Charging Order Protection is a concept that’s used by every Tom, Dick and Harry marketing asset protection to attempt to lure you into purchasing products that oftentimes are ineffective and inappropriate. It’s also something I rely upon and use everyday in my business and I’m just going to touch on it briefly right now. We’ll have in depth training on this topic later, but for now we’re just getting ready for the cocktail parties.
What is Charging Order Protection
Well, what we know is that charging order protection is on everybody’s marketing brochures saying form an LLC or form a partnership and this will give you complete and total iron clad asset protection. Well, that’s bull.
Charging order protection is a remedy thats provided in the uniform limited partnership act, all the partnership acts, all the LLC, acts by statute. It’s a set of rules that limit a creditor’s ability to disrupt the partnership or the LLC and I’m going to go to a book I wrote Asset Protection Trusts (coming soon to full members). This is my first protection book.
It’s more than 20 years old and I sold it to Matthew Bender, The Times Mirror Corporation. They paid me some good money for it but it was really my dissertation for my Doctor of Juridical Science at New York University Law School. And, by the way, anybody who takes the major course on the actual, excuse me, actual document preparation will get a copy of this(if you’re a member, soon).
Now, I want to go to page 53. There we go, Charging Orders – Family Limited Partnership. This is interesting material and what I wanted to do is read to you the provision in the law that changes the remedy. This is a good way to start making attractive assets less attractive to a creditor. Now, here is what the rule says:
On application to a court by a judgment creditor, the court may charge the partnership interest of the partner with payment of the judgment.
The judgment creditor has only the rights of an assignee of the partnership interest. Well, what does all that legalese really mean?
What it means is that a general partner, let’s just stick to partnerships, a general partner runs the partnership. It doesn’t have to own very much of it. It can own none of it in some States. The general partner is in charge of when the money is distributed by the partnership and the thought was that if you made the debtor, the general partner and the limited partner was the debtor’s trust or just plain the debtor again or one of his other businesses or entities, that the debtor would be in a position to decide when distributions were made. And therefore the debtor could tell any creditor that there would be no distributions, basically delay distributions and a charging order says that the creditor can only get what is actually distributed by the general partner.
So, everybody was all excited that this is putting the debtors back in control of their assets and they could hide behind this statutorily created screen. Tens of thousands of people use this for bad purposes.
Every doctor who is leaving his wife in favor of his scrub nurse would put his life savings into a family limited partnership and blithely go on thinking that his soon to be ex-wife couldn’t touch it and the courts got sick of the abuse. The courts started fabricating judicial remedies or judicial exceptions to the charging order rules and this all started with Security Pacific Bank, a case back in the 70s where the court said a creditor could actually take over the partnership interest and then force the dissolution of the partnership and that’s become the way around this.
And what’s happened is there’s a lot of law on this and I’m not going to go into it now. I’m going to go into it in great detail later but the bottom line is this is a fragile limitation on a creditor’s remedies. You should not rely upon it. It does not have the strength that I would put my life savings into any entity and rely upon this.
Judges have fabricated exceptions and if they want to make one in your case, you can count on it they will. There are some recent cases that point to situations where two or more unrelated people were in a real business together and charging order protection was deemed to hold up. This is a type of case that it’s supposed to be applied to. This is what charging order was for.
If you and I form a doughnut shop, I’m the general partner and you’re the limited partner and you put up the money and I do the work and we split profits 50-50 and then my wife divorces me, this remedy was designed to prevent my wife from being able to walk in and decimate our business by forcing all the assets to be distributed. But you know what, don’t rely upon it. Don’t count on it.
Charging order protection is not something that I believe is a safe tool in the long run. With that said, I use partnerships everyday. I use LLCs everyday and I love charging order protection when done correctly. I’ll teach you more how in the video lessons soon to come.
I’m taking on a very popular & very common misconception. It deals with corporations and the strength of protection they give. Now, we’ve all heard that corporations offer excellent protection, that they have a corporate veil.
What is a corporate veil?
This corporate veil protects the shareholders from creditors of the corporation provided all the formalities had been met, provided the corporation is adequately capitalized and adequately insured, provided regular meetings are held, provided that all of the statutorily required rules to keep a corporation up and running have been complied with. We’ve paid our fees.
Let’s just pretend we’re perfect and you and I have the same old doughnut shop I keep using. I’m the cook and you’re the investor and we’re splitting at 50-50 and it’s a corporation so we each own 100 shares exactly 50-50. And let’s just assume I’m frying some doughnuts up some morning at 4:00 o’clock and my grease gets on fire and it explodes and it badly disfigures three local cheerleaders from a high school where buying they’re buying doughnuts for their, you know, for their cheerleading society.
Well, believe me these badly injured girls are all going to have great hungry contingent fee litigators jumping at the chance to tear us apart. They’re certainly going to sue the corporation no doubt. Well, who else are they going to sue?
Well, let me tell you. They’re going to sue me and they’re going to sue you and if you’re married, they’re going to sue your spouse. So, that’s just the way it always works. This corporate veil is an illusion with most small companies.
Yes with IBM. If I’m an IBM shareholder and IBM gets sued for some anti-trust violation or gets sued because they made a product that was defective or injured somebody, believe me that’s not going to stop at the corporate level.
They might go to the individual who ran the program that caused the problem. They might even sue some members of the board who or the president alleging that he or she knew or should have known but that’s really tough and it isn’t going to get to the shareholders.
But listen with our little doughnut shop, with our local car dealership, with our local hardware store, they’re going to get right to the people who manage and the people who own the company and they’re going to allege that we either had the power and we should have known that we did have the power and we should have known about the dangerous nature of our fried machine. That’s just the bottomline.
They’re going to nail our spouses that will ruin our sex lives, that they’ll make it so there’s a lot of strain in the marriage. They will do everything to encourage settlement. So, how strong is a corporate veil?
