March 16, 2011

Asset Protection Trust

There is nothing illegal, wrongful or unethical about protecting your assets from potential creditors. 

Asset protection is commonly practiced by millions of Americans, including myself in multiple situations. 

The key feature of asset protection is the method used to achieve it. Some methods work in California, while others do not.

For example, a savvy real estate investor will purchase property through a limited liability entity, such as a LLC or a corporation. Thereby the real estate investor's liability, subject to a few exceptions, is limited to the company's assets regardless of whether a judgment, fine or levy against the company exceeds the value of the company's assets. 

Assume that Willis purchased a home in San Francisco’s Sunset District for $400,000 through his company, Winning, LLC. Willis then leased the home to Lionel for 1 year. Sadly, Lionel slipped and fell on a banana peel that Willis had negligently left on the property. Lionel broke his hip, thereby ruining his promising soccer career and successfully sued Willis for $500,000. At this point, if Willis had owned the home personally, Lionel could enforce the judgment against all of Willis’ assets until he collected his $500,000 judgment. However, Willis had prudently decided to own the rental home through a LLC, thereby limiting his liability to the company’s assets. Consequently, Lionel’s recovery would be limited to whatever the company owned, namely $400,000. Even though the LLC did not have the assets to satisfy Lionel’s judgment, California law says that Willis is not personally for the debts of his LLC, specifically $100,000. Corp C § 1710. Thus, Willis would be able to walk away from his lawsuit financially battered and bruised but not ruined.

Now contrast the above example with the case of a person who creates a revocable trust and funds the trust with a rental property and is also the beneficiary of this trust. 

The aforementioned would be an example of a “self-settled” trust. The reason being is that there is a overlapping of positions whereby the settlor, the person who writes the trust, is also the beneficiary. California law is very specific in saying that creditors can reach the assets of a self-settled trust. Prob C § 15304. From the above example, if Willis owned the rental property through his revocable trust, then Willis would have unlimited personally liability for the liabilities arising from the operations of the rental property. Thereby Lionel could enforce his $500,000 judgment against any of Willis’s assets. For instance, if Willis owned another home, Lionel could attach a judgment lien to the home, if Willis had a bank account, Lionel could execute a bank levy on that account, if Willis had a job, Lionel could perform a wage garnishment on Willis’ paycheck.

One of my law books wisely says “if a deal is too good to be true, it is probably not true.” So the next time you hear somebody or some advertisement talk about asset protection, pay attention to how they intend to achieve it. Often times, there is some elaborate procedure discussed involving an exotic location such as the Cayman Islands or the Bahamas, which is usually hype, or worse fraud. There is a correct method to achieve asset protection; the right steps have to be followed however.