State Exemption Laws: Pitfalls to Avoid (Part 2)


Volume XIII – Number 2 – June 2004

© Donlevy-Rosen & Rosen, P.A.


Pitfalls To be Avoided – Part 2

INTRODUCTION. All states provide some degree of “asset protection” through their state exemption laws. Such laws shield certain types of assets, such as homestead, wages, annuities, life insurance and retirement funds from creditor claims. This issue of the APN is the second of two parts addressing the most frequent errors people make in attempting to implement asset protection on their own by using (or failing to use) state exemption laws.

BACKGROUND. As we mentioned in Part 1 (APN, Vol. XIII, No. 1), self-implemented asset protection often results in investments which provide neither the maximum return, nor optimal asset protection, and decisions that are often made without proper estate tax considerations. We reiterate, one should proceed with caution and utilize experienced counsel before attempting to utilize state exemption laws. Part 1 addressed five pitfalls: #1: Not Getting Advice of Experienced Counsel Before Using State Exemption Laws; #2: Not Considering What the Exemption Laws Offer; #3: Changing State of Residence; #4: Converting Non-exempt Assets into Exempt Assets at the Wrong Time!, and  #5: Titling the Asset Improperly. This issue will address five more pitfalls.

PITFALL #6: RELYING ON A STATE EXEMPTION WHEN OTHER INVESTMENTS OR STRUCTURES WOULD BETTER SUIT ONE’S GOALS FOR ASSET PROTECTION, ESTATE PLANNING AND INVESTING. Individuals residing in states which provide generous homestead creditor protection will often invest a substantial portion of their wealth in a residence. Often, they do this not focusing on the fact that the state law only protects the primary residence in the state in which they reside – so that any second home or investment property is fully exposed to creditor claims. Also, homestead exemptions typically cover only the residence (building), not the contents, such as furnishings. For example, in Florida, an individual may have unlimited value protection for the actual residence (assuming that it is on ½ acre or less in a municipality), but only $1,000 of the individual’s furnishings are protected. PLANNING TIP: to expand this protection, one might consider built-in furnishings. In addition, putting an inordinate proportion of one’s net worth in a homestead residence results in the loss of other investment opportunities. The real estate market is not always the best investment vehicle. Before taking advantage of an exemption, one should have the drawbacks and limitations of the exemption clearly explained by an experienced professional.

PITFALL #7: USING LIFE INSURANCE AND/OR ANNUITY CONTRACTS AS A PRIMARY INVESTMENT AND/OR ASSET PROTECTION VEHICLE.  In states which provide life insurance and/or annuity exemptions, individuals will place a disproportionate amount of their net worth in such vehicles. Life insurance policies and annuity contracts are often marketed as a method of investing assets with protection from creditors. However, individuals do not always weigh and are often unaware of the hidden costs of such vehicles – such as built-in commissions, termination fees, limited investment offerings (usually restricted to a limited number of proprietary mutual funds), and the inflexibility of such vehicles when compared with other protective vehicles, such as a properly implemented asset protection trust (APT) or a properly implemented APT in combination with a limited liability company (See, APN, Vol. X, No. 1). In addition, and very importantly, any investment or premium payment made once a threat of a claim exists is subject to attack on fraudulent transfer grounds – and may be undone by a court (See, APN Vol. I, No. 5 and Vol. IV, No. 4). The availability and the extent of the exemption with respect to cash value of life insurance during one’s life varies widely among the states and is limited to $4,000 of cash value in bankruptcy where the federal exemptions are applicable. Some states, like New York, New Jersey, and Florida, provide a more generous exemption; others do not. Alternatively, better protection for the insurance may be available by transferring ownership of the insurance to an irrevocable insurance trust, limited partnership, or limited liability company. Each of these provides additional impediments to creditors, such as spendthrift clauses and charging order limitations. Each of these can usually be used for estate planning purposes as a means of removing the assets from the individual’s estate. However, if a life insurance trust is used, it should be in place – that is fully executed – before the policy is acquired, and the policy should be acquired directly by the trust as the initial policy owner (and “applicant”). Also, if premiums are paid after a claim is asserted, the creditor may be able to recover the premiums paid. Before committing a substantial portion of one’s assets to an annuity or life insurance trust, the individual should speak to an experienced asset protection professional.

PITFALL #8: TITLING A LIFE INSURANCE POLICY IN A SPOUSE, CHILD OR OTHER FAMILY MEMBER. Individuals often purchase life insurance and make a family member the owner of the policy. The rationale for this action is that this will somehow protect the insurance policy for the spouse, child, or other family member. In states where life insurance is exempt, it is generally exempt as against the creditors of the insured – not the creditors of the owner. Thus, placing policy ownership in a family member exposes the policy (and any cash value) to the claims of such family member’s creditors. In addition, transferring title raises gift and estate tax issues.  Instead, if an individual has a  properly structured life insurance trust purchase a policy initially, or own it for 3 years before the death of the insured (individual), the insurance death benefit will not be included in the individual’s taxable estate and the death benefit will escape estate taxes. One should never transfer life insurance policy ownership directly to a family member; rather, a qualified attorney should prepare a life insurance trust to purchase the life insurance policy (or to hold existing life insurance policies).

PITFALL #9: PURCHASING OR OWNING A LIFE INSURANCE POLICY ON ONE’S OWN LIFE; MAKING ONE’S ESTATE THE BENEFICIARY, CAUSES THE LOSS OF PROTECTION OF THE DEATH PROCEEDS!  A state exemption law may only protect the death proceeds of a life insurance policy from the creditors of the insured if the proceeds are not payable to the individual’s estate (or to a trust obligated for the deceased individual’s debts). A few states also protect the proceeds from the creditors of the beneficiaries. If an individual’s estate is the beneficiary of his life insurance policy, the policy proceeds will be available to the creditors of the individual’s estate through the probate proceeding, and will also be included in the individual’s estate for the purpose of determining the gross taxable estate for estate tax purposes. On the other hand, if the individual were to have his life insurance trust purchase a life insurance policy on the individual’s life and make the trust the owner and the beneficiary, the death proceeds would not be included in his estate, and would not be reachable by the creditors of the individual’s estate. If one already owns a life insurance policy on his own life, and transfers ownership to a life insurance trust (and does not have his estate named as the beneficiary), he must survive 3 years from the transfer for the death benefit to be excluded from his estate for estate tax purposes.

PITFALL #10: INDIVIDUALS RELY ON TAX QUALIFIED RETIREMENT VEHICLES TO BE PROTECTED FROM THE CLAIMS OF THEIR CREDITORS.  Courts have chipped away at the guaranteed protection of various tax qualified retirement plans, and have created exceptions and limitations out of “thin air”. (See APN Vol. XI, No. 3). If one is an owner of, or a partner or a shareholder in, a business, one’s pension benefits may not be protected. One needs to take matters into his/her own hands. Following the asset protection rule of “removing the ability of any U.S. court to disrupt the individual’s planning”, protecting retirement plan assets can be effectively accomplished by causing the retirement plan to establish a single member offshore limited liability company (an LLC) governed by properly structured documents containing special protective provisions, so that at the critical time (when a creditor is trying to “get at” the retirement assets), no U.S. Court would have the power reach the retirement assets. For a more detailed description of such structure, see APN Vol. XI, No. 3. To be certain that one’s qualified retirement plan assets will be available for retirement enjoyment: don’t depend on a U.S. court to follow the letter of the law. Get competent, experienced counsel and properly protect your assets.

CONCLUSION. Use experienced, qualified legal counsel for effective exemption utilization.

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