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Much of estate planning focuses on transferring your wealth to loved ones in a tax-efficient manner. But for many people, it’s equally important to protect that wealth against frivolous lawsuits or baseless creditors’ claims. If your business, professional or personal activities expose your assets to attack by unscrupulous litigants or creditors, consider incorporating asset protection strategies into your estate plan.

From the simple to the complex

When it comes to asset protection, there’s a wide variety of techniques to consider. Here are several, from the simple to the complex:

Buy insurance. Insurance is an important line of defense against potential claims that can threaten your assets. Depending on your circumstances, it may include personal or homeowner’s liability insurance, umbrella policies, errors and omissions insurance, or professional liability/malpractice insurance.

Give it away. If you’re willing to part with ownership, a simple yet highly effective way to protect assets is to give them to your spouse, children or other family members, either outright or through an irrevocable trust. After all, litigants or creditors can’t go after assets you don’t own (provided the gift does not run afoul of fraudulent conveyance laws). Choose the recipients carefully, however, to be sure you don’t expose the assets to their creditors’ claims.

Retitle assets. Another simple but effective technique is to retitle property. For example, the law in many states allows married couples to hold a residence or certain other property as “tenants by the entirety,” which protects the property against either spouse’s individual creditors. It doesn’t, however, provide any protection from a couple’s joint creditors.

Contribute to a retirement plan. You may be surprised to learn that maxing out your contributions to 401(k) plans and other qualified retirement plans doesn’t just set aside wealth for retirement, it also protects those assets from most creditors’ claims. IRAs also offer limited protection: In the event of bankruptcy, they’re protected against creditors’ claims up to a specified amount (currently, over $1.3 million). Outside bankruptcy, the level of creditor protection depends on state law, which varies from state to state.

Set up an LLC or FLP. Transferring assets to a limited liability company (LLC) or family limited partnership (FLP) can be a highly effective way to share wealth with your family while retaining control. These entities are particularly valuable for holding business interests, although they can also be used for real estate and other assets. To take advantage of this strategy, you simply set up an LLC or FLP, transfer assets to the entity and then transfer membership or limited partnership interests to yourself and other family members. Not only does this facilitate the transfer of wealth, but it also provides significant asset protection to the members or limited partners, whose personal creditors generally cannot reach the entity’s assets. These entities also offer an added level of asset protection: The personal assets of members and limited partners that are held outside the LLC or FLP are shielded against claims by the entity’s creditors.

Establish a DAPT. A domestic asset protection trust (DAPT) can be an attractive vehicle because, although it’s irrevocable, it provides you with creditor protection even if you’re a discretionary beneficiary. DAPTs are permitted in around one-third of the states, but you don’t necessarily have to live in one of those states to take advantage of a DAPT. However, you’ll probably have to locate some or all of the trust assets in a DAPT state and retain a bank or trust company in that state to administer the trust. The amount of protection provided by a DAPT varies from state to state. Also, the enforceability of a DAPT whose grantor resides in another state hasn’t yet been fully tested in the courts. So careful planning is critical.

Establish an offshore trust. For greater certainty, consider an offshore trust. These trusts are similar to DAPTs, but they’re established in foreign countries with favorable asset protection laws. For example, these countries typically don’t recognize judgments or orders by U.S. courts and otherwise make it difficult for foreign creditors to collect their debts there. Although offshore trusts are irrevocable, some countries allow a trust to become revocable after a specified time, enabling you to retrieve the assets when the risk of loss has abated.

Beware of Foreign Reporting Requirements

If you decide to use an offshore trust, it’s critical to comply with applicable reporting requirements. For example, a U.S. owner of a foreign trust must ensure that the trustee files annual information returns on Form 3520-A, subject to a failure-to-file penalty equal to 5% of the value of the trust assets or $10,000, whichever is greater. In addition, U.S. beneficiaries of foreign trusts must file Form 3520 to report transactions with the trust, including any distributions they receive. The penalty for failure to file is 35% of the reportable amount or $10,000, whichever is greater.

These penalties can be devastating. In one case, the sole owner and beneficiary of a foreign trust liquidated the trust and took a distribution of more than $9 million. He failed to file Form 3520 or 3520-A, resulting in a penalty of more than $3 million.

A word of warning

Keep in mind that asset protection isn’t intended to help you avoid your financial responsibilities or evade legitimate creditors. Federal and state fraudulent conveyance laws prohibit you from transferring assets (to a trust or another person, for example) with the intent to hinder, delay or defraud existing or foreseeable future creditors. And certain types of financial obligations — such as taxes, alimony or child support — may be difficult or impossible to avoid.

Start planning now

To be effective, asset protection strategies should be implemented as early as possible. Their protection extends only to unanticipated future claims. Once a claim exists or is reasonably foreseeable, it may be too late.

© 2022

Disclaimer: The THK Legal Blog is for informational purposes only and should not be relied upon as legal advice. In no case does the published material constitute an exhaustive legal study, and applicability to a particular situation depends upon an investigation of specific facts. You should consult an attorney for advice regarding your individual situation. All THK blogs are considered advertising material by the Indiana Bar Association.