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PROTECTING SUBSTANTIAL ASSETS AGAINST YOUR CREDITORS; BEYOND THE LIVING TRUST

By David M. Griffith, Esq.

Q. I am a shopping center developer and I just received a large distribution from the sale of a power center that I developed about seven years ago. I intend to continue developing shopping centers for another five years or so, but I would like to protect the asset base that I have built up, including this latest pay-out. I am concerned about my continuing liability as a shopping center owner. There has been some questionable litigation in the past against my centers in terms of ‘slip and fall’ and similar claims. Although I carry insurance I am never certain that the insurance carriers will cover me in every case. Is there anything I can do to protect my assets from the continuing litigation craze?

A. There are some generalizations that you can you employ in getting started on understanding the law in this area. First of all, there is no panacea or ‘silver bullet’ in the area of asset protection. For example, you can set up a foreign asset protection trust in some exotic locale, like the Grand Cayman or Cook Islands, and this will provide you with greater, but not absolute protection, from your creditors. The ‘downside’ of this approach is that the political situation in such jurisdictions may change, and the cost of employing a foreign trustee is such that these are not usually recommended unless you have more than $500,000 in liquid assets and you are in a ‘high’ risk profession, of which real estate development may qualify. In certain circumstances the standard approaches available here in the State of California may be sufficient, but not totally creditor proof. Again, any plan can be attacked successfully, depending on the set of circumstances, the resourcefulness and determination of the creditor, and the judge or jury’s disposition in a particular case.

Three other generalizations to keep in mind: (a) the earlier you get started the better, in that if you put together a legitimate asset protection plan before you have ‘problems’ (e.g. existing creditors or litigation that could result in judgments against you), then it is less likely to be successfully challenged; (b) the less control you yourself retain, and the more control given to your wife, children, or a third party trustee, then the less likely that a challenge by a creditor will prevail; and (c) you should keep a reasonable portion of your assets (say 25 to 50%) in your own name to prevent a court from finding that your asset protection program was done in furtherance of a master plan to defraud creditors. In summary, if your asset protection plan is so aggressive as to defy logic, it may be dismissed by any reviewing court as a scheme to defraud creditors. Your strategy must be undertaken in ways that are entirely consistent with prudent estate planning and investment management, including diversification.

The ‘Primary’ Concerns - the Fraudulent Conveyance Act and the Bankruptcy Act

Your primary concerns are the four year statute of limitations for fraudulent conveyances and one year for transfers made in anticipation of bankruptcy. Concerning fraudulent conveyances you have to be concerned about ‘current’ creditors and ‘future’ creditors. Future creditors may be those achieving a judgment against you in litigation that was ongoing while you were in the process of transferring assets. Any transfer that you make to a trust, or other asset protection alternative, that assists you to avoid or evade a creditor is a ‘fraudulent transfer’, can be reversed by a judge, and can result in criminal penalties).

A ‘fraudulent transfer’ is defined as ‘a transfer made or obligation incurred... whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if you made the transfer or incurred the obligation... (a) with actual intent to hinder, delay, or defraud any creditor... and (b) without receiving a reasonably equivalent value in exchange for the transfer or obligation, and (you) (1) were engaged or were about to engage in a business or transaction for which your remaining assets... were unreasonably small in relation to the business or transaction; or (2) intended to incur, or believed or reasonably should have believed that you would incur, debts beyond your reasonable ability to pay as they became due.’

‘Creditor’ means a person who has a ‘claim’, which means a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.’ CA. Civil Code Sec. 3439.01

The most recent interpretation of this law in California was In re: Marriage of Dick, 15 Cal.App. 4th 144 (April 1993), involving a divorce, where the court ‘unwound’ the fraudulent transfers:

“The crucial finding was that husband has organized his assets in a labyrinth of trusts and corporations... to shield and protect him from creditors...although the evidence fails to disclose any assets actually standing in husband’s name....he has access to and control of extensive assets... the transactions by which he transferred ownership of assets... to various off-shore trusts and corporations were for the purpose of tax avoidance and to create a shelter from creditors, and that for the purpose of this divorce proceeding, they must be disregarded... the court is entitled to look past the apparent form of ownership in which husband’s assets were held to determine the extent of husband’s true interest in them and the availability of those assets in assessing husband’s ability to pay.”