The answer is it’s not strong at all. You should never depend upon it to give you any meaningful protection in a small company.
That’s the bottomline truth and with that said, I love corporations. Asset protection corporation is a corporation. It’s a sub S corporation which is the worst type of corporation you have if you care about asset protection because it cannot be owned by a foreign trust.
So, I stay away from sub Ss except asset protection corporation never really has any value independent of me. And if I’m dead, it’s pretty much worthless and I decided to take the step of having it as a corporation because it saved me a few dollars in self-employment taxes.
The bottomline is that you should not assume that a small closely-held corporation will give you any meaningful insulation from creditors of the corporation because they’re always going to go after you personally and your spouse.
It’s just the way it’s done. So, keep insurance, do asset protection for your liquidity and your assets that are protectable but don’t think some little corporation is going to do the trick because it simply doesn’t.
Video Transcript – Nevada Corporations are Scams unless you live in Nevada
Today, I take on one of my favorite scams and one of the legitimate asset protection issues that you’re all going to confront. If you do any looking on the internet for asset protection, you’re going to come across Nevada corporations.
I did a search just a second ago for Nevada corporations and asset protection and look 172,000 results. Everybody and their mother is a Nevada expert. Everybody and their mother who doesn’t have any skill and doesn’t have any training and wants to make some money in the asset protection world consider promoting asset protection via Nevada corporations.
These all got started by Bill Reed and his asset protection group, a total bunch of crooked scammers. What they did is they advertised that they could form an entity for you in Nevada, that Nevada didn’t have any taxes so they got lots of idiots and lots of non-idiots to buy into their rules that you could form an entity in Nevada and eliminate State taxes.
For instance, you could form a doughnut shop in California or New York incorporated in Nevada and eliminate Nevada – eliminate California or New York State taxes.
Why Nevada Corporations are bad
It’s a bunch of bull. It’s not true. It’s tax fraud per se. They also advertised that you would have bearer shares. That’s bull.
Nevada doesn’t allow somebody else to own your shares on your behalf and be treated as the real owner. What they really ask you to do is to trust some basically nearly insolvent scammer to hold a title to the stock in your corporation or your membership interest in LLC or partnerships and basically you trusted them to not steal your money.
The crooks, Bill Reed and his cadre of people, were eventually put away. They spent good time in jail and they’re still out promoting that though. They had great materials. They promoted it to everybody. The bottomline is Nevada is not a good place for you to do asset protection unless and until you actually live in Nevada.
Now, I’m going to show you a few of the important rules and by the way, we will go into this in detail in the more meaty portion. This is just the overview. This is the simple rules. Nevada corporations, like I said they stink as asset protection vehicles.
Stay away from them unless you live and work or are involved with Nevada. Then they’re perfectly fine.
There’s nothing wrong with being there. I do know from several conversations with the Office of the U.S. Attorney in the second district of New York, when they consult with me on things, they did tell me they were looking at Nevada filings a lot more seriously than other places. You know why? Because all the tax or a lot of the tax protestors and the tax cheaters are going there thinking they can save taxes. Well, don’t. Don’t get in the middle of some petty illegal scam. Don’t get earmarked as a crooked person. It’ll just come back and bite you. Stay away from Nevada unless there’s a reason. They’re marketed as tax saving vehicles. They’re not. They create a myriad of gift tax problems, a myriad of income tax problems.
Who’s going to pay the tax, your bearer share expert that’s holding your title? Well, they don’t have money to pay your tax. You’re probably going to pay the tax but you’re going to say that they own it. Give me a break. Just walk away. If something is too good to be true, just stay away.
What’s a better alternative? That’s important. It always makes sense to use entities like LLCs and partnerships although you’re soon going to find that they’re pretty poor asset protection entities in and of themselves and standing alone. I use them all the time and love them.
You’ll learn why but it’s a much better alternative to use an entity in a clean, safe jurisdiction such as Delaware or at the State that you live.
Much better alternative and if you use the State where you live, you can be the agent for service or process. Save yourself 150, 200 bucks a year.
I also like Delaware in certain States because they actually do allow you to form an anonymous LLC, a truly anonymous LLC, not that great for asset protection but it’s a start. Just take this short, short video as a base point to start. When you see those 172,000 ads for Nevada bearer share or asset protection tax savings, just walk away. Write the guys off as scammers unless you live in the State of Nevada.
Video Transcript- Domestic Asset Protection Trusts in 3 min
Today, I’m going to take on a widely promoted, widely advertised product that you should stay away from. Don’t touch it. What is it? Domestic asset protection.
Well, simple, domestic asset protection and domestic asset protection trusts. This is absolutely a ridiculous way to spend your hard earned money thinking you’re getting decent asset protection. It’s only worth two minutes but places like Delaware, Alaska, Nevada and several other States have enacted asset protection rules so that their corporate service providers can promote domestic asset protection trusts.
They’re widely promoted by some big banks. It does not work. It is pure garbage. These people must be on some sort of drug that’s a lot stronger than anything I’ve heard of. They forget about the fact that there’s no secrecy in Delaware. You can always get to the trustee. They forget about the main thing that we have a Constitution in the United States. We have a Constitution with the full faith in credit clause.
What does it say? It says that any judgment in any State is enforceable in another State. Yes, you have to go through a small process. You may have to re-litigate a small number of issues. Usually not, you just usually register it but I mean they’re forgetting all this. This is a sham designed to allow their domestic companies that, you know, pay a lot of – or Delaware don’t pay taxes, but pay a lot of fees, help support the government giving them a way to get more customers.
Well, they’re selling you garbage. Do not do a domestic asset protection trust. It has been never tested and until you see the Supreme Court of the United States saying that the full faith in credit clause of the Constitution is trumped by some little law enacted by a little State like Delaware or Alaska, a big State there, a State law is trumping the U.S. Constitution. You should stay away from them. They are in my mind malpractice per se.
