Attorneys who offer estate planning and business succession planning services are not just in the business of passing assets to the next generation. We are in the business of helping to protect those assets too. Asset protection involves ensuring that as many assets as possible are outside the reach of creditors and the bankruptcy courts.
While bankruptcy is sometimes necessary and/or the best option for a fresh financial start, it can expose hard-earned assets to seizure and liquidation by the bankruptcy trustee. It is not always possible to predict whether you (or one of your heirs or beneficiaries) will need to file for bankruptcy. But it is possible to take asset protection measures just in case.
Bankruptcy laws provide for certain types and amounts of properties to be “exempt,” placing them outside the reach of the bankruptcy trustee. In addition, there are certain strategies that are “exemption-like,” which end up offering similar protection.
For many individuals, their interest in a business is one of their most valuable assets, not only from a financial standpoint, but in terms of personal investment and a legacy they hope to leave. What is the best way to protect an interest in a Limited Liability Company (LLC) from bankruptcy?
In general, making the LLC’s operating agreement “executory” is the best way to provide protection in the event of one member’s bankruptcy. Section 541 of the Bankruptcy Code defines the extent of the debtor’s bankruptcy estate, which includes all of the debtor’s legal or equitable interests as of the beginning of the bankruptcy case. Any such interests become property of the bankruptcy estate despite any provision in an agreement or law restricting or conditioning transfer of that interest.
However, Section 365 of the Bankruptcy Code, which deals with executory contracts, carves out a possible exception. An executory contract is an agreement in which both sides still have obligations to perform, and if one side fails to perform, it would constitute a breach of contract. Such a contract, because it is not yet fully performed, is both a potential asset and a potential liability of the debtor. Section 365 governs executory contracts and may allow, in some cases, the enforcement of contractual restrictions on transfer. That would keep the interest in the LLC out of the bankruptcy trustee’s hands.
How do you ensure that your LLC’s operating agreement is executory? Make sure it sets forth the obligations of the members, such as to provide capital and labor; to participate in various activities of the LLC; to offer management services; and to provide personal expertise in the running of the business. The agreement should make clear the specific reasons why each member’s continuing involvement with the company is material to the company’s business purposes and objectives. These types of provisions must be thoughtfully considered and carefully crafted.
A spendthrift provision in a trust is a clause that restricts a trust beneficiary from being able to transfer their rights to future payments of capital or income from the trust to a third party. Creators of trusts, known as “grantors” or “trustmakers,” often utilize spendthrift provisions because they keep beneficiaries from wasting trust income and assets.
Spendthrift provisions can also help protect assets in an irrevocable trust from being seized by the trustee in a bankruptcy case. Section 541(c)(2) of the Bankruptcy Code states that “A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” In other words, if the debtor could not voluntarily transfer their interest in the trust, the bankruptcy trustee cannot reach that interest.
If you have any familiarity with the bankruptcy process, you already understand that fraudulent or preferential transfers of assets to keep them from being counted in the bankruptcy estate are forbidden. For example, you cannot repay a $10,000 loan to your brother or sell your classic Mustang convertible to your best friend for a dollar right before filing bankruptcy.
But if you have income that is already exempt under bankruptcy law, it can be argued that transferring it into an asset protection vehicle such as an Ohio Legacy Trust would not be a fraudulent transfer, as the income would not have become a part of the bankruptcy estate anyhow. Transferring that exempt income into a protected asset can offer broader protection than just exemption from bankruptcy.
What types of income are exempt? Benefits such as workers compensation benefits, unemployment benefits, Social Security retirement or disability benefits, and certain veterans’ benefits and Black Lung benefits. In addition, the Consumer Credit Protection Act makes 75% of an individual’s net income exempt, meaning that it can be placed in an asset protection trust for further protection. This strategy could be especially beneficial for high earners.
The time to take these protective measures is long before bankruptcy becomes an immediate concern. If you are interested in learning more about using exemption-like strategies for asset protection for your business and family, contact an experienced Ohio estate planning attorney to schedule a consultation.