Some Recommended Strategies

1. Post Nuptial Agreement - the simplest strategies involves not owning any any assets or limited assets in one’s own name. The post nuptial agreement is a document in which each spouse endorses the other’s estate plan and is used often to change community property into separate property to protect assets. Based upon California Civil Code Sections 5120.130 and 5120.140 a married person’s separate property is not liable for a debt incurred by the other spouse before or during marriage, except for the ‘necessaries of life’, while living together. (‘Necessaries of life’ are defined as food, shelter, clothings and medical care).
2. Qualified Personal Residence Trust (QPRT): this trust allows you to pass a personal residence along to your children during your lifetime and avoid estate taxes on the property when you die. This trust is irrevocable and allows you to give your home to anyone you choose, but to continue to live in it during the term of the trust. To establish the trust you set it up for a term of years, say 20 or 30 years. During that term, you live in the home, continue to pay all the bills and submit a gift tax return the year you create the trust. By creating the trust you are considered to have made a gift of the home at its current value, not some future appreciated value. And you are allowed to reduce that current worth by (a) the value of your right to live in the house, and (b) your right to give it away by a will if you die before the QPRT term ends. The only significant risk of a QPRT is if you die before the term of the trust ends, in which case the house becomes part of your taxable estate. Conversely, if you survive the term the house is tranferred to your beneficiary and your estate is reduced by the value of the home. Given the current depressed state of California real estate this is considered a good time to establish a QPRT.

3. Exemptions: the primary exemption benefit in California is the $75,000 homestead exemption. There are also other exemptions for an automobile, personal property, income, etc. These exemptions should be perfected in the case of an individual filing for personal bankruptcy, as part of his or her overall bankruptcy plan. A chart of the standard exemptions is set forth as Exhibit A to this letter.

4. Family Limited Partnership (“FLIP”): this is method of making gifts of real estate to children at deeply discounted prices. As long as the value of these gifts is below the $600,000 lifetime exemption for each parent the children will avoid gift taxes. A FLIP will also serve to reduce the value of the estate when the parents die. The standard model is for the ‘at risk’ party to serve as general partner or set up a corporate general partner, and have the wife and children as limited partners. The FLIP is the most sophisticated and expensive of estate planning techniques and requires the additional guidance of a tax accountant.

5. Charitable Remainder Trust: charitable remainder trusts are commonly used techniques, whereby individuals can give appreciated property to a trust for qualified charitable organizations, avoid having the capital gains taxed and receive an annuity payout for a term of years, or for their lifetimes on the entire asset base, without diminution for the capital gains tax, hence increasing cash flow. In addition, a charitable deduction against income can be obtained. Assuming that this transfer is not a fraudulent conveyance, the asset base and income stream (until distributed) will be protected during the settlor’s lifetime.

6. Charitable Lead Trust: this form of charitable trust received considerable attention recently because Jacqueline Kennedy Onassis used it in her will to pass a substantial portion of her estate on to future generations with minimal taxation. In such a trust, a set amount of money is distributed to charities each year, and at the end of its term, the remaining assets are passed on to a named beneficiary. Such trusts are a possible vehicle for lowering income and estate taxes, provided your heirs do not need the funds right away. (Using such a trust is one possible way to pass along a family business without being forced to sell it to pay the taxes on the appraised value). For example, say your total estate is $700,000 and you put $250,000, or a business worth $250,000, into a charitable lead trust for 24 years. You can set the payout rate to charities as high or as low as you wish, but to maximize the tax benefits on a trust of this size, a 4% rate is recommended. Then you would be passing along $10,000 annually to charity, and the present value of the gift, discounted at a current federal tax rate of 8.4%, would be $101,750. Your taxable estate is reduced by this amount to to $598,250, or just below the $600,000 exemption, so your estate taxes are zero.

7. Life Insurance/Life Insurance Trust: a life insurance policy is often a significant alternative to a protection of assets trust. When the insured dies the proceeds are generally exempt from the insured’s creditors, although not necessarily from the beneficiaries’ creditors. A husband, for example, should be be able to make his wife the owner as her separate property, and beneficiary of an insurance policy, and have it escape his creditors or the creditors of his estate. Likewise, an irrevocable or revocable life insurance trust may provide an additional advantage if the settlor is not only concerned about the settlor’s creditors, but also the beneficiaries’ creditors, because if the trust has a spendthrift clause, when the insured dies the creditors of the beneficiary will not be able to reach the principal (and perhaps not even the income until there is a distribution). The primary difference between the revocable and irrevocable life insurance trust is that the irrevocable trust provides for estate tax savings because the proceeds will generally not be included in the decedent’s estate, but there is a corresponding loss of control because you cannot, without the cooperation of the trustee and beneficiaries, reclaim the trust property (the policies and certificates) if you later change your mind.