There are some circumstances where I could see doing them but they’re not inexpensive to do. Those circumstances would be where all the assets were in say Delaware. All the defendants and plaintiffs were always going to be going to be in Delaware. There would never be a federal issue ever and in those circumstances I can see how you might say the full faith in credit clause is irrelevant.
But guys it’s just as much work to do a domestic trust as an offshore trust. Why not go to some place where you can make your opponent spend oh $10 to collect 10 cents. Make it so that they don’t understand the culture, the language, the rules. Why make it easy for your creditors. Actually, asset protection is game theory as much as it is reality. Yes, you need to have good technology.
Technology needs to be something you can disclose and you need to never be ashamed of it. It has to make logical, legal, ethical sense but why make it easy. So, bottomline, stay away from domestic asset protection trusts. They do stink. They have for 12 years and they will continue to stink.
Today, I’m going to be talking briefly about offshore single member LLCs. What are they used for? How do you form them? What does an agreement look like? I’m going to keep it simple and straightforward right now.
What are single member LLC’s?
Offshore single member LLCs are normally disregarded entities. You need to be very careful to make sure that if you want it to be a disregarded entity, you take care in your formation steps and there’s a whole video on that. I encourage you to watch it.
Don’t try to do this on your own. Make sure you have a CPA who really knows the rules helping you. But anyway, an offshore single member LLC properly formed, disregarded properly formed to be disregarded for tax purposes is a hugely helpful tool.
Why is it helpful? Because many banks out there don’t want to do business with trust. They also don’t want to do business with U.S. people.
So, if you go to them with a U.S. person settling an offshore asset protection trust, you have a 50-50 chance that they’re going to say fine.
I want your deposit and we will not worry about your offshore trust being a U.S. person. We will treat it as a non-U.S. person and that allows the bank to comfortably take you as a client because they don’t want anything to do with the IRS. They don’t want anything to do with the SEC.
They don’t want anything to do with the Department of Justice in any way but they do want your money. So, they invent these unique little caricatures that an offshore asset protection trust is not a U.S. person. We all know that’s false but it let’s them take your money so what do you care.
But a lot of times banks that are formed in jurisdictions that are based upon German law that would be basically the whole civil law world, a lot of those banks don’t know what a trust is and they’re not comfortable with it. So, they don’t want a trust account.
What they’ll often ask you to do is have your offshore asset protection trust form an offshore entity, usually a disregarded single member LLC. It does not cost you any more taxes and it is acceptable to the bank. Therefore, they don’t have to review a trust agreement.
So, I find it very helpful with banking and – but I want to encourage you, don’t do this on your own. This is something you need a real pro. You do not want to make mistakes.
You do not want to file – fail to file your tax returns disclosing the existence of any offshore accounts et cetera. That is a game you never want to play, you never want to get in the middle of that. You will end up living with Bubba. It’s not worth it.
But you may end up wanting an offshore LLC. And I wanted to show you briefly what they look like. I’m going to close this now.
It’s the same as almost every other single member LLC in the world. What I want you to know though is don’t get hosed if you have to form one. These don’t cost tens of thousands or even $2,000 or $3,000 in most cases.
With this type of agreement and a good company representing you, you should expect no more than $1,000, maybe $1,500, they’ll always ask for more but I don’t think you should ever have to pay more for just the simple formation process of an offshore LLC. And Nevis is a great jurisdiction for this. I don’t usually use them for trust work but I love them for a company formation and they’re not very expensive to do business in.
Here we have a simple agreement. You should flip through it. It’s got all the same provisions of any other onshore or offshore LLC. Nevis is special though because they copied the Delaware statute. So, it’s very familiar to people who are used to doing business in Delaware and it works just fine.
I’m not going to talk about it anymore in this particular video except to say, you know, use it, print it, give it to your advisors.
It’ll help you. What I did want you to note is that the signature provisions require the offshore trust to sign and this one is actually done for a kinetic asset protection trust because it has a U.S. co-trustee. You may or may not want to do that.
You’ll have to watch the videos on kinetic asset protection trust. Usually you will not want to do a kinetic asset protection trust unless you’re represented by somebody who really knows what they’re doing.
Anyway, this is just my introduction letting you have a taste of this, giving you the form and warning you to be careful.
Do not get one, ripped off or two, get sloppy. Make sure you report your accounts and make sure you do all the work so that your accountant looks you in the eyes and says okay my friend, here is your disregarded offshore single member LLC. Go to work. Thank you very much.
Although equity stripping can be an effective (and sometimes the only) means to protect assets, it requires much skill to implement properly. Poorly designed programs are often either vulnerable to fraudulent transfer rulings, or are costly from a tax and/or economic perspective. In addition to exploring the benefits of equity stripping, this chapter seeks to identify potential flaws in certain equity stripping programs, along with creative solutions that sidestep these problems.
Equity stripping is the process of encumbering an asset with one or more liens as a means of protecting the asset from future creditors. As defined by the Uniform Fraudulent Transfers Act (―UFTA‖), a lien is ―a charge against or an interest in property to secure payment of a debt or performance of an obligation, and includes a security interest created by agreement, a judicial lien obtained by legal or equitable process or proceedings, a common-law lien, or a statutory lien.‖1 In layman’s terms, this means a lien attaches to any collateral you give someone in order to ensure you repay a loan or fulfill an obligation. This includes a mortgage, deed of trust, or an agreement that uses personal property as collateral (placing a lien on non-titled property is usually accomplished by way of a security agreement; public notice of the agreement is filed with the appropriate Secretary of State’s office via a UCC-1 form.) It could also be a judgment lien, tax lien, or other non-consensual lien. While you retain title and (usually) possession and enjoyment of the property, a lien technically gives its holder an ownership interest in your property. This means if you default on your debt or obligation, the lien holder may force the sale of your property at a foreclosure auction and use the proceeds to pay off the balance of the debt or obligation.
