When contemplating a plan for asset protection, practitioners and their clients often focus on the most exotic approaches, such as foreign and domestic trusts, transmutation agreements,1 and limited liability companies. Indeed, they often overlook the fundamentals of asset protection, including exempt assets--those that cannot be seized by creditors because they are exempt under federal or state law. Any asset protection plan should begin with an inventory of the client's exempt assets, which should in turn lead to an inquiry whether the client's nonexempt assets can be converted into exempt assets.
For debtors whose assets are in California, exempt assets offer powerful planning opportunities. Still, whether a particular asset is exempt from a creditor's claims is often subject to a jumble of rules, exceptions to rules, and ambiguities. Practitioners seeking to address a client's exposure to outstanding and potential claims must be aware of the applicable federal and state exemptions.2
Homestead Exemption. The best known but least effective exemption is the homestead exemption. At $50,000 for a single person, $75,000 for a married couple, and $150,000 for a homeowner 65 years or older or disabled,3 the California homestead exemption is simply not large enough to shield most Southern California residences from seizure, even in the current economic climate. As a result, homeowners often engage in "equity stripping"--loading their residences with debt up to the homestead amount. For example, a married couple who are subject to claims by creditors and who own a home with a fair market value of $500,000 might encumber the residence up to $425,000, on the assumption that the $75,000 homestead exemption will deter a creditor by making the residence worthless to any purchaser in a foreclosure sale. But equity stripping will deter only the most impatient creditor. A creditor who can wait will record the judgment in the county in which the residence is located, at which point the judgment will become a lien on the residence.
The homestead exemption might deter the creditor today or until next year, but with every passing year the homeowner's equity will increase, either from natural appreciation or from the reduction in the principal. In the interim, the debtor cannot sell, refinance, or even devise the residence to an heir without first retiring the judgment. What is worse, the judgment will bear interest while the debtor will effectively make mortgage payments for the creditor. Neither the homestead exemption nor equity stripping will work to protect a debtor's house from a creditor willing to bide its time.
Qualified Retirement Plans. If the homestead exemption is the weakest statutory exemption, then the most powerful exemption is the Employee Retirement Income Security Act of 1974 (ERISA)'s4 protection of the liquid assets in a pension, profit-sharing, or 401(k) plan. For a plan to be qualified and enjoy substantial tax benefits as a result, the plan must contain an antialienation clause that prohibits the involuntary assignment or transfer of plan benefits to anyone other than the plan participant.5 The exemption is absolute, covering contributions to the plan made by both the employee and the employer--and applies even if the debtor is in control of the plan and has the ability to make immediate distributions from the plan.6 Most significantly, because the antialienation requirement is a creature of federal statute, it will trump any state statute prohibiting fraudulent transfers.7
Does this mean that an individual may cavalierly transfer assets into a qualified plan with the actual intent to "hinder, delay or defraud" a creditor and thereby shield the transferred assets from his or her creditors? In most cases, the answer is yes.
Those searching for exceptions to ERISA's general rule permitting a debtor to transfer assets into a qualified plan and thus place those assets out of the reach of creditors will not find very many. One involves ERISA itself, which provides an exception for a divorcing spouse. It authorizes a court to issue a Qualified Domestic Relations Order (QDRO) directed at the plan administrator to facilitate an award for spousal maintenance, child support, or the division of property.8 As a result, qualified plan assets may become subject to division between divorcing spouses to the same extent as other marital assets.
Another implicates the U.S. Constitution's supremacy clause. While the supremacy clause enables an ERISA antialienation clause to trump any state creditor's claim,9 the supremacy clause does not do the same for federal claimants. Thus, the Federal Debt Collection Procedure Act takes precedence over an antialienation clause.10 For example, nothing in ERISA prevents the IRS from seizing a taxpayer's interest in a qualified plan to collect federal income taxes. Nevertheless, the IRS has ruled that while it may levy upon the ERISA account of a plan participant, the plan administrator need not respond to the levy until the participant has a right, under the plan, to receive distributions.11 However, if the participant has a right to elect immediate distributions, the IRS may seize the participant's account, even if the participant has not made such an election.12 Further, while the supremacy clause may not bar the IRS from seizing the ERISA account of a taxpayer, it will bar the Franchise Tax Board--or any other state tax collector--from doing so.13
The principal exception to the general rule prohibiting the alienation of ERISA plan accounts applies to "owner only" plans, which are qualified plans whose only participants are the owners of a business (and their spouses). In a typical example of these plans, a doctor forms his or her own personal corporation, which establishes a qualified pension or profit-sharing plan with the doctor as the only participant in the plan.
