The best offense is frequently a good defense. No matter how astute a business person you are, or how skilled you are as an investor, or how lucky you are with your lottery tickets, it does little good if you leave your assets hanging like a slab of meat in the water for trial lawyers to sink their teeth into.
Let’s face it: America is growing increasingly litigious, and the more assets people think you have, the more tempting a target you will become for frivolous lawsuits.
If you are a business professional or if you own a business, you could be hit by any of the following:
- Trademark Infringement Lawsuits. You might think you’re just parodying a well-known song, or you could think it’s no big deal to paint Disney characters on the wall at the daycare center you own and operate. The original trademark owner may disagree – and sue for damages.
- Sexual Harassment Accusations. Just because you think the lawsuit is without merit doesn’t mean the plaintiff won’t go forward with the case.
- Employment Discrimination. Again, a lawsuit could be justified or unjustified. A well-meaning hiring manager could expose you to a discrimination suit just by asking a pregnant applicant, “When’s the baby due?” You’ll also need to be careful to fire an employee legally.
- Faulty Products. You could manufacture a chair, and someone could hurt his back when it collapses underneath him. Courts may find you liable for damages.
- Malpractice Claims. These aren’t just for doctors and lawyers. A financial advisor could be accused of selling an unsuitable investment and be held personally liable.
- Breach of Contract Claims. If you are doing business under the terms of a contract and fail to live up to those terms, the counterparty could be economically damaged by your failure. Whether intentional, unintentional, or due to negligence, a jury could hold you responsible.
- Work-related Vehicle Accidents. You own a pizzeria. Your driver runs over a pedestrian while delivering a pizza on your behalf. He’s at fault – but you’re the one with the deep pockets. The victim’s lawyers will come after you or your insurance company.
- Workers’ Compensation Incidents. The same employee comes back to work the next day…and slices off his finger while cutting a pie. You, again, are on the hook to pay for treatment and rehabilitation, although workers compensation insurance laws generally require you to carry insurance to protect both your business and your worker.
- “Slip-and-Fall” Accidents. The same employee gets his finger patched up and comes back to work. He mops the dining room floor. A customer slips and falls, and breaks her hip. Again, her attorneys may target you as the liable party, and come after you and your business.
Your business isn’t the only source of potential liability. Consider the following possibilities:
- Divorce. Divorce can pose a major threat to your finances for a number of reasons. First of all, your former spouse likely has more detailed knowledge of your total finances than most creditors. Unlike other creditors, your spouse can break up a retirement plan under a QDRO (qualified domestic relations order) obtained through the courts, and furthermore, you cannot discharge alimony or back child support debt in bankruptcy, and unpaid alimony has priority over your heirs in probate courts. Finally, unlike your other creditors, your former spouse can potentially have you thrown in jail for failure to pay child support. Another difficult circumstance arises when a former spouse is awarded a number of shares in a corporation you own with him or her. In this case, your ex will have full access to your books, and is entitled to a dividend whenever you pull money out of the corporation for yourself – despite no longer contributing anything of value to the business. To guard against this potential situation, consider a prenuptial agreement or other buy-sell agreement to ensure both parties can be satisfied, and the business unencumbered.
- Auto Accidents. You don’t have to be the one in a wreck to be held liable. For instance, say your uninsured or under-insured teenager causes a wreck – even if your teen is insured, you could be liable if your car insurance isn’t adequate. Check your own coverage to be sure it’s sufficient as well. Your state will have minimum liability requirements, but with today’s juries, awards of multimillion dollars are not outside the realm of possibility.
- Social Host Liability. This applies if you have a party, serve alcohol, and a guest causes an accident or injury after leaving. Alternatively, your kids could have a party while you’re out of town, drink a few beers out on your deck, and expose you to the liability, even though you weren’t even in the same state at the time.
- Vicarious Liability. If your business partner or employee gets in a wreck, yes, you could be sued.
- Employee Actions. If your employee causes damage, it could result in a liability to the company. That liability could attach to you personally as well if you don’t take specific steps to protect your personal assets from business debts.
- Debt. This occurs if you lose your job and default on debts, leading to eventual bankruptcy.
- Medical Issues. If you have a serious medical issue and can’t pay your bills, you could be liable. After all, if you can’t work for a period of time, you will lose some or all of your income, even if you have disability income insurance in place. Even if you have good coverage, you could take a hit from uncovered expenses, such as coinsurance, again leading to bankruptcy.