Obviously, if a creditor obtains a lien on your asset, your assets could be jeopardized. At the same time, liens can be extremely useful. This is because a properly completed (a.k.a. ―perfected‖2) lien will, with very few exceptions, take precedence over all future liens as long as it is in effect.3 If all of a property’s equity is attached to existing liens, then all future liens placed on your property will essentially be worthless to their holders. This is because there is no equity left for the subsequent liens to attach to, which means if a junior lien holder (whose lien doesn’t
1 UFTA §1(8). Note that the UFTA’s definition was derived from Title 11 USC (bankruptcy code) §§101(36),(37),(51), and (53).
2 Depending on the circumstances, a lien may be perfected by recording a mortgage or deed of trust at the recorder’s office in the county where the property is located (for real estate), recording a title with a lien on it at the department of motor vehicles (for vehicles), filing a UCC-1 form with your Secretary of State’s office (for non-titled property), or by a court’s issuance of a judgment, which can then be used to file judgment liens.
3 One exception is a property tax lien, which will usually take precedence over all other liens, regardless of when it arose.
attach to any equity) tried to foreclose, he would get nothing from the sale, since every prior lien holder would be paid first, leaving the creditor with nothing but the expenses he incurred in foreclosing on the property.
Oftentimes, equity stripping is the only viable means of protecting an asset. For example, financed property usually can’t be transferred into an LLC or other limited liability entity without technically triggering a loan agreement’s ―due-on-sale‖ clause. If the clause is triggered, then the lending institution typically reserves the right to accelerate the loan, making the entire balance payable within 30 days; failure to repay the entire loan may result in foreclosure on the property. Even though lenders usually choose not to accelerate the loan if a due-on-sale provision is triggered, I strongly recommend against playing with fire! To be safe, you could get the lender’s written permission to transfer property to an LLC or other entity. However, the Garn-St. Germain Act4 allows us to equity strip most properties without needing a lender’s permission to do so.
Another situation where equity stripping is desirable is when one is protecting their home. Under §121 of the Internal Revenue Code, a property that is a person’s home for two years in any five year period qualifies for an exemption on gain if the property is sold. This exemption is $250,000 for an individual or $500,000 for a married couple. Although placing the home in a single member LLC (SMLLC) or other entity with ―disregarded entity‖ tax status5 will preserve this exemption, placing the home in a family limited partnership (―FLP‖), family LLC (―FLLC‖), or corporation will not. Therefore, it may instead be more appropriate to strip the equity to the FLP or FLLC. Also, it is usually not a good idea to hold a strictly personal asset in a business entity. The reasons for this are more thoroughly examined in the chapter ―Asset Protection a Judge Will Respect‖.
Yet another major benefit of equity stripping is that it can be used to protect anything of value. For example, a gentleman once asked me if I could equity strip his race horse. I answered yes, you can even equity strip a horse! If a creditor then tried to seize the horse and sell it, an equity stripping program would ensure the creditor wouldn’t get a dime for dong so – all money would go to the senior lien holder, which happens to be an entity that’s friendly to the debtor. Thus, equity stripping can protect assets that are not only difficult or impossible to move offshore (such as real estate), but it can also protect assets that cannot easily be moved outside of a business and leased back (such as accounts receivable.)
Now that we understand the basics of how equity stripping works, let’s examine programs that are vulnerable to failing under court scrutiny (the Bad), programs with painful tax and economic consequences (the Ugly), and programs that have neither shortcoming (the Good.)
Bogus Friendly Liens
4 This act is found in 12 U.S.C. §1701j-3(d). An excerpt is as follows: ―With respect to a real property loan secured by a lien on residential real property containing less than five dwelling units, including a lien on the stock allocated to a dwelling unit in a cooperative housing corporation, or on a residential manufactured home, a lender may not exercise its option pursuant to a due-on-sale clause upon—
(1) the creation of a lien or other encumbrance subordinate to the lender’s security instrument which does not relate to a transfer of rights of occupancy in the property‖.
5 A disregarded entity is any entity that is ignored for tax purposes. Instead, all of the entity’s activities are treated as activities of its owner. Disregarded entities include grantor trusts, single member LLCs (SMLLCs), and Disregarded Entity Multi-Member LLCs (DEMMLLCs.)
By far the most commonly used of the flawed equity stripping strategies is the bogus lien. A bogus lien involves a friendly party (either a relative, LLC, Nevada corporation, or other entity) filing a lien against the target asset. The lien is ―bogus‖ because the owner of the target asset receives nothing in exchange for granting the lien. In other words there is no loan or bona fide obligation as a basis for the lien. Even if there is a basis for the lien, the lien may still be bogus if its basis is much less than the lien’s amount. Under the UFTA, a lien must be an amount that is of ―equivalent value‖ to the debt or obligation.6 What’s worse, under the UFTA bogus liens fall in the category of fraud-in-fact, which is much easier to prove than constructive fraud. Consequently, although the bogus lien is easy to implement and maintain, it is also usually pretty easy to attack and eviscerate. Should a bogus lien occur shortly before a creditor threat arises, a knowledgeable attorney should have little problem convincing a judge to invalidate the lien. Nonetheless, despite the weakness inherent in bogus liens, the fact that they are not a widely known tool means they may offer limited asset protection if they are inconspicuously implemented far in advance of any creditor claims.7
After the Bad, we must examine the Ugly. Ugly programs usually work as far as asset protection is concerned, but they can be quite painful economically. Let’s examine these Ugly programs, so that you can avoid potentially painful hidden costs and tax traps.
