Protecting personal assets; it's vital to safeguard personal property before problems occur.

Professionals who practice in partnerships face special risks because they can face liability for potential claims against their partners. In larger practices, a professional may be vulnerable to claims against his or her personal assets resulting from engagements performed in distant cities of which he or she had no knowledge. Even those who practice in professional corporations can be hit with personal malpractice suits. Failure to adopt a plan that protects assets from creditors can have tragic consequences for professionals who are sued.

Personal liability is increasingly troubling for CPAs in particular because of the trend that targets CPA firms as the deep pocket for investors and federal regulators. The magnitude of the potential liability cannot be overestimated. At the same time, however, insurance premiums for accountants are so high that some CPAs are risking practicing without insurance.

CPAs, however, are not the only ones who must worry about personal liability. Many of their clients also face possible malpractice litigation or liability for their partners' actions. CPAs are uniquely suited to prepare and analyze their own balance sheets and those of their clients when considering asset protection. They should remember, however, the strategies described here don't apply to all situations and should be used as a starting point for discussions with legal advisers. This article discusses how professionals can use funded revocable living trusts and family limited partnerships to protect assets. Some of the discussion is based on Virginia law, but the concepts generally apply elsewhere. Although the article discusses income tax and estate planning ramifications, its primary focus is protecting assets from creditors other than the Internal Revenue Service using strategies that also can play a critical role in income tax and estate planning considerations.

USING TRUSTS TO PROTECT ASSETS

For married couples, forming two funded revocable living trusts is a good way to protect assets of the more vulnerable spouse from claims. Assume one spouse is a law firm partner and is worried about a future malpractice claim, and the other is in a profession less subject to legal liability. It may be appropriate to create one funded revocable living trust for the law firm partner and another one of these trusts for the less vulnerable spouse.

Statutes in several states now provide that each spouse is entitled to hold his or her own property. Virginia's provision says the wife's property is not subject to the husband's debts or liabilities (assuming the property was not transferred to the wife as a fraudulent conveyance, which will be discussed below). Further, transfer of assets to an express, written trust controlled by the wife rather than to the wife outright makes it less likely a court would nullify the conveyance if challenged by a creditor (again, assuming no fraudulent conveyance). One reason for this conclusion is, as discussed below, there can be significant estate planning advantages to using a funded living trust. Thus, there are good reasons besides asset protection for adopting this type of plan.

The couple begins by taking an inventory of all their assets. The more valuable ones, such as homes and investments, are transferred to the trust of the spouse less vulnerable to litigation. (As a precaution, this spouse should purchase an umbrella insurance policy.) Other assets, such as the couple's cars, are transferred into the lawyer's trust. The assets are transferred to the trust by listing them on a specially drafted schedule A accompanying the trust agreement and deeding them to the trust. To be included, newly acquired assets must be added to the schedule.

Each spouse is the creator (that is, the grantor or settlor), initial beneficiary and trustee of his or her trust. Each trust can be amended or revoked at any time if, for example, financial planning goals change and asset protection becomes less important because the professional spouse retires or otherwise becomes less susceptible to judgment. For federal income tax purposes, the trust creators are treated as the trust property owners and no separate tax return for the trust need be filed.

There are other advantages besides asset protection to using funded revocable living trusts. For example, using a trust helps avoid the time, expense and publicity associated with probate. In addition, a living trust can provide for incapacity planning. If the grantor can no longer manage his or her own affairs, trust assets can be managed by someone chosen by the grantor rather than a court-appointed guardian. Also, the living trust can be drafted to take advantage of the $600,000 exemption from gift and estate tax and the marital deduction. For an estate of $1.2 million (which today is not uncommon, particularly considering life insurance), failure to take advantage of these estate planning tools can result in a needless federal estate tax of $235,000 on the death of both spouses. This tax can be avoided rather easily through estate planning.

CPAs should remember, however, that planning for asset protection sometimes can be inconsistent with estate planning. For example, a CPA with household assets of $1.2 million may choose to put $900,000 of assets in her spouse's trust and the remainder in her own. While this will protect the bulk of their assets from lawsuits, it's not good estate planning, since the heirs will have to pay taxes on $300,000 of the spouse's assets when he dies, taxes that would have been avoided if the couple's assets were split evenly in their trusts. Planners must weigh liability concerns against estate planning goals.