The IRS and the U.S. Department of Labor together administer ERISA. A plan having only owner-participants will not disqualify the plan for tax purposes. The company will be free to make contributions to the plan on the sole owner's behalf and obtain immediate tax deductions when doing so. But the Labor Department has long taken the position that ERISA exists to protect common law employees, and thus a plan whose only participants are owners and their spouses is not an ERISA plan. Accordingly, the antialienation protection of ERISA does not apply to owner-only plans.14 Moreover, courts have consistently upheld the Labor Department's position.15 However, if the plan has just one nonowner participant, then the plan is fully qualified, and all participants, including the owners and their spouses, are fully shielded by the antialienation provision.
If the plan had common law participants when the contributions were made but no longer does--a fairly typical situation--the Labor Department's position may have grave consequences. Whether the owner of the corporation discontinued the plan or terminated the corporation's employees, it appears that any plan without nonowner participants is unprotected, regardless of whether the plan once had common law employees. If the doctor who formed a one-person corporation wants to assure that the plan assets are protected, the doctor simply needs to hire one common law employee and enroll that employee in the plan.
For those who do not have a qualified plan, the planning opportunity is obvious: create one. There is nothing that prevents a person, even one facing an adverse judgment, from creating a qualified plan and transferring large sums of otherwise nonexempt assets into the plan, thus shielding those assets from creditors--provided that the plan has at least one nonowner participant. The annual amount that an employer may contribute to a qualified pension plan is based on factors such as the participant's age and the amount deemed necessary (by the plan's actuaries) to fund the retirement benefit prescribed by the plan. For someone who is old enough, the amount that he or she can shield from creditors is substantial.
A person who does control a qualified plan might be tempted to stuff assets into the plan in excess of the deductible amounts prescribed by the plan. This strategy is not advisable. For one, a contribution not permitted by the plan may be deemed to be void ab initio, resulting in it not being subject to the antialienation clause.16 What is worse, any excess contribution willfully made by an owner-employee will result in all plan contributions by the owner-employee being deemed distributed. Once distributed, they are not protected.17
There is one last, but critical, limitation to the efficacy of ERISA plans. Although the protection these plans provide to plan assets is almost complete, they provide no protection once the plan makes a distribution to the participant, even if the participant segregates the distribution and can trace the assets to the plan. This means that by transferring assets to a qualified plan, a person may not be able to access those assets for many years. But this is usually a better result compared to letting those assets be seized by creditors.
Individual Retirement Accounts. IRAs are retirement plans that afford many of the same tax benefits as ERISA retirement plans. But they are not creatures of ERISA, and hence do not provide the participant with the same federal law protection as ERISA plans.18 California, however, does provide a limited exemption for IRAs. Funds contributed to IRAs are exempt "only to the extent necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor, taking into account all resources that are likely to be available for the support of the judgment debtor when the judgment debtor retires."19
The inquiry as to whether an IRA is exempt is thus determined on a case-by-case basis. It is clear, however, that the exemption is designed to permit the individual to keep body and soul together upon reaching retirement; it is not intended to permit a retiree to maintain the lifestyle he or she enjoyed prior to retirement. Whether, and to what extent, an IRA account is "necessary" for retirement is determined by two criteria:
o Is there a present need for the funds?
o Can the IRA holder replace the funds if the IRA is forfeited to a creditor?20
Thus, in one case, a court allowed a 60-year-old in poor health and facing the possibility of being laid off from work to keep a $167,000 IRA despite a $120,000 salary.21 However, in another case, a 55-year-old working physician with no dependents and $5,000 in monthly income from an ERISA plan and Social Security could not keep a $270,000 IRA account.22 Since one of the criteria is whether the individual will be able to replace the IRA, it appears that the key factor is the person's age. It is highly unlikely that someone in his or her thirties could rely on the exemption.
IRAs are superior to ERISA plans in one respect: While ERISA protects the account only while the funds are in the plan, an IRA is protected even after the funds have been distributed, provided that the IRA owner can trace the funds to the IRA.23
Private Retirement Plans. To complicate matters further, California provides an unlimited exemption for "private retirement plans." Under Code of Civil Procedure Section 704.115(b), "all amounts held, controlled, or in the process of distribution by a private retirement plan, for the payment of benefits as an annuity, pension, retirement, allowance, disability payment or death benefit are exempt." The problem is that the statute does not define a "private retirement plan." Fortunately, the courts have filled in some of the blanks.
Clearly, a "private retirement plan" is not a plan governed by ERISA. However, a private retirement plan must arise in an employment context; someone cannot simply throw a bundle of otherwise attachable cash into an account labeled "private retirement plan" and hope that the cash will be exempt. The plan must be in writing and designed and used "principally" for retirement purposes.24 The statute permits loans to participants, provided that the loans are made in accordance with the plan's procedures, evidenced by promissory notes, and charge a market rate of interest.25
A California private retirement plan does not suffer from some of ERISA's limitations. For one, the plan is not required to have at least one nonowner participant. Thus, an ERISA pension plan that fails due to the fact that it has only owner-participants may be saved--in its entirety--as a California private retirement plan. It is unlikely, however, that an ERISA profit-sharing plan would qualify as a private retirement plan unless the plan prohibited distributions prior to retirement. Second, a private retirement plan is not subject to ERISA's funding limitations. The plan participant can place any amount in a private retirement plan as long as the plan arises in an employment context and is designed and used principally for retirement.