Tax Consequences of Certain Valid Friendly Liens
Not all friendly liens are bogus. If a friendly party gives you an actual loan that is equivalent in value to the lien, for example, and he is not an ―insider‖8 as defined in fraudulent transfer law, then the lien will probably survive a court’s scrutiny. However, there may still be problems with such a lien. First, you need to find a friendly person or business entity (which you may or may not have funded with your own cash) that is willing to loan you money on friendly terms.
My experience is that people generally have more wealth placed into hard assets than liquid assets. Therefore, you may find it difficult to scrape together enough personal wealth to equity strip your $500,000 home. Second, the interest payments that arise from equity stripping business assets may not be tax-deductible (especially if the equity stripping program also involves the purchase of a personal asset such as life insurance, discussed below), but they will almost certainly be considered taxable income to the lender. If you have a friend who loans you
6 See the UFTA §4(a)(2).
7 Although §4(a)(2) of the UFTA says that a transfer is fraudulent if no exchange of reasonably equivalent value is received in exchange for the transfer, it also stipulates that a fraud-in-fact transfer must also occur (1) during or shortly before a business transaction in which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (2) the debtor intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due. If both of these criteria are not met, then a bogus lien will not automatically be considered a fraudulent transfer, although it may still be considered fraudulent if the creditor can prove the transfer occurred ―with actual intent to hinder, delay, or defraud any creditor of the debtor‖ (see UFTA §4(a)(1).)
8 Under §1(7) of the UFTA, an insider is a relative, business partner (who has significant control or voting influence in the business), or a business entity that an individual has significant control over or voting stock in. Interestingly enough, a business partner who doesn’t control the business, and a business that the individual doesn’t control (at least directly) is not an insider under the UFTA.
his own money, and he’s genuinely profiting from interest payments, then he shouldn’t mind paying the tax. However, if he intends to gift your interest payments back to you, so that you aren’t losing money in the arrangement, then someone is going to have to foot the tax bill.
Finally, remember that if you receive a cash loan, you now need to protect the loan proceeds from creditors, and also make sure to structure the promissory note (a.k.a. loan agreement) so that the loan is not paid down gradually over time.
Equity Stripping via Commercial Loans: Outrageous Interest Expenses and a Possible Super-Nasty Surprise
The strength of any lien held by a legitimate commercial lender is it’s practically impossible to invalidate. The weaknesses are everything else, especially from an economic standpoint. To illustrate the point, let’s look at the drawbacks of taking out a 2nd mortgage to equity strip a home. In this example, the home has a fair market value of $500,000 and an existing mortgage of $200,000. The problem with taking out a 2nd mortgage to equity strip is threefold. First, commercial lenders usually only loan up to about 80% of a property’s value9, leaving 20% of the equity exposed. Securing additional loans to completely encumber the property usually involve very high interest rates (typically 15% or so.) Second, as the loan gets paid down, the property becomes less and less encumbered and therefore more equity becomes vulnerable. Third, the cost of making interest payments on the loan can be quite expensive.
For example, say you take out a $200,000 2nd mortgage on the property, to equity strip it to 80% of its value. If this was a 30 year loan repaid in monthly installments at 7% interest, you would pay $195,190.00 in interest before the loan was paid off. If you take out another loan for $100,000 in order to strip the property of all equity, you may pay 15% interest. Under the same repayment terms as before, the interest payments equal an additional $355,198.40. Inflation notwithstanding, this is a very expensive means of asset protection! Of course you could invest the loan proceeds in government bonds, annuities or life insurance, but you will still likely end up paying more than you would earn with these investments. Riskier investments (such as stocks) could provide a greater return, but you could also lose money and end up worse off than if you hadn’t invested the proceeds at all.
Even from a non-economic standpoint, there are still problems with commercial equity stripping. For example, mortgages are typically paid down over time, leaving more and more equity exposed to a creditor. Furthermore, if you find yourself under creditor attack, you may very well lose the means to make loan payments. Therefore, if you don’t have cash set aside outside of a creditor’s reach, you may find yourself defaulting on your loan, resulting in foreclosure of the very property you were trying to protect! Although these last 2 problems may be overcome, other commercial equity stripping shortcomings may be difficult or even impossible to remedy.
Accounts Receivable Equity Stripping Through Premium Financing: Variable- Rate Loan Traps, Disappearing Tax Deductions, and So-Called “Exempt” Life Insurance Products
Occasionally a commercial lender is willing to offer a home equity line of credit up to 125% of the property’s value; however these loans are often difficult to qualify for unless the applicant has an extremely high credit score. The interest payment costs remain problematic.
The concept behind accounts receivable (―A/R‖) premium financing for the purpose of asset protection is relatively simple. Essentially a business uses its A/R as collateral to obtain a loan, which is then used to purchase a life insurance product or annuity. Because many states protect such policies from creditors, the reasoning goes, the loan proceeds have been protected while also protecting (via equity stripping) the A/R. Furthermore, because the policy accrues interest, this helps offset the loan’s interest payments.
Equity stripping in such a manner has become a very popular asset protection technique. But I need to make it clear that the biggest reason these programs are popular is not because they work (although the best programs do work.) Rather, these programs are popular because they are very lucrative for their promoters. For example, an asset protection planner convinces you to take out a loan for $100,000, using your A/R as collateral for the loan. Then, he tells you to invest the money in a universal life insurance policy, because your state exempts these policies from the claims of creditors, and furthermore you could always borrow cash from the policy in the future if you needed to, right? Sounds like a great way to protect your A/R, right? Well, what the promoter didn’t tell you is he just made up to $55,000 from this arrangement, and although this program may very well protect your A/R from future creditors, A/R equity stripping through premium financing contains many traps and pitfalls, and most programs out there do not avoid these pitfalls.