CPAs also will want to consider whether shifting assets into one spouse's trust is a good idea given the possibility of divorce. State laws on divorce vary, but transferred assets generally are considered marital property and thus within the divorce court judge's jurisdiction to redistribute. Even after assets have been placed in individual trusts, a judge may decide to split them between the couple or take retained trust assets into account when making other allocation decisions. CPAs thus should consider state divorce laws and court precedents in an attempt to avoid forming trusts that would be undesirable in the event of divorce if it's unlikely trust assets will be redistributed by the court.

Other trusts can afford the same amount of asset protection as funded revocable living trusts and, in certain circumstances, are effective tax planning tools. For example, children's trusts are useful for income shifting and irrevocable trusts for avoiding probate. However, neither spouse-parent should be the trustee of either of these trusts because retaining control would mean losing the tax advantages associated with these trusts.

An alternative to the trust arrangement for married couples only is to title certain property tenancy by the entirety. Some states provide that tenancy by the entirety property is immune from creditors of a husband or wife (but not of both). When one spouse dies, the title passes tax free to the surviving spouse. (Under joint tenancy and tenancy in common, the property isn't immune from creditors.)

This option does have its drawbacks, however. First, the surviving spouse's step up in basis is only one half of the property's value. Accordingly, if the surviving spouse sells the property, the gain on one half of the property not included in the decedent's estate will be recognized. Further, if the less vulnerable spouse dies first, the professional would become sole owner of the assets and subject to creditors' claims. Also, although tenancy by the entirety is common for home ownership, it is more difficult to title personal property that way. In fact, ownership of personal property as joint tenants or tenants in common is the rule. And courts have held that all assets held as joint tenants or tenants in common can be reached by creditors of only one party.

FAMILY LIMITED PARTNERSHIP

A second effective entity for asset protection is the limited partnership. Generally, limited partners are liable only for their partnership contributions and not for any partnership debts, provided they don't participate in control of partnership business. General partners, on the other hand, control the partnership and are fully at risk for partnership debts.

Accordingly, a couple (or single person) can transfer assets into a family limited partnership and give limited partnership interests to relatives or friends, putting the gifted limited partnership interests beyond the reach of the spouse's creditors. Although the spouses would no longer own all the assets in the limited partnership, as the general partners they would retain complete control over the partnership. Thus, if they were only 5% general partners, they would still control 100% of the partnership. Further, they would be entitled to compensation and other expenses for managing the partnership business.

Of critical importance-if the CPA spouse is ever sued-is that a successful creditor would be entitled only to a "charging order." This entitles the creditor to receive only the distribution (if any) that the debtor-spouse would receive as the general or limited partner; the order doesn't give the creditor any right to partnership assets or a voice in management or control. Partnership assets thus retain their protected status.

A family limited partnership has several advantages over other asset protection tools. If both spouses are vulnerable to lawsuit-a CPA and an MD, for example-setting up two funded revocable living trusts will not protect them. However, assets transferred to a limited partnership will be protected and the couple can maintain control as general partners.

There also are sound income and estate planning reasons to transfer assets to a family limited partnership. First, it allows a couple to shift income to children or other relatives through gifts of limited partnership interests. Income from these limited partnership interests is then taxed to the limited partners. If the parents together own 10% of the partnership and the partnership's income is $100, the parents would be taxed on only $10 of income. Once the interests have been given away, they generally no longer are in the couple's gross estate. Couples can take advantage of the gift tax provisions by giving $20,000 worth of limited partnership interests each year to a limited partner. These independent reasons for forming a limited partnership may help demonstrate there is no fraudulent intent on asset transfers to the partnership if this strategy subsequently is challenged in court.

FRAUDULENT CONVEYANCES

The steps outlined above afford maximum protection if implemented before lawsuits arise or creditors exist. If property is transferred to a trust after a judgment is rendered or a lawsuit begun, the transfer may be nullified as a fraudulent conveyance. There are two primary types of fraudulent conveyance.