8. Irrevocable Trust: in a normal irrevocable trust, as long as the settlor is not a beneficiary, the property is transferred out of the settlor’s hands and it should be exempt or insulated from the settlor’s creditor’s claims. The beneficiaries and spouse should also be protected from the settlor’s creditors, as well as their own. Such trusts take advantage of a ‘spendthrift’ clause, which is based upon the non-assignability of the beneficiary’s interest in the trust until received, whether the transfer or assignment is voluntary or involuntary.

9. Spousal Gifts: under the United States transfer tax system, almost all transactions between spouses are tax-free. Therefore, a genuine gift to a spouse, not a fraudulent conveyance, is a superior planning technique to protect the donee spouse from the donor spouse’s creditors. Even in a community property situation, a legitimate gift will offer a good deal of protection from the donor spouse’s creditors.

10. Qualified Retirement Plans: generally, IRAs are considered part of a bankrupt estate and can be reached by creditors. But the U.S. Supreme Court has held that qualified pension plans, as opposed to IRA’s, are exempt from under federal bankruptcy law from creditor’s claims, because of federal preemption.

Q. I have heard that wills are considered inferior to a new transfer instrument being used by many professionals now in asset protection and estate planning - the revocable living trust. Should I consider such a trust to protect my assets?

A. While revocable living trusts are fast replacing wills as the instrument of choice for testamentary transfers they have a limited usefulness in asset protection planning. The major reason why a revocable living trust is generally not employed as the principal strategy in asset protection planning is the so-called “self-settled” trust rule, which states that: “If the settlor is a beneficiary of trust he or she created... and the settlor’s interest is subject to a provision restraining... transfer...., the restraint is invalid against the settlor’s transferees or creditors...” California Probate Code Sec. 15304(a). A revocable living trust is a trust you establish during your lifetime while reserving the right to amend it or terminate it at will. You can serve as your own trustee and also be the primary beneficiary of the trust. Upon your death, the successor trustee whom you have designated can step in to distribute the remaining assets of the trust to the beneficiaries of your choice.

A revocable living trust can offer many advantages over a will as a means of disposing of your assets at death. Because assets that have been titled in the name of the living trust bypass probate (and the related substantial costs, probate period of 1-2 years, and loss of control and privacy), they also avoid the delays that may be involved in the probate process, and are usually less subject to ‘contest’ than wills are. An additional benefit is that the provisions of the trust are private and known only to the beneficiaries and trustees, whereas a will is a matter of public record when filed.

Other features of a revocable living trust:

1. Tax neutral - it does not cause any taxes to be paid and it does not alleviate any tax burden for its creator. The IRS has ruled that a separate taxpayer ID number for the trust is not needed while its creator is alive and the trust need not file separate income tax returns. All of the income of the trust is picked up by its creator on his or her own income tax return and his or her social security number appears on all trust investments (compare this with an irrevocable trust, where a separate taxpayer ID number is required and separate tax returns are filed).

2. Avoids the necessity for a conservator being appointed in the event of incapacity - in the trust document you name someone to take over the adminstration of the assets of the trust in the event that you are unable to manage them yourself.

3. Maximum flexibility - you can change the trust at any time, even discontinue it. Your property stays under total control of your trust, even if you are incapacitated.

4. Transfer involves passing title from your individual name to your trust. Title should be changed on all real estate and other property with formal titles (e.g. checking and savings accounts, stocks, CDs, insurance, mutual funds, etc.). The form of revocable living trust most often recommended for married couples with children is the Qualified Terminal Interest Trust (QTIP). This trust is also known as a ‘by-pass’ or “A-B” trust. Both spouses stipulate that when one dies, a predetermined part of the deceased’s assets will be held in trust for specified beneficiaries, managed by the survivor and a co-trustee. The survivor gets the income from the trust and may even dip into its principal (with the co-trustee’s approval) to keep up his or her standard of living. But he or she may not change the beneficiaries, who receive the full assets of the trust, usually free of federal estate taxes, after the second spouse dies. This trust allows passage of up to $1.2 million in assets tax free to your beneficiaries. The trust starts out as a revocable trust, then splits into two parts, Part A and Part B, on the first spouse’s death. The deceased spouse’s part, Part B, spins off up to $600,000 of the couple’s combined assets and becomes irrevocable. Eventually, the assets in the B trust go to heirs, other than the surviving spouse. But while the survivor is alive, he or she collects the interest and investment income on the assets. When the second spouse dies, both the assets in the B trust and those in the A trust go to the designated heirs.

David M. Griffith is a real estate and business attorney with offices in Long Beach. He serves as legal counsel to California Centers Magazine. For more information please contact 310/983-8017.