Recently, I was engaged in the topic of Asset Protection. A CPA standing nearby scoffed at the topic and said, “Just buy an umbrella.” It occurred to me that even a well-respected professional did not realize that an Asset Protection Plan is more than just insurance; it requires diversification and planning to offset risk.
What is Asset Protection? Asset Protection is a strategy used to protect your assets from creditors because of existing law, insurance coverage, and/or ownership (legal title) of those assets.
Good Asset Protection: Step One
The first step in Asset Protection is generally accomplished through already existing laws. If you drive an automobile, there is a law requiring you to have certain minimum insurance coverage (primary coverage). The money invested in your 401(k) and/or IRA are protected from your creditors by the Federal Employee Retirement Income Security Act. If you are married, the deed to your marital home is likely titled as “tenants by the entireties” so that the home is protected from the individual liability of the innocent spouse. You have homeowner’s insurance on your house (primary coverage), which provides individual liability protection. Thus, if you are sued personally, the primary insurance policy would theoretically cover the exposure, and even if it did not, the creditor could not take the money out of your 401K or take your marital home. But what if the primary insurance denies coverage or a judgment received is in excess of your policy limits? You need to diversify to offset the risk.
Better Asset Protection: Step Two
The second step in an Asset Protection strategy is to purchase an Umbrella Liability Insurance policy. An umbrella policy provides excess coverage once your primary layer is exhausted. Simply put, if you are found liable for a judgment above your primary layer of insurance, the umbrella policy would pay. The mistake most people make is not diversifying beyond purchasing an umbrella policy.As one of my partners often reminds me, “you cannot crystal ball everything!” The reality is that you will not know with certainty whether you are covered by your primary insurance or your umbrella insurance until after a lawsuit occurs. And even if coverage is not denied, you will not know if your insurance limits are adequate until after the judgment is handed down. This is not a flaw in the insurance coverage; it is a practical reality where no one can foresee the future. It is advisable to diversify your Asset Protection plan because relying solely on insurance may not provide adequate protection.
Consider a few examples that would cause personal exposure should you fail to diversify beyond steps one and two:
- A father lets his son take the spare family car to college, but neglects to notify his insurance company. While at college, the son is involved in a car accident. After being sued, they learn that the primary insurer is denying coverage. The father’s umbrella policy would not cover the son.
- What if the father was driving and forgot to pay the premium on the $100K primary auto insurance policy? Now he has no coverage. The first $100,000 of primary coverage is now his responsibility before the umbrella policy would pay.
- What is the exposure of an accident even if coverage exists? It depends on who is injured. Take an accident involving the death of a 35-year-old father of two children who earns $40K a year. With a 30-year working life expectancy, the exposure is $1.2M for lost earnings alone and does not address other legal arguments that would likely increase the exposure, including pain and suffering and loss of consortium. Even with primary auto coverage of $100K and an umbrella of $1M, the personal exposure would still be $100K (exposure $1.2M - $100K primary limits - $1M umbrella limits = $100K personal exposure).
Some would say to purchase $2M in umbrella coverage. But consider the exposure if the accident involved a 45-year-old father earning $200K per year. The wage-loss exposure alone is $4M. As my partner says, “you can’t crystal ball everything!” By only taking steps one and two, you do not have control over your assets because you are at the mercy of future events which may exceed your insurance coverage, assuming coverage exists. To be protected, you need to plan smarter to offset the risk.
Step Three: The Best
The third step in Asset Protection is to create a privately-owned holding company. In conjunction with the first two steps, a holding company protects your legally liquid assets should the other steps not protect you to the fullest extent needed. By changing ownership (legal title) of your investment assets to a privately-held holding company, you gain control and protect the assets invested from exposure outside of the holding company.
Your legally liquid assets are those that could be easily taken from you in the event that you were found liable in a lawsuit and had inadequate insurance coverage or, because of the particular facts of your case, no coverage. These legally liquid assets would be the money in your brokerage account, savings account, and the cash once paid from your 401K, IRA, pension, annuity, or life insurance policy.
A holding company’s business purpose is to make profit on the assets invested in the company. You invest your legally liquid assets in your holding company, thereby changing the legal ownership to the holding company, which is controlled by the members of that holding company. The members can then control the distribution of money from the holding company, unlike an insurance company where you have no control over the payments. The members of the holding company should be you and at least one other person, such as your spouse, adult child, or even a friend. The legal effect of forming a holding company with multiple members is that the innocent members help provide protection of the assets and control over distributions from the holding company from a hostile creditor.
The practical effect is similar to owning rental property. Let’s say that your brother rents a house from you. In a separate matter, he is sued and found liable. Your brother’s creditors cannot legally force you—the property owner—to sell the property to pay for your brother’s debt because he does not have control—the legal right—to sell the property. If you choose to sell the property to help your bother, you have control to make that decision. But, you cannot be forced to sell simply because of your brother’s hostile creditor. This example is essentially the same as a holding company.
The geographic location of the holding company is a key factor. Certain states in the U.S. provide favorable venues in which to form a holding company, even if you don’t live in that state. You could also consider offshore countries. The basic strategy is simple—the holding company owns the money, the holding company is controlled by the members, and a hostile creditor of any member cannot easily access the money. Best yet, the fees associated with forming a holding company are currently tax deductible!
What It Means to You
Asset Protection is similar to investing: diversifying and smart planning are key to protecting your money. Following all three steps—forming a holding company in conjunction with having adequate insurance coverage and availing to the existing laws—is a wise strategy that will provide the most effective Asset Protection Plan. For a free consultation, call Cipriani & Werner’s Dennis Cullen, Esq., at 1-888-488-2638.