First, a creditor may bring an action to void a debtor's conveyances made with intent to delay, hinder or defraud creditors. Intent can be difficult for creditors to prove, so courts sometimes find the necessary intent in "badges of fraud." These include

* The transferor's retention or possession of property or of an interest in transferred property.

* Transfers between family members for allegedly antecedent debt.

* Transfers made while creditors are pursuing the transferor or threatening to sue him or her.

* Lack of or gross inadequacy of justification for the conveyance.

Depending on state law, even those who became creditors after a transfer may be protected.

Second, conveyances and gifts made by someone claiming insolvency or near insolvency are fraudulent in relation to existing creditors whether or not the debtor intended to defraud. Although state law in Virginia, for example, does not define "insolvency," such transfers typically include those for less-than-fair consideration when the debtor fails to retain sufficient assets or capital to cover future business needs or debts. Suits by creditors in the state seeking to avoid a transfer without consideration or one made upon marriage must be brought within five years from the date the transfer was recorded or, if not recorded, five years from the date the transfer originally should have been discovered. Thus, the longer the assets are held in trust or in a family limited partnership, the better the chance of protection.

The term "existing creditors" is construed broadly. They include those with obligations against the debtor when the conveyance was made even if their claims haven't been taken to court or decided upon until after the conveyance. In one Virginia case, the court said, "A contingent liability is as fully protected against fraudulent and voluntary conveyances as a certain and absolute claim, and whoever has a claim arising out of a preexisting contract, although it may be contingent, is a creditor whose rights are affected by such conveyances and can avoid them when the contingency happens upon which the claim depends."

Applying this concept, the court voided the gift of a diamond ring from a debtor to his wife in 1978, a month before he was sued under an indemnity agreement and three years before judgment was entered.

Accordingly, it's important to transfer assets before judgment, suit or creation of creditors. If transfers are not made beforehand, some have suggested that the family limited partnership can be used to circumvent the fraudulent conveyance statutes. The theory has evolved from cases that hold that transferring property to a corporation in exchange for stock equal in value to the property transferred is not fraudulent because the stock is available for creditors. In other words, because only the manner in which title to the property is held has changed, the transferor has maintained the same net worth. Thus, the debtor-transferor is not insolvent.

Creditors thus would have to prove intent to defraud. This could be difficult if the transfer can be justified for independent reasons, such as estate planning and income tax shifting. In one case, U.S. Shoe Corp. v. Beard, no fraudulent intent was found when the debtor transferred property to a newly formed corporation for business purposes. Under this strategy, however, instead of transferring property to a corporation, the transfer would be to a family limited partnership because a partner's creditor is limited by statute to a charging order. Under the laws of many states, a limited partner's creditor is treated the same as an assignee and thus has no vote in the partnership and no interest in its management or assets. The creditor can receive only the distributions to which the debtor-partner would be entitled (up to the amount of the debt). Even then, however, the partnership agreement can allow the general partner to reinvest partnership distributions in the partnership for reasonable business needs. Accordingly, the creditor may be forced to wait for distributions while reporting and paying income tax on money not received. Similarly, creditors of limited partnership general partners have no rights to partnership property to satisfy their claims against general partners.

The above interpretation of the law is not foolproof. Nevertheless, for those already subject to suit and seemingly without other recourse, the plan may insulate assets from creditors. As the court said in U.S. Shoe Corp. v. Beard, as "long as the debtor does not conceal or destroy assets.... the fact that his conduct imposes greater impediments upon the creditors' ability to reach those assets does not amount to an intent to defraud, delay, or hinder such creditors. " Further, if the debtor is not insolvent at or after the transfer, there is no ". . presumption that the transfer was made with the intent to delay, defraud or hinder such creditors. "

Of course, this plan can succeed only if the debtor is solvent before assets are transferred into the family limited partnership. If the debtor is insolvent, he should consult a creditors' rights or bankruptcy specialist.

