Are you really protected against liability?

John D. Pocket was a successful real estate developer in New Jersey. He had accumulated a sizable portfolio of real estate and securities investments. John always sought the advice of his attorney and CPA with respect to his business and personal affairs. However, although much planning was evident. there was always the exposure of a lawsuit.

A few years ago Congress passed legislation known as the Comprehensive Environmental Response Compensation and Liability Act (CERCLA), which provides for substantial penalties and liability for cleanup of contaminated soil. John recently became aware of a multi-million dollar claim arising under this law.

As if that.were not enough, the real estate market took a nosedive when the economy began to sour and John is left with substantial negative cash flow and is being squeezed by his lenders. As a result things began to collapse and John found himself retaining bankruptcy counsel.

John and his family have lost all their assets and rewards of many years of hard work. Had he availed himself of appropriate asset protection planning as part of his estate planning the outcome could have been very different.

In addition to real estate developers, other candidates for such planning are physicians, attorneys, accountants, architects, board members, and those with "deep pockets" who need to protect themselves from claims of future creditors or predators.

Some of the basic techniques used to protect one's assets include transferring assets to one's spouse and establishing trusts for children or other family members. Such transfers, however, involve the surrender of all rights to control the asset and subject the owner to potential problems such as divorce or other intra-family disputes. Using a constructive trust theory some courts have held that the transfer of assets to a spouse is ineffective since the spouse is merely holding the property for the debtor spouse as a trustee. Gifts in trust, where the grantor retains certain rights over the property, are generally not protected from attachment from the grantor's own creditors. Grantors seeking to protect assets by transferring to domestic trusts must therefore sever all ties to the trust property. Other traditional planning techniques include the use of homestead exemptions (especially in Florida and Texas which have very liberal exemption statutes), life insurance exemption, and property held in a joint tenancy. However, these techniques are limited in their application.

One of the more common and effective asset protection techniques is the use of a limited partnership. The owner of the property contributes it to a limited partnership in which he or she is the general partner and family members may be the limited partners. As the general partner the transferor retains control over the assets while the assets are safe from creditors. Under the Uniform Limited Partnership Act, a creditor of a limited partner is only entitled to attach the limited partner's interest in the partnership. That is, if the limited partnership is structured and conducted properly, the creditor will not be able to attach any of the assets owned by the partnership nor force a sale of such assets. The general partner has the added bonus of receiving a salary from the partnership as well as controlling the timing of any distributions. Since such remedy is unattractive to a creditor the debtor is in a much better negotiating posture.

In addition to the asset protection such a partnership affords one of the extra benefits is in the estate planning area. For example, if a parent is the general partner and transfers fractional interests to his or her children then the estate taxes on the parent's death would be based only on the fractional interest the parent retains, even though the parent has retained total management control.

Concealing or transferring assets in anticipation of a lawsuit, however, may be construed as a fraudulent conveyance under most state statutes. Accordingly any transfers made must not make the transferor insolvent as a result of the transfer. Such determination must be made with consideration of any pending or threatened litigation.

Some attorneys take the partnership concept one step further by establishing offshore trusts. The use of such trusts is based on the procedural and substantive laws which certain foreign jurisdictions have enacted to thwart creditors. The principal that a grantor cannot establish a spendthrift trust to avoid his own creditors is not found in the laws of many foreign jurisdictions. In the United States, a judgment rendered in any state is enforceable in any other state. This would result in subjecting a domestic trust to a judgment. On the other hand, certain foreign jurisdictions do not recognize U.S. judgments. This factor, in itself, serves as a major roadblock to plaintiff's counsel. Some of the jurisdictions which have enacted these statutes are the Isle of Nan, Cook Islands, Cayman Islands, and most recently the Bahamas.

In addition to giving protection to creditors, foreign trusts provide other benefits such as probate avoidance and confidentiality. Foreign trusts are not intended to be used as a tax avoidance device and therefore must comply with U.S. tax laws. Foreign trusts allow the grantor to retain control of the property without violating any spendthrift rules.

With proper advance planning there is no reason why peace of mind in the form of asset protection cannot be a goal which every successful professional and businessman can achieve.

Gideon Rothschild is president of Gideon Rothschild, P. C, a Manhattan law firm specializing in estate planning, asset protection planning and tax controversies.