Unfortunately, this is a litigious society. There are steps that you can take to protect assets from being subject to a judgment from a lawsuit. The following is not an exhaustive discussion of the techniques that can be used for asset protection, and the techniques used will depend upon your own specific situation.
Two Very Important Caveats: 1. Taking asset protection steps after there is a threat of a lawsuit can be viewed by a court as a fraudulent conveyance, and asset protection measures at that point will not be effective. For instance, if you create a limited liability company after the threat of a suit, the court may allow the “corporate veil” to be pierced and the assets in the limited liability company to be seized to satisfy a judgment. 2. If you establish a legal entity such as a family limited partnership or limited liability company, you must observe business formalities such as conducting meetings and not buying your groceries out of the business bank account. You also should not have assets of a purely personal nature in the entity, such as a motor home that you never lease to anyone. If you do not observe the business formalities, a court can rule that the business is your “alter ego” and the corporate veil can be pierced to seize the assets in that entity to satisfy a judgment.
Retirement Plans: Maximize contributions to your retirement plans and IRAs. Retirement plans and your own IRAs are 100% protected from judgments in Texas. However, an inherited IRA is not protected from lawsuits.
Homestead: Your homestead is protected from judgments in Texas. Some clients opt to have a large investment in their homestead as an asset protection vehicle. An urban homestead can have up to 10 acres. A rural homestead can have up to 200 acres.
Umbrella Insurance Policy: While, strictly speaking, an umbrella insurance policy is not an asset protection device, I recommend to clients that they have an umbrella insurance policy. An umbrella insurance policy is a policy that provides funds to pay a judgment if the amount of the judgment exceeds the amount of another policy, such as your auto or home insurance. This insurance is cheap – you can obtain a million dollar policy for a few hundred dollars a year. The insurance company commonly requires that both your automobile and homeowners insurance be placed with that company. If the amount of the judgment exceeds the policy limits, you are liable for the excess.
Life Insurance: If you have a large estate, I recommend having your life insurance in an irrevocable life insurance trust to reduce or eliminate estate taxes. If you own the life insurance in your own name, I recommend having the first beneficiary designation on the policy be an individual, rather than your estate or a revocable trust. The contingent beneficiary can be your estate or revocable trust for estate tax purposes. If you are killed in an automobile accident that is your fault, a party obtaining a judgment cannot get your life insurance proceeds if the proceeds are payable to an individual, while the injured party can get to the life insurance proceeds if those proceeds are payable to your estate or revocable trust. If the life insurance is owned in your own name and there is no possibility of a lawsuit, your spouse can sign a qualified disclaimer within nine months of your death if the spouse is the beneficiary and the insurance proceeds are needed to fund the bypass trust for estate tax reduction purposes.
Annuities: Annuities are 100% protected from judgments in Texas.
Family Limited Partnership (FLP): For assets that are not exempt under Texas law, such as cash, stocks, and bonds held personally by you, create a family limited partnership to hold these assets. If a creditor wins a lawsuit against you and obtains a judgment, the creditor may take possession of certain assets of the debtor. FLPs provide asset protection from potential creditors of a partner because a partner’s creditor cannot seize the partnership interest and thereby become a partner. Instead, the remaining partners continue to control the partnership and the creditor typically receives only a “charging order” against the debtor-partner’s interest. A charging order gives a creditor the rights of a mere “assignee” of the partnership interest to the extent of the debt. In this position, the creditor receives only the partner’s share of income (as determined by the general partners) plus the right to inspect the books of the partnership. The creditor gets no voting rights, control, or any other power in the partnership. The creditor cannot sell partnership assets, liquidate the partnership to satisfy the debt, or force a distribution of profits. Although the creditor cannot require a distribution of profits, the creditor is required to pay income tax on its pro rata share of any income received by the partnership. This feature of partnership law makes an interest in a FLP an “ugly” asset to creditors. Consequently, most creditors would rather negotiate a settlement favorable to the debtor than become an assignee of the partnership interest. One key point is to not place “lawsuit magnet” assets such as rental properties into a FLP along with your stocks and bonds. If a lawsuit should arise from the rental property, the creditor can sue the limited partnership itself and obtain the assets owned by the partnership.
Limited Liability Companies (LLC) – “Lawsuit magnets,” such as rental properties, should be in a limited liability company, not in a subchapter S corporation. Under Texas law, the members and management of a LLC are not personally liable for the activities of the LLC. The managers of a subchapter S corporation are personally liable for the activities of the corporation. Additionally, the membership interests in a LLC are subject to the same “charging order” laws as a family limited partnership, and the membership interest cannot be seized by creditors. The corporate shares of an S corporation can be seized by creditors.
Offshore Trusts: I do not recommend the use of offshore trusts. These trusts can be expensive to create and maintain. There is enhanced IRS scrutiny if you have an offshore trust, and even if you have paid every penny that you ever have owed to the IRS, undergoing an audit is never any fun. Offshore trusts also do not work in many cases, as there is an increasing trend among judges to find you in contempt of court and give you jail time until the trust protector in the offshore jurisdiction releases the assets. There are plenty of onshore techniques such as limited liability companies and family limited partnerships which can be used to shield your assets from judgments.
Trusts for Children: Think of this as asset protection for the next generation. You may want to consider having the inheritance that you are leaving your children held in trust when you die. If the child should ever be sued or get a divorce, having the inheritance held in trust will go a long way in protecting that inheritance.
Estate Tax Implications: Some of these techniques, such as having a large homestead and IRAs, have to be weighed against any estate tax implications that arise from the use of that technique.
By Bill Wollard
Also see Business Planning Lawyer Dallas for more information about planning your organization in Texas.