TIMELINESS IS KEY

The boom in litigation against professionals makes it imperative that CPAs and many of their clients consider how to structure their assets to protect them from creditors. By doing so, important income tax and estate planning goals also can be realized. The law already provides the legal entities to enable individuals to protect assets, so CPAs need only implement the best plans for themselves or their clients before a threat to personal property arises. n TIPS FROM A LITIGATOR ON AVOIDING MALPRACTICE LIABILITY

Edward F. Mannino, chairman of the Philadelphia-based law firm Mannino & Associates PC, was named one of the nation's top trial attorneys by the National Law Journal in 1990 for his "enviable record in corporate defense and lender liability litigation." He has represented the plaintiff in litigation against CPA firms. In a recent Journal interview, Mannino drew on his experience to caution CPAs against practices that could make them more vulnerable to malpractice actions.

When asked how a CPA firm can avoid malpractice litigation, Mannino answers with a smile, "It's simple. Follow the rules." He then explains that the profession has built a body of detailed standards for audit engagements. "If an auditor follows all of those standards," he says, "there should be no problem later on."

Mannino notes that sometimes, however, the rules are bent in the rush to complete an engagement on time and within budget. He says firms performing audit engagements should be particularly careful to adhere to the following practices.

* Follow the audit plan and document each step. Mannino says, "If you look at an audit plan and there are steps that are not checked off, or steps not taken, that can be construed as negligence." Therefore, it is very important to have someone review the workpapers to make certain that all steps in the audit plan have been taken and have been reviewed by a partner.

* Address and respond to the concerns of the staff accountants on the engagement. When a staff member addresses memoranda to an audit manager or a partner on an issue, the concerns should be investigated, a determination made and a written response sent to the staff member.

Mannino recalls a case in which he represented the Federal Savings and Loan Insurance Corporation, which is now part of the Federal Deposit Insurance Corporation, against a CPA firm. The CPA firm had been auditing the financial statements of a savings and loan institution for 15 years but had not uncovered the fact that the president of the institution had been embezzling funds for the last 7 years. However, a firm accountant had noticed weaknesses in internal controls and had expressed these concerns in a memorandum to the audit manager. But the firm never responded adequately. During litigation, the plaintiff used this omission as one tool to demonstrate recklessness.

* Be certain budgeted time is actually spent on assigned audit tasks. If time allocated in the audit plan is not actually spent on the job, the reasons for the change should be documented. Similarly, if a task must be reassigned to a staff member not thoroughly familiar with the company, the reasons should be documented. Without proper documentation, says Mannino, it can be argued that such changes in the audit plan constitute negligence.

To illustrate the importance of following budget guidelines in the audit plan, Mannino explained how some small savings and loan associations hid illegal loan activity by setting up false accounts. In an audit, confirmations for the false accounts were sent to a post office box. A qualified audit staff devoting the proper amount of time to confirmations would almost certainly question the reasons for sending such a high percentage of confirmations to a few post office boxes. However, a staff with limited experience and under time constraints might overlook the situation. WHERE THE RISKS ARE Mannino believes the growth in lawsuits against CPA firms may peak this year. He predicts some states may adopt stricter interpretations of the rules defining the conditions under which some groups are able to bring suits against CPA firms. He also thinks some courts, in determining whether a proposed lawsuit has merit, will start to look at the functions CPAs perform. In his view, judges will give less weight to suits involving engagements performed for private individuals than those performed for the public at large.

Still, he cautions CPAs to be particularly conscientious when performing engagements in the following areas:

n Any audit of a financial institution. Mannino points out there has been "a lot of insider corruption uncovered" and he expects more to surface. He says that unless auditors are completely familiar with the latest standards on financial institutions and have a sound working knowledge of the industry, "they could get hurt."

* Forecasts or tax opinions for real estate projects. Mannino says, "Frankly, I wouldn't give any forecasts on a real estate project in this environment. In a typical deal, the developer proposes to build or remodel a project, and the CPA firm signs off on income forecasts for the property perhaps five years out. I would not do that. It's just too risky. I would audit the books of the company, but let it end there."

* Not-for-profits. Mannino notes both hospitals and universities have largely become money-losing operations in the past several years, and the recession has aggravated the situation. He believes a problem could easily develop at some point with either a hospital or university bond issue. It is common practice for a CPA firm auditing a university's financial statements to also audit a hospital attached to it, even though each has a highly specialized accounting system. In such a system, Mannino believes a CPA firm can get caught in the middle if its auditing staff is not intimately familiar with both industries.