By David B. Mandell, JD, MBA and Jason M. O’Dell, MS, CWM
Over the last decade, too many attorneys have sought cookie-cutter asset protection plans to give them some peace of mind that if they ever endure a malpractice case, they won’t lose everything. While we admire their commitment to pro-actively managing risk, we must remind them that all asset protection plans are not created equal. In fact, many will not even work if they ever are relied on.
Why is this? Essentially, it is because of a basic tenet of asset protection: that any asset protection plan that will truly stand up if challenged must have economic substance. Taken a step further, superior asset protection planning involves tools that are primarily used by people for non-asset protection purposes. In this way, the best asset protection plan involves tools typically not thought of as asset protection tools. In other words, the best asset protection is not asset protection.
While few clients realize this crucial fact of asset protection planning, all of the leading attorneys in the field know it quite well. In fact, we are not alone – as tax attorneys and CPAs know this adage is equally true when it comes to tax planning.
Simply put, when determining whether or not a particular transaction with significant tax benefits was an illegitimate tax shelter or not, the IRS or tax court typically uses a simple test – Would a taxpayer have done this deal if not for the tax benefit? In other words, they are asking whether or not this transaction was simply done to save taxes or did it have another economic purpose? If there was such a purpose, the transaction stands; if it was only tax-motivated, it fails.
This same test applies when evaluating whether or not a creditor protection tactic will be upheld if challenged down the road. Here, the question is did this transaction have an economic purpose, or was it simply done for asset protection purposes? If you are using tools that millions of Americans use daily for non-asset protection purposes, you can convincingly answer yes.
In the many books either of us have written, we use a sliding scale approach to evaluate asset protection techniques – with the lowest (-5) being an asset that is completely vulnerable and the highest (+5) being an asset that cannot be taken by a creditor even in bankruptcy. This is important to understand here because every (+5) asset protection technique, whether at a personal balance sheet or law practice, has significant economic benefits to the client, irrespective of asset protection.
Which asset protection tools are not asset protection tools? Let’s examine a few of them briefly:
A. Qualified Retirement Plans: The term qualified retirement plan means that the retirement plan complies with certain Department of Labor and Internal Revenue Service rules. You might know such plans by their specific type, including pension plans, profit sharing plans, money purchase plans, 401(k)s, or 403(b)s. Properly structured plans offer a variety of real economic benefits: you can fully deduct contributions to these plans and funds within them grow tax-deferred. In fact, this is likely why most law practices sponsor such a plan.
What you may not know is that under federal bankruptcy law, and nearly every state law, these plans are protected against lawsuits and creditor claims – enjoying (+5) protection status. IRAs are also (+5) protected in bankruptcy, with some limits, although their state protection depends on the state. For both, the overwhelming majority of millions of Americans who use qualified plans and IRAs are not using them for asset protection purposes. This, then, is a great example of attractive economic tools that just so happen to have tremendous asset protection benefits as well.
B. Non-Qualified Plans/Fringe Benefit Plans: Benefit plans that are not qualified are relatively unknown to many attorneys, despite the fact that they are right in the tax code and can be categorized as non-qualified plans or fringe benefit plans. These types of plans should be very attractive to lawyers in private practice, as they can be terrific hedges against future tax increases and they can be used in addition to qualified plans. Once again, non-qualified/fringe benefit plans are generally not used for asset protection purposes, but they may have such benefits – depending on how they are structured.
C. Captive Insurance Companies (CICs): CICs are used by many of the Fortune 1000 companies, for a host of strategic reasons. In a law practice setting, the owners actually create their own properly-licensed insurance company – to insure various types of risks of the practice. These can be economic risk (that revenues drop), business risks (that electronic records are destroyed), litigation risks and even malpractice (keeping some risk in the captive and reinsuring the rest). If it is created and maintained properly, the CIC is like any insurance company -- established in a real economic arrangement with its insureds. Also, CICs can enjoy tremendous creditor protection (+4/+5) if the ownership is structured properly.
D. Cash Value Life Insurance (CVLI): CVLI policies are purchased by millions of Americans each year for their tax benefits (generally, tax-free growth, can be accessed tax-free and pays income tax free to heirs), for family protection and for estate planning purposes. Nonetheless, in many states, the cash value can enjoy the top (+5) protections. In this way, an attorney can purchase a product that is widely recognized as a part of a financial plan and enjoy (+5) protections easily.
Many clients who have implemented generic asset protection plans may be disappointed if they are ever attacked – as they may be ignored by courts that see no economic substance. On the other hand, those who implement techniques such as those described above may be pleased – not only will their protection be upheld, but they may build significant wealth along the way. The authors welcome your questions.
David B. Mandell, JD, MBA, is a former practicing attorney and author of 10 books on legal, tax and financial issues, including Wealth Secrets of the Affluent, published by John Wiley & Sons, Inc., the largest business book publisher in the world. He is a principal of the financial consulting firm OJM Group (www.ojmgroup.com ) where Jason M. O’Dell is also a principal. They can be reached at 877-656-4362 and Mandell@ojmgroup.com.
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