Blog Author: Stephen C. Hartnett, J.D., LL.M. (Tax), Director of Education, American Academy of Estate Planning Attorneys, Inc.
Much depends upon whose assets you are looking to protect. If the assets are those that are coming to you, the debtor, then typically, those can be protected completely.
The debtor could protect their own assets in three general ways: 1) insuring against the risk, 2) shifting the assets into categories protected under state law or federal bankruptcy law, or 3) shifting the assets to someone or an entity where the creditor cannot attach.
Whenever the creditor is looking to protect their own assets, especially by shifting them to someone else, the threshold question is whether it is a fraudulent transfer. A transfer may be deemed to be fraudulent based on various badges of fraud:
- Transfer to an insider
- Debtor retained possession of the property after the transfer
- Transfer was concealed
- Debtor was sued or threatened to be sued prior to the transfer
- Transfer was of substantially all assets
- Debtor absconded
- Debtor concealed assets
- Inadequate consideration
- Debtor was insolvent or became insolvent shortly after the transfer
- Transfer occurred shortly before or after substantial debtor was incurred
- Debtor transferred the assets to a lienor who transferred the assets to an insider of the debtor
These badges of fraud are found in common law, the Uniform Fraudulent Conveyance Act, the Uniform Fraudulent Transfers Act, or the Bankruptcy Code. While the badges of fraud underlie each of these, they each have their own spin on the concept.
Assuming it is not a fraudulent transfer based on the laws of the jurisdiction, the debtor is free to engage in asset protection planning, including transferring the assets to others.
There is no panacea or solution for every circumstance. But, here are a few strategies and some of their pros and cons:
- Liability Insurance. I’m listing this first since it is often forgotten. Clients often have insurance for their home and auto. But, often, clients do not have an umbrella policy or other liability insurance, other than as a driver. An umbrella policy is often a very inexpensive way to insure against many risks. However, it is limited to liability from certain activities.
- Gifting Assets. You can gift assets to family members, such as your spouse, and remove those assets from the reach of your future creditors. Such a transfer is irrevocable and you cannot force a return of these assets. The transfer could be problematic in the event of a divorce.
- “Tenancy by the entirety.” Tenancy by the entirety is a form of joint tenancy, only available between married couples, which is available in about half the states. In most states with tenancy by the entirety, both real property (like a house) and personal property (like a brokerage account) may be held in that form. In about 1/3 of the states with tenancy by the entirety, it is only available for real estate. With tenancy by the entirety, a creditor of one spouse cannot attach the property. However, a creditor of both spouses, like someone who slips on the sidewalk of the home held in tenancy by the entirety, could reach the asset. The tenancy by the entirety form ends at the death of the first spouse. If the spouse with creditors is the survivor, that spouse receives the property by operation of law and it is no longer protected from their creditors due to tenancy by the entirety.
- 529 plans. Assets deposited into a 529 plan for children, stepchildren, grandchildren, and step-grandchildren may be protected in bankruptcy up to the maximum amount allowed for a 529 plan in your state, as long as the assets were deposited more than 2 years before a bankruptcy filing. For example, in California, the maximum for 529 plans is $475,000 per beneficiary. The account owner can still withdraw these funds and use them for themselves. So, this could be a way to shield a large sum if you think ahead. However, investments options may be limited and there may be negative income tax consequences if the funds are not used for higher education.
- 401k or retirement plans. Assets you contribute to a retirement plan, including the growth thereon is exempt in bankruptcy. These can be great ways to shelter assets from creditors. Withdrawals may face a 10% early withdrawal penalty if made before age 59 ½. Amounts withdrawn would be includible in your taxable income if from traditional accounts. Similar rules apply to IRAs but they may only be protected up to $1 million, depending upon the circumstances.
- Irrevocable Trust. An Irrevocable Trust can be used to protect assets from future creditors. In most states, you cannot be a beneficiary of such a trust and obtain asset protection. The assets transferred to such a trust are transferred irrevocably from you and you cannot get them back.
There are many ways to protect your assets from creditors. The key is thinking far in advance and structuring your assets to protect them, years before any creditor surfaces.