The Best Defense is a Good Offense

When it comes to their finances, many people probably cite an IRS audit as the biggest threat. Although an audit certainly can pose a significant problem, it could pale in comparison to a frivolous lawsuit or forced bankruptcy filing.

For this reason, asset protection — the process of arranging affairs to shield assets from potential creditors, litigation and other legal hazards — has steadily risen to prominence during the past decade. More people are realizing that, to protect their assets, the best defense is a good offense.

Ownership strategies

Naturally, how you own an asset has a big effect on how well you’re able to protect it. One common strategy, because it is easy to accomplish, is tenancy by the entirety.

This type of ownership is a form of joint tenancy with right of survivorship that can apply to personal residences. Available in most states, it’s perhaps the simplest and least intrusive form of asset protection and allows you to protect your home for as long as you and your spouse continue to use it. Unfortunately, persistent creditors can eventually succeed to ownership of the property when you sell or upon your or your spouse’s death, regardless of who dies first.

As an alternate approach, if one spouse is more likely to be the object of a lawsuit than the other, shifting assets to the “safer” partner can protect them. Understand, though, that shifting too much property to one spouse could interfere with the estate planning goal of balancing assets to take advantage of each person’s estate tax exemption. Then again, holding a home in tenancy by the entirety may not help achieve your estate planning goals either.

Family limited partnerships

Another technique for protecting assets is to transfer them to a family limited partnership (FLP) in exchange for limited partnership interests for you and your family. You also can use a properly structured FLP to reduce gift and estate taxes on transferred assets.

In general, a limited partner’s creditors cannot reach the FLP’s assets — they can only obtain rights to receive any distributions made from the FLP to the limited partner. By retaining a small general partnership interest (1%, for example), you can retain control over the property while providing some level of protection from potential creditors.

Creditor issues aside, the IRS has made headlines in recent years by challenging valuation discounts on FLP interests. A properly structured and operated FLP, however, likely will survive most challenges, perhaps after some compromise on the amount of discount taken for gift tax purposes.

Trusts

Gifts made to a trust — whether by you for your beneficiaries or for you by another grantor — are protected from potential creditors. With an irrevocable life insurance trust (ILIT), for instance, you buy life insurance in, or transfer it to, an irrevocable trust. The policy’s value is protected because you’re no longer considered the legal owner. At the same time, the trust also protects it — until funds are distributed — from the creditors of your beneficiaries.

There are other trusts to consider, too. In recent years, several states have followed Alaska’s lead and passed laws to provide protection to “self-settled” trusts. These trusts are available to residents of any state, but the costs of setting up and maintaining them are typically higher than with normal living trusts and should be weighed against their asset protection benefits.

Offshore trusts might be another option. These trusts have gained some attention as asset protection tools, and they can offer significant protection. But offshore trusts come with their own set of costs and risks — namely, they not only must comply with the laws in the country in which they’re established, but also must be structured in accordance with U.S. tax laws and regulations.

The right mix

These are just a few strategies to help ensure your assets stay with you or go to where you want them to. Bear in mind, though, that it’s unlikely any one asset protection measure will suit all of your needs. Find the right mix and you’ll stand a better chance against any challenge.

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