Consider the following:
Contrary to what many believe, interest payments your company makes on a loan it took out to purchase an annuity or life insurance policy for you are often not tax deductible (you may or may not be able to overcome this problem if you work with a competent tax attorney.) Almost all loans secured by A/R are variable rate loans, whereas your life insurance product or annuity generally grows at a fixed rate, or in accordance with the stock market’s performance.
In other words, three months after you take out your loan, you may be unhappily surprised with rising interest rates on your loan, which makes your A/R financing program much more expensive than you thought it would be, and now you’re stuck between a rock and a hard place. That’s ugly! Although the policy you bought may be exempt in your state, if the company that sold you a policy operates in other states, then a judgment creditor could enter their judgment in a state where your policy is not exempt. Because the insurer operates in that state, and your policy is not exempt there, the creditor could seize your policy in the non-exempt state. Congratulations, you just lost your $100,000 policy, but you still have a $100,000 loan to pay off. Super Ugly!!!
Above all, remember this: a life insurance salesman can earn up to 55% commissions by selling you a life insurance policy. In other words, he makes up to $55,000 by selling you a $100,000 policy as part of an asset protection program. Do you think some of these insurance reps. might be looking to fatten their pockets, rather than set up a plan that’s best for you? Do you see the conflict of interest here?
Now I must emphasize that equity stripping A/R through premium financing is not always a bad way to go; it is sometimes possible to overcome all A/R premium financing shortcomings if you use a planner that really knows what he’s doing (most don’t.) But, considering that many people who’ve done this type of equity stripping were afterwards very
unhappy, make sure you’ve addressed all the potential traps and pitfalls before committing to such a program.
Now we come to the Good ways to equity strip. I need to emphasize that even a Bad program may protect assets, and some Ugly programs can avoid their Ugliness (though most don’t.) The reason the following programs are Good is because they more easily sidestep equity stripping pitfalls. However, keep in mind that proper equity stripping requires much skill, and even a Good technique can turn Bad or Ugly if done incorrectly.
As we’ve seen, almost anytime a lien involves cash, there tends to be several pitfalls awaiting the unwary. However, a re-reading of the legal definition of the word ―lien‖ gives us valuable insight into how these traps may be avoided:
“lien” means charge against or interest in property to secure payment of a debt or performance of an obligation;10 [emphasis is mine.]
Quite frankly, it amazes me that other asset protection planners fail to capitalize on the fact that liens are commonly used to secure obligations, and are every bit as valid as cash loans. Furthermore, it amazes me that other asset protection planners don’t realize a lien securing an obligation is superior in many ways to a lien securing a loan. For example:
There is generally no negative tax or economic consequence to fulfilling an obligation.
No worrying whether or not your interest payments are tax-deductible.
No interest expenses at all, for that matter.
No worrying whether your variable rate loan will exceed your fixed-rate (or risky variable rate) investment.
It’s very easy to structure a security agreement so that the lien is not reduced or paid down until your obligation is completed in full. You can even structure the agreement so that the lien grows until the obligation is fulfilled. Your secured obligation almost certainly has absolutely no value to a creditor, whereas the cash proceeds of a loan always have lots of value to a creditor, meaning you’ll have to jump through more hoops to protect the loan proceeds.
If you’re in trouble with creditors, your liquid assets may be unavailable for loan payments, meaning your ―protected‖ property is in danger of foreclosure. However, since creditor troubles should not affect your ability to fulfill non-monetary obligations, (or rather we could arrange a monetary obligation with a ―friendly‖ entity) foreclosure is not a problem. You don’t have to worry about ―how am I going to get $625,000 to equity strip my $500,000 home?‖ Cash loans are easy to quantify, making it very difficult to justify a large lien securing a small loan. However, certain obligations can be difficult to quantify, which gives us
10 See Title 11 USC §101(37). Note that this definition is in harmony with §1(8) of the UFTA.
more leeway when we are structuring an obligation to be of ―equivalent value‖ to the cash value of a lien.11
With the above in mind, let’s examine some ways in which a bona fide obligation may be used to place a valid lien on your property.
Equity Stripping via LLC Capitalization
One of my favorite methods of equity stripping is via LLC capitalization, a method developed to rectify the shortcomings of other equity stripping programs. The concept goes like this: two people form a Limited Liability Company (LLC) in order to run a business (which could be some legitimate, yet easy-to-do activity such as investing in stocks and bonds.) Under the LLC Acts of every state, each member (member being the LLC equivalent to partner) can obligate the other, per a written agreement, to contribute capital (assets) to the company so that it has a means to operate. One of the members contributes a smaller amount of assets up front to capitalize the company, in exchange for a small but significant ownership interest (usually 1-5%).
The other member promises to make a large capital contribution over time, in exchange for an upfront large interest in the company (95-99%). Because the first member contributed his capital up front, but the second one did not, the 1st member has a valid reason for making sure the 2nd member makes good on his promises. Therefore, the LLC places a lien on the second member’s property to ensure he fulfills his obligation to capitalize the LLC over time. As long as the LLC is not considered an insider under applicable fraudulent transfer law, and the obligation is valid, its fulfillment demonstrable, and it ―makes sense‖ in a business context, a rock-solid lien has been created on the 2nd member’s property. Such an arrangement is illustrated in Figure 1, below.
11 Structuring a loan or obligation to be of equivalent value to a lien is a critical consideration under fraudulent transfer law. See UFTA §4(a)(2).
It’s important to note in this scenario that Member 2’s promised contribution could take many forms. It could be a promise to contribute cash, services, equipment, or other property. And after the lien expires, the members could dissolve the LLC and typically all returns of capital will revert back to them tax free. Furthermore, almost any type of asset could be equity stripped via this method, whether it be A/R, real estate, or personal property. Indeed, the flexibility of equity stripping via LLC capitalization is so great, that practically any type of asset could be protected, according to practically any terms that fit within the realm of normal business practice.
