Although the idea of asset protection, i.e. protecting assets from creditors of a person who owns them, may seem simple at first glance, it's not. In reality, implicit in asset protection is a rather nuanced process of dealing with the interplay between federal and state law.
Let me explain...
Often, the laws that protect assets from creditors are passed by the states and vary from state to state. In particular, the following are made possible by state law, as opposed to federal law:
- Limited liability entities, such as limited partnerships and limited liability companies
- Irrevocable trusts
- Homestead exemptions
Although the protections associated with the preceding concepts vary substantially from state to state, in general, the creditors of a person who has a beneficial interest in a limited liability entity or an irrevocable trust may be prohibited from satisfying their claims against that person from the assets owned by such entities.
For example, John transfers ownership of a $1 million vacation house into the name of an irrevocable trust. He only retains very specific rights in the trust, which include the right to use the vacation house as he pleases.
5 years after the transfer, a disgruntled business partner sues John for something John did 4 years after the transfer. The business partner is awarded $10 million of damages by the court.
Because John doesn't own the vacation house, the irrevocable trust owns the vacation house, his business partner is likely precluded from forcing a sale of the house in order to satisfy the $2 million judgment against John.
John only has a net worth of $1 million because the irrevocable trust owns the vacation house. As a result, his business partner won't be able to satisfy the $2 million claim from the trust assets, i.e. the house, meaning that at least $1 million will go unpaid.
In the example above, the protections that John has from the claims on his creditor are enabled by state law.
In addition, some federal laws also protect assets from creditors, such the Employee Retirement Income Security Act ("ERISA") that governs many types of retirement accounts, but that is another discussion for another day.
Although the concept of bankruptcy is often portrayed as a way for people to get a fresh start, it may be more beneficial to creditors as opposed to consumers, often times.
In particular, Section 548 of the Federal Bankruptcy Code gives a bankruptcy trustee the power to avoid, i.e. nullify, transfers that were made for less than fair market value when the transferor was insolvent, i.e. has a negative net worth, with "actual intent to hinder, delay, or defraud any entity to which the debtor" is indebted within two (2) years before the date of the filing of the petition.
In addition to federal bankruptcy laws, however, state bankruptcy laws can often be used to avoid transfers, as well.
The Supremacy Clause
There are state laws that protect assets and there are federal laws that empower creditors, but which wins if these laws are at odds against each other?
To make a long story short, federal law wins — and thus creditors often win — because valid federal law is supreme to, and preempts, state law.
Going back to the previous example of John, if he had transferred the vacation house to the irrevocable trust after the $2 million judgment had been awarded, the creditor could have compelled John's case to Federal Bankruptcy Court because John was insolvent at the time of the transfer and the creditor could have petitioned the bankruptcy trustee to avoid the transfer to trust, thereby removing the home from the trust as if the transfer never happened, which could then lead to the forced sale of the vacation house in order to satisfy the $2 million claim against John.
This brief overview of some important considerations associated with asset protection is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.
Steve Cook is an asset protection lawyer at Cook & Cook. Although his main office is located in Mesa, Arizona, he represents clients throughout the Phoenix, Arizona Metropolitan area including the following east valley cities: Scottsdale, Paradise Valley, Tempe, Chandler, & Gilbert.