(k) or defined benefit plan, it is worth noting that a creditor cannot obtain a charging order for a plan administrator to break up a plan or force distributions, so these funds remain safe as long as they are held in the plan. However, assets distributed from a plan do lose protection. Most 401(k)s allow loan and penalty-free withdrawals in the event of economic hardship or disability.

Individual Retirement Accounts

Assets that are held in an IRA have some degree of protection. Creditors cannot garnish the IRA of a deceased person to cover any debts.

This also applies to annuities and life insurance when the deceased person has a named beneficiary that is a person, charity, trust, or other entity. If an estate goes to probate, creditors may try to go after the assets during that time. In terms of state protections, many states have laws that define a creditor's ability to collect against such accounts as IRAs and annuities, with many having a great deal of protection.

Other states provide more limited protections, similar to bankruptcy laws in terms of reasonable necessity, a standard applied differently among the states. Because exemptions and laws will differ from state to state, it's best to work with a financial professional to determine how to protect each of your accounts from creditors. In addition, many states have provisions regarding how long before financial trouble hit an annuity was purchased; thus, it is better to plan in advance rather than waiting until trouble appears on the horizon.

529 Plans 

For 529 plans (education savings accounts), protection is a state-level issue, with many states offering protection to the donor and beneficiary on the accounts. Again, these laws differ among states. Some states may offer protection only on a portion of the account, or only if the plan is held by a resident of the state in which the plan was established.

Life insurance protections also exist at the state level, and as such, the protections again vary by state, with some protecting the full value of a policy and others having many more limitations on how much is actually protected from creditors. For protections on a federal level, IRAs, annuities, life insurance, and college savings plans are generally all exempted from bankruptcy estates as well, adding another layer of protection that could be needed.

Domestic Asset Protection Trusts

Other kinds of trusts can provide asset protection. Seventeen US states have their own state asset protection trust rules. These domestic asset protection trusts (DAPTs) are self-settled irrevocable trusts that put assets out of the reach of creditors.

DAPTs don't only offer asset protection; there are also state income tax savings, depending on the state. Several different types of asset can be held in a DAPT, including securities, cash, real estate, higher-risk assets, and even LLCs. When establishing a DAPT, it's important to find a state with laws that will provide the best protection for the funded trust, as well as ensuring that the assets used to fund the trust have a long-term time horizon to make withdrawals from the trust infrequent and carefully considered.

It is important to do proper due diligence before setting up the DAPT. Not all states have DAPT protection. The asset protection varies from each state, and there is no uniformity. Each state may have their own waiting period for statute of limitation for the asset protection to be in effect. The statute of limitation determines how long it will take for the trust assets to be protected. Nevada, for example, has a 2-year statute.

There must be one trustee who is a qualified resident of the state to set up the trust. The trustee can be a professional trust service or a family member.

Nevada Asset Protection Trust

Nevada has unique trust laws and state taxation regulations that make it an ideal place to set up trusts for advanced estate planning.

By putting assets in a Nevada asset protection trust, the owner of the trust can reap great benefits. For trusts, Nevada has no capital gains tax and strong asset protection. One does not need to be a resident of Nevada to take advantage of these tax and protection benefits; the requirement is that one of the trustees must be a Nevada resident, or a trust company operating in Nevada may be used.

It is important to know that this trust is an irrevocable trust, meaning you give up ownership over the assets. The owner of the trust maintains control over all the assets in the trust, except for distributions. It is this lack of control over distributions that keeps creditors from being able to go after the assets. There is no limit to the amount of assets protected under the trust.

Family Limited Partnership

To aid with tax-free transfers of wealth, assets, and real estate related to a business, a family limited partnership (FLP) can be created. An FLP is a business or holding company in which family members pool their resources, and each purchases shares or units to fund a business project. This set-up is a way to maintain generational wealth; each year, individuals can gift FLP shares to other individuals tax-free, up to the annual gift tax exclusion.

Besides providing tax savings, an FLP can be a strong asset protection tool. The two major components of an FLP are general partners and limited partners. General partners are in control and set up the FLP; limited partners have limited liability. If established properly, it is very difficult to obtain assets of the limited partner in a FLP. The creditor can pursue a court ruling and obtain charging order, but the general partner has the authority to refuse any distribution.

Limited Liability Company

If a business owner is looking to further protect business assets, one of the best ways is to form an LLC. Without an LLC, the business owner and the business are one and the same in the eyes of the court. If the business is sued, personal assets may be seized to pay for court and legal fees as well as for ruled damages. The establishment of an LLC separates personal assets from the assets and operations of the business.

With an LLC in place, should a business be sued, the business owner's personal assets may not be pursued to pay court fees, legal fees, and ruled damages. To best protect personal assets, it is important to completely separate personal finances from those of a business, including keeping good LLC records; establishing unique bank accounts and credit lines for the business; and making sure that all purchases, contracts, legal documents, and other related items are all done in the LLC's name and are signed on behalf of the LLC.

Placing Assets Under Your Spouse's Name

One of the simplest ways to protect your assets can be to place them in the name of a spouse who is not a physician and therefore isn't as vulnerable to the risks that someone in the medical profession may be. If assets are purely under the ownership of a spouse, those assets may not be touched in the case of a lawsuit or other legal procedure. To make sure that every asset is covered, it may be further advantageous for the married couple to obtain an umbrella policy. An umbrella policy is a type of liability insurance that goes above what other insurance policies have specified they will cover and can also be used as primary insurance for items that other policies do not cover at all.

The drawback of this strategy is that if there's a divorce, the asset protection is gone because the assets possibly will get split. If the couple has an umbrella policy, then in the event of a divorce, it would need to be reviewed to make the changes to reflect the changed circumstances.

These are some of the ways in which asset protection can be built into a physicians' financial planning, some of them very complex. Every financial plan is different, and the best plan is one that is customized to suit all the specific needs for your situation. To navigate the complexities, it is best to work with financial advisors with experience in these areas. Your assets are part of your legacy, and making a plan to protect them now will be most beneficial to you, your family, and your business.

Syed Nishat, BFA, and Aadil Zaman, MBA, are financial advisors and partners at Wall Street Alliance Group, based in New York City.

Securities offered through Securities America, Inc., member FINRA/SIPC. Advisory services offered through Securities America Advisors, Inc. Wall Street Alliance Group and Securities America are separate companies. Securities America and its representatives do not provide tax or legal advice; therefore, it is important to coordinate with your tax or legal advisor regarding your specific situation.

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