The Lessor’s Lien: A/R Equity Stripping Without Premium Financing Headaches
As a corporate officer of several companies, I am often tasked with reviewing various real estate lease agreements. Most of these agreements contain a lessor’s lien clause. These liens are not part of an intentional asset protection program; rather they are liens that arise in the normal course of business. As mentioned previously, a lien may be used to ensure someone meets an obligation. In this instance, the lessor wants to make sure that the lessee fulfills his lease, so oftentimes a UCC-1 financing statement (used to perfect a lien against non-titled property) is filed against the lessee’s accounts receivable, furniture, equipment, and other assets. Of course in this situation the lessor is not trying to protect the lessee’s assets against other creditors, but that is exactly what he’s doing.
The best asset protection planners understand how liens are used in such everyday business arrangements, and they capitalize on such processes. Utilizing a standard business arrangement for asset protection is especially desirable because it appears that no intentional asset protection was done. Because normal business arrangements often use accounts receivable to secure a lease agreement, a lessor’s lien is an especially good way to protect this valuable asset.
The best type of lessor’s lien, of course, is one that is held by a company who is friendly towards the lessee, because we can then draft the lease and lien terms to best suit our needs. Often times I will take property in a business, sell it to another business, and lease it back to the original business. This is called a ―lease-back‖ arrangement, and has two benefits: first you protect one piece of property by putting it in a separate entity, and then you lease back the property to the original entity, and put a lessor’s lien on a second asset. For example, an LLC could sell an office building to a 2nd LLC, lease the building back to the 1st LLC, and subsequently place a lessor’s lien on the 1st LLC’s accounts receivable.
As simple as the concept sounds, a lessor’s lien in this or similar circumstances still requires a high degree of skill to do correctly. The trick is to transfer the original asset into a separate entity in a manner that won’t be considered a fraudulent transfer, among other things. Also, one must structure each entity so that they’ll be respected as separate entities if challenged in court. For example, sometimes if one entity is sued, and the managers of that entity also happen to manage the 2nd entity, both entities will be considered to be only one entity under the ―theory of interlocking directors.
This piercing of the veil of the 2nd LLC will not only avail the 1st LLC’s creditor of the 2nd LLC’s assets, but also invalidate the reason for a lien on the company’s accounts receivable. Therefore if you wish to do a lessor’s lien between friendly companies, make sure you hire a skilled professional to assist you.
Multi-Stage Equity Stripping: The Solution to Traditional Equity Stripping Shortcomings
Despite the advantages of equity stripping via LLC capitalization and the lessor’s lien, these programs may not completely meet an individual’s needs. For example, if an individual wanted to protect their $500,000 free and clear home, they would have to promise a large capital contribution of either services or cash to the LLC. Honoring such an obligation might not be desirable. Furthermore, if the person who held the obligation manages the LLC, then the LLC that holds the lien would be considered an insider under fraudulent transfer law. Although this does not necessarily mean a fraudulent transfer has occurred, it may somewhat reduce the lien’s chance of survival if its validity was challenged. Fortunately, multi-stage equity stripping allows us to overcome these obstacles.
Multi-stage equity stripping is simply the process of placing two or more liens on a piece of property. If the target property is real estate (the most common equity-stripped asset), we most often have a client use the property to obtain an Equity Line of Credit (ELOC). The benefits of an ELOC are fourfold. First, although the lien is filed when the ELOC account is opened, one need not pay interest or other fees until the ELOC is actually used. Only under severe creditor duress does the ELOC even need to be exercised12. Second, oftentimes homeowners wish to ―un-trap‖ equity in their homes, so that they may invest the proceeds for profit.13 An ELOC is an 12.
Although the lien is placed on the asset when the ELOC account is obtained, the lien is dormant for practical purposes unless the line of credit is used. Once creditor threat arises, the ELOC should be fully utilized, with loan proceeds being transferred out of creditor reach. We often accomplish this by using ELOC proceeds to purchase an asset of equivalent value that is unavailable, undesirable, and possibly exempt under law from creditors, such as an offshore annuity from a major foreign insurance company.
13 Often those using an ELOC try to claim an income tax deduction on ELOC interest payments. Such individuals should be aware that the maximum ELOC balance towards which interest payments are deductible is $50,000 for a single individual or $100,000 for a married couple. See IRS publication 936 (2004) for more information. This publication may be accessed at http://www.irs.gov/publications/p936/ar02.html#d0e2069.
ideal means of doing this. Third, an ELOC can continuously strip a target property of 75% or so of its equity. Unlike a traditional mortgage, which will gradually be paid down, one can choose to only pay interest on the ELOC (or, if principle payments are required, then the repaid principle could be taken out again), thus ensuring, if necessary, that an increasing amount of equity will not be exposed to creditors. Furthermore, because much of the equity is stripped via an ELOC, it is easier to strip the remaining equity with an equity stripping via LLC capitalization program. Finally, even if a less than ideal (strength-wise) equity stripping via LLC capitalization program is used, from a creditor’s standpoint the program will only attach to the least desirable equity.
This is because if a creditor forecloses on a debtor’s real property, the property will likely only sell for 60-80% of its fair market value. Because the ELOC typically covers this equity anyway, and the ELOC has virtually no chance of being undone by a court, the creditor has little incentive to challenge the 2nd lien. Despite this fact, we still wish to place the 2nd lien on the property, to cover its equity in case the property appreciates, or if in the future the owner decides to sell the property for fair market value while a junior judgment or other ―hostile‖ lien is encumbering the property.