- A Callable Loan. In some cases, lenders reserve the right to “call” a loan, demanding immediate repayment. This means you will either have to quickly refinance the debt (if you have the means) or sell the asset to raise the cash. If you can’t do either, bankruptcy could be the result.
- Foreclosure. If you fall behind on your mortgage payments, the bank could seize the property in a process called foreclosure. Federal law limits liability from debt secured by your personal residence. However, there are no such restrictions on commercial loans, and a commercial foreclosure could put other assets at risk, unless you take steps in advance to contain the risk.
How to Protect Yourself
Make no mistake – bad things happen to good people all the time. You don’t have to be irresponsible or negligent to get sued. To protect what you have, it’s vital to take some defensive measures, to make it more difficult for creditors to seize your assets in the event you lose a lawsuit, have a judgment entered against you, or are forced into bankruptcy.
1. Use Business Entities
If you are an entrepreneur of any kind, it’s important to separate your personal assets from those of your business. If you neglect to take specific legal steps to create a separate business entity, such as a corporation, limited liability company (LLC), or limited partnership, a simple business dispute could well cost you everything you own.
There are a number of business entities to consider:
- Sole Proprietorships. Sole proprietorships offer no limit on personal liability. One mistake could cost you your home, depending on your state.
- General Partnerships. General partnerships are the worst. If your business partner has a personal dispute that has nothing to do with you and he or she loses a lawsuit, you two are joined at the hip. Technically, lawyers could come after you because of your partner’s actions, whether regarding the company or his or her personal life.
- Limited Partnerships. Limited partnerships can help limit your liability. If you invest as a limited partner in a partnership, you cannot be sued for anything more than what you have invested in the business. The worst that can happen is that your investment will be wiped out. But lawyers cannot come after you personally to make good on a claim against the business. Here’s the catch: You can’t take an active role in running the business. If you do, you are a general partner, and your assets are fair game.
- Corporations. Corporations provide excellent asset protection for their owners. With the exception of cases of egregious fraud – such as if you fail to pay payroll taxes to the IRS, or if you do not treat your corporation as a separate entity from yourself – your personal assets cannot be stripped from you in the event that your business loses a lawsuit. There are two kinds of corporations: S corporations and C corporations. They are taxed differently and have different restrictions on ownership, but both provide similar asset protection for their owners.
- Limited Liability Companies. Limited liability companies also provide asset protection against business lawsuits for their owners, but with fewer restrictions on ownership than S corporations. They also allow their owners to choose whether to file federal taxes as a corporation or as a partnership. There is one major advantage LLCs have in some jurisdictions: charging order protection. If your corporation loses a suit, a judge could award a number of the shares of the business to the creditor. This gives them access to your books. With an LLC, even if the plaintiff gets a membership interest, he can’t force a distribution of cash, but he still gets taxed as if he received it. This “poison pill” can help you prevent a lawsuit or settle on favorable terms.
2. Own Insurance
Some professions generate more exposure to liability than others. If you are a financial advisor, an OBGYN, a real estate agent, or a professional in any other field that generates a lot of lawsuits for malpractice, keep your errors and omissions coverage paid up, and, if you can afford to, invest in extra or expanded coverage. But don’t stop there – you also need to enact these kinds of coverages:
- Homeowners Insurance. Homeowners insurance helps cover you if someone is hurt on your property. Choose a deductible you can cover with your savings, and make sure liability coverage is adequate in case someone gets hurt on your property and decides to sue you.
- Commercial Liability Insurance. This type of insurance protects your business if someone gets hurt on the premises, or is injured as the result of an action by an employee.
- Worker’s Compensation Insurance. This is mandatory in most jurisdictions. Worker’s compensation protects you and your workers alike by ensuring that there’s enough liquidity in place to take care of any employee who gets hurt on the job, and that the expenses don’t come out of your pocket.
- Auto Insurance. Don’t settle for the minimum legal liability coverage – additional coverage is usually affordable. Buy enough additional coverage for your auto insurance so that you will have meaningful protection in the event your vehicle is involved in an accident and generates a lawsuit. As a general rule of thumb, make sure your total liability coverage is at least equal to your total assets.
- Umbrella Coverage. Umbrella coverage is backup insurance that can be used in the instance that your other coverages are inadequate. In the event that your auto, homeowners, or other liability coverages are exhausted, umbrella coverage pays benefits up to the limit of the policy. For example, if you have $1 million in auto liability and get hit with a $2 million judgment, your umbrella policy will pick up the additional $1 million in coverage. Otherwise, the plaintiffs could start coming after you to seize assets for damages. Typically, these policies get underwritten for $1 to $5 million in face value. It’s usually very affordable.