The Ninth Circuit recently shed considerable light on the metes and bounds of a private retirement plan. In In re Rucker,26 the court held that the exemption would survive even if one of the plan owner's motives was asset protection, provided that the owner could also prove that retirement planning was the principal object in creating the plan. Moreover, all the "facts and circumstances" would determine which was the predominant motive.
In Rucker, the private retirement plan was a failed ERISA plan because the debtor was the sole participant of the plan. Even worse, the debtor had intentionally overfunded the ERISA plan and apparently had filed fraudulent reports with the IRS. All the facts and circumstances militated in favor of a finding that asset protection--not retirement planning--was the principal motivation for the plan. Since all the facts and circumstances must be considered, the fact that no withdrawals or loans had been made from the plan was not a safe harbor. Conversely, if withdrawals or loans are made, it is not fatal to the exemption.
The lesson of Rucker is the same one that asset protection planners preach with respect to all forms of asset protection: The earlier the plan is created vis-à-vis the making of the claims against the owner, the more likely that the plan will survive scrutiny. Otherwise, the contributions will appear to be made merely to protect assets and not for retirement purposes as required.
While ERISA affords no protection once plan assets are distributed from an IRA or a private retirement plan, California does preserve the exempt nature of distributed assets, provided they can be traced to their exempt source.27 Assets from a fully exempt private retirement plan (or ERISA plan) that are rolled over into an IRA remain fully exempt and not subject to the IRA's "necessary for retirement" limitation, according to the court in McMullen v. Haycock.28 As a result, counsel must now determine the provenance of the IRA. If it began its life as a qualified plan or a private retirement plan, it is fully exempt. If it has always been an IRA, the exemption is qualified.
A private retirement plan can be a powerful asset protection tool, provided that the owner is willing to part company with the contributed assets until retirement. Like the decision to transfer funds to a qualified plan, if the choice is losing the asset to a creditor now or waiting until retirement to enjoy the asset, most will choose the latter.
Life Insurance. Whatever planning that is done with life insurance is usually done with a view toward reducing estate taxes, not keeping assets exempt from the claims of creditors. The principal estate planning tool is the irrevocable life insurance trust (ILIT), a device that removes the death benefit of life insurance from the estate of the insured (and the insured's spouse) at a relatively low gift tax cost. If the ILIT is established to remove the insurance from the taxable estate, the owner of the policy may not be the trustee of the ILIT or otherwise retain any incidents of ownership over the policy. If the ILIT is established early enough (before creditors assert their claims), the attributes inherent in every ILIT will likely shield the life insurance policy, as well as the policy proceeds, from creditors.
Aside from ILITs, California generally exempts life insurance from creditors. Under Code of Civil Procedure Section 704.100(a), "[u]nmatured life insurance policies (including endowment and annuity policies) but not the loan value of such policies, are exempt without making a claim." A cursory reading of this statute leads to the conclusion that life insurance policies, endowment policies, and annuities are all exempt. But courts have ruled that to qualify for the exemption, the life insurance contract must be one that creates an estate in favor of the insured upon the insured's death. This is the classic term or whole life policy that features a death benefit.29 Thus, if a person takes a large sum of otherwise nonexempt cash and uses it to purchase an annuity contract that provides for the payment of regular annuity payments over that person's lifetime, the annuity payments will not be exempt.
As the code section makes clear, the insurance policies are exempt, but the "loan value"--that is, the cash surrender value--is not.30 Nevertheless, California makes it almost impossible for a creditor to access the loan value. By statute, the loan value of an unmatured life insurance contract is exempt from execution.31 If execution is not available, a creditor trying to seize the loan value can perhaps move for a turnover order or an order requiring the policy holder to exercise his or her right to borrow on the policy. But if the policy has been transferred to the trustee of an ILIT, even these remedies are probably not available. Moreover, if the creditor has a money judgment, no procedure is available to assist the claimant in accessing the cash value.32
The purchase of life insurance, and the transfer of the policies to a trustee under an ILIT, can be a powerful asset protection tool. For those willing to purchase a policy that provides for a death benefit--a classic life insurance policy--liquid assets that might have been easily attachable are suddenly free from the claims of creditors.
If the insured dies, and the life insurance becomes cash, the insurance proceeds that are now in the hands of the beneficiaries remain exempt, but only to the extent "reasonably necessary" for the beneficiaries' support.33 If the cash had not been used to purchase life insurance, the decedent's creditors could have proceeded against the estate. But this fact provides little opportunity for planning. Most view dying as too aggressive an asset protection technique.