How Equity Stripping Works When Creditor Threat Arises
Implementing the best program for your situation is not all we must know in order to protect assets via equity stripping. We must also know what to do if a judgment or other non-consensual lien, such as a federal tax lien, attaches to equity stripped property (hereinafter we’ll include all such liens when we use the term ―judgment lien‖). Although a judgment lien may not attach to any actual equity, if we ever sell the property, the lien may follow the sold property afterwards. Since prior liens are usually paid-off at the point of sale, this means that these hostile liens could then be the first liens on the property once the buyer acquires it! Of course this would be unacceptable to the buyer, as well as to any institution that might finance the purchase, so before selling this property, we must get rid of all hostile liens. This is accomplished by having our friendly lien foreclose on the property. Foreclosure, of course, is only necessary when you want to sell equity-stripped property that has junior hostile liens on it. Often a favorable settlement is reached prior to this occurrence, and thus the hostile lien is removed and foreclosure is not necessary.
Before discussing foreclosures, we must warn that not all states treat foreclosures identically. Therefore, checking with a local attorney is a must before foreclosing. With that in mind, foreclosures typically happen one of two ways: by judicial foreclosure, or by a private party foreclosure. The type of foreclosure depends on the type of lien filed against the property. If the lien is a mortgage, then foreclosure occurs under court supervision. A deed of trust is foreclosed without court oversight. Obviously, a deed of trust is easier to foreclose, since it doesn’t involve the court, and therefore a deed of trust should be used as the lien document of choice whenever possible. Regardless, however, expect to pay $2,000 to 5,000 to for the entire foreclosure process.
The foreclosure process usually requires posting at least a couple public notices of such in a local newspaper or other publication, and it can take anywhere from three to six months from its inception before the actual auction occurs. The auction will typically be held by the deed trustee if the lien is a deed of trust, or a sheriff if the lien is a mortgage. When a foreclosure sale is held, the minimum bid is usually the amount of the lien that is being foreclosed.
The winning bidder must pay at least this amount, or more, if he bid above the minimum. However, when thebidder acquires the property, it is still subject to senior liens. For example, if we have a $500,000 home with a $400,000 1st mortgage and a 2nd lien (which is our equity stripping program) on it for $250,000, and the 2nd lien forecloses, the bidder must pay at least $250,000 and he still pays on the $400,000 mortgage note after he acquires the property. Any liens junior to the foreclosing lien, however, are wiped out, and the buyer has no obligation to pay them.
Obviously, in our preceding example the buyer would not be getting a good deal. He’d pay at least $250,000 for a $500,000 piece of property, but he’d still have to pay off the $400,000 1st mortgage. This begs the question ―what happens if no one bids at the auction, since doing so may not be a good deal?‖ In this case, if there are no bidders, then the lien holder who foreclosed becomes the new owner of the property, which is still subject to senior liens but free of junior liens. If this lien holder was an entity friendly to the property’s owner, it could then sell the property, and sale proceeds would flow into that LLC, thus remaining out of creditor reach. Careful planning would even allow us to restructure the entity so that the Internal Revenue Code §121 exemption14 on gain upon sale of a personal residence is allowed when the property is sold.
In summary, although equity stripping requires great skill to do correctly, creative and knowledgeable planners should have no problem finding an effective equity stripping method that meets their clients’ needs while minimizing the expense and effort involved in maintaining such a program.
14 Section 121 of the IRC allows one to sell a personal residence that has appreciated (up to $250,000 if the seller is single or $500,000 if married) without recognizing taxable gain upon sale. The seller must live in the personal residence at least two of the five years immediately preceding the sale in order to qualify for this exemption
Limited liability means you are not responsible for a business’s debts, and generally the business is not responsible for your personal debts. It is like you and your business are two unrelated people–almost like your business is a distinct person. Unless a creditor convinces a judge that it is your alter ego, it will remain separate.
This talk is about liability of management. Even though managers, corporate officers, directors, and managing partners are not liable for business debts, they may be held liable for their own torturous acts, even if done while working on behalf of the company. Hence the existence of directors and officers insurance.
Alter ego arguments are arguments creditors will use to try to get after your business assets and not all of these apply to entities that are not corporations. The first is called ‘instrumentality’or ‘domination’and this is where a single person manages an entire entity thus ignoring the multitiered management structure the entity is supposedly have. This currently only applies to corporations which should have a Board of Directors and corporate officers. A single person for filling all the rules in a Corporation may cause the Corporation to be held as that person’s alter ego. This alter ego argument is not applied equally amongst the 50 states! It varies from state to state.
A lot of one man S corporations can find themselves in hot water if they are sued and the plaintiff argues along these lines. It is better to use an LLC taxed as an S Corporation. It is okay to dominate an LLC with a single manager.
The next argument is called ‘improper purpose’and is when you use the entity to perpetrate fraud or injustice or when you are a business entity for personal use. Co-mingling business and personal funds or using business funds for personal use is also considered an improper purpose. If an entity is created with no business purpose and personal assets transferred to them with no relationship to any business purpose simply as a means of shielding them from creditors, under such circumstances, the law views the entity is the alter ego of the individual debtor and will disregard it to prevent injustice.
The next topic is the argument related to ‘proximate cause’ which means that the lawsuit would that must be tied to the business entities activity. If it is not then a creditor cannot sue or argue alter ego for the entity unless there is suing an owner of the entity and are trying to reverse pierce it. But just because you do not own, but are still tied to it in a stealthy manner, and entity does not mean you cannot be tied to it. This is why bearer shares often do not work and may cause other problems.
If the company does not have enough capital to meet its anticipated debts, then it can be pierced under the theory of under capitalization. Creditors believe your corporation should have enough cash to pay for all the inventory you just ordered, and a judge may pierce the entity if you do not.
Reverse piercing is when a creditor tries to get assets in a business for the debt of one of its owners. We discussed this in the lesson on charging order protection. Normal piercing is when a creditor tries to get an entity owner’s personal assets for debt or judgment against the business.