- Long-Term Care Insurance. Long-term care insurance protects you against the financially devastating costs of in-home or nursing home care for chronic ailments, such as dementia, Alzheimer’s, strokes, paralysis, multiple sclerosis, spinal cord injuries, and the like. Medicare doesn’t provide much coverage for these afflictions, and most major medical insurance policies don’t provide any. Without long-term care insurance, you could be on the hook for more than $200 per day in nursing home costs – until the expenses drive you into poverty so you can qualify for Medicaid. The longer you wait, the higher the premiums get. Additionally, you could develop an ailment that would preclude you from getting coverage, or at least make it prohibitively expensive. Alternatively, consider purchasing long-term care insurance for your parents if you’ll otherwise be on the hook for this expense.
3. Use Retirement Accounts
Federal law provides unlimited asset protection to ERISA-qualified retirement plans, and up to $1 million in assets in an IRA in the event of bankruptcy. Some states provide even more protection to IRAs, though some states have opted out of the 2005 Bankruptcy Reform Act’s federal bankruptcy exemptions and exempt a lesser amount.
Check the laws in your state to see how much protection is provided to funds in these accounts. Speak to an attorney familiar with the laws in your state to determine whether creditors can opt between the state and federal exemption amounts.
If your state has a generous exemption, consider moving cash you won’t need until you reach at least age 59 1/2 into one of these protected entities. Bear in mind that you will be restricted by an annual contribution limit, which varies depending on the type of retirement plan. If you go over this limit or withdraw funds prior to age 59 1/2, you may be assessed penalties. Retirement accounts are excellent vehicles to protect long-term savings, and provide substantial tax benefits, but need to be thoroughly understood and used with care.
4. Homestead Exemptions
Some states provide a lot of protection to home equity, which means that if you declare bankruptcy, the law prohibits courts from awarding home equity to creditors. In some states, including Texas and Florida, state law protects an unlimited amount of home equity. Other states provide relatively little protection to home equity in the event of bankruptcy.
Check the laws in your state – if your state provides a generous homestead exemption, consider contributing extra principal to mortgage payments to protect those funds. Principal contributions to the vagaries of the housing market are subject to risk, in that you will lose access to the equity and the cash if property values fall.
Alternatively, if your state provides a minimal homestead exemption, accelerating mortgage payments or paying down principal may not make sense if you are looking to protect assets from creditors.
Examine how your home is titled. If you own your home with your spouse as tenants by the entirety, both you and your spouse own an indivisible interest in the home. If only one of you is named in a suit, creditors cannot force the other spouse to sell his or her interest in the house. Because the interest is indivisible, this can help you protect home equity where state law doesn’t provide a sufficient homestead exemption.
This option is only available in some states, and it only applies to your personal residence, not investment property. Other forms of titling include tenancy in common: joint tenants with rights of survivorship.
The way you have a property titled can have profound ramifications in the event a that creditor makes an attempt to seize it. Speak to a lawyer licensed in your state for specifics concerning your situation.
6. Annuities and Life Insurance
Some states provide significant protection to annuity balances and to assets in cash value life insurance policies. For instance, Florida provides unlimited protection to these assets, while Oregon provides protection for up to $500 per month in annuity income. Each state has its own laws, so check with an attorney licensed in your state for specific exemptions.
7. Get Rid of It
Creditors cannot seize assets that you no longer own. Therefore, consider transferring ownership to irrevocable trusts, from which family members may be able to draw an income or give the assets to family members outright, as part of a strategic gifting program. As of 2012, you can give away up to $13,000 per person without incurring a gift tax liability, subject to a lifetime gift tax exclusion of $5 million.
If you are in a high-risk profession, consider transferring assets to your heirs early – call it an “advance on your will.” If you don’t expect to need the money while you’re alive, you might benefit from watching them enjoy the inheritance.
8. Don’t Wait to Protect Yourself
You can’t wait until the lawsuit is imminent before you make these moves. If you do, the courts could rule that your transfer of funds into a protected class is a fraudulent conveyance and disallow the transfer, leaving those assets exposed.
Above all, don’t become a tempting target, and avoid displays of conspicuous consumption. This could attract trial lawyers and cause them to take a plaintiff’s case where they would otherwise pass on it.
This article is by no means a comprehensive guide to asset protection measures and strategies. Each case is different, and the field of financial and legal planning interfaces with state laws to a significant degree. This is just an overview of some of the major issues and risk factors involved, and there is no substitute for working with a qualified and experienced professional licensed in your state.