Don't let a lawsuit rob your heirs of their inheritance
Estate planning is about more than to whom your farm passes at your death. It is also about making sure you have an estate to live on and to pass on!
After the U.S., Japan is the second largest economy in the world. I recently heard there are more lawyers in West Los Angeles County than in all of Japan. Some might say we have a sue-happy society and too many “frivolous” lawsuits are filed. Others say it is trial lawyers who protect the little guy. But one thing I know: if you are on the wrong end of a lawsuit, and a court awards a large judgment against you, you can literally lose the farm because of one simple mistake, and it doesn’t even have to be your fault.
How to lose a farm in one simple step
The classic example of a lawsuit that wipes out your farm is personal injury. Some third party is hurt by the activities of you or your employees. The injured person sues you to recover compensation for their medical bills, lost income (if the injury kept them from working), and pain and suffering. We’ll call this a claim and the injured party the claimant.
It is important to note that you cannot put asset protection planning into place after a claim arises. Doing so is considered fraudulent, and can be worse than doing nothing at all. So, like death and tax planning, protecting your estate from claims means doing legal planning before something goes wrong.
Two kinds of asset protection
There are two primary types of protection. One is using legal entities to confine risks so that a claim won’t reach you or your assets. Think of this as “corking” the liability bottle. This applies to situations where you do not cause the injuries personally, but are somehow legally responsible. The second involves creating barriers between claims and your valuable assets. This is like building a moat around your castle. It focuses on the assets you want to protect, no matter where the claim comes from.
How a Claim Arises
Say you hire Tom to work for you during harvest. Tom is driving the combine down the road and fails to see a car that has the right of way. He runs into that car, causing serious injuries to its driver. The law allows the injured driver to sue the person who hurt them—Tom, who was driving the combine—and whomever Tom was working for at the time he caused the injury. This means the claimant sues you.
Tom has very few assets of his own, so he files bankruptcy and his life goes on largely unchanged. But you? You turn the claim in to your insurance carrier. If you’re lucky, the insurance company settles it for less than your coverage limits. Otherwise, the claimant gets a judgment against you for an amount exceeding your limits, and forecloses on your farm to pay the claim.
Bottle it up and cork the bottle
Incorporating your business (or forming a limited liability company) is one way to create some claim protection. But the protection created is limited, and probably not as effective as you think.
Imagine that before the accident described above occurred, you incorporated your operation and your corporation hired Tom. Now the claim would be filed against Tom and the corporation (his employer). Your corporation would be sued, but you would not be sued personally. You have “corked” the bottle, trapping the claim inside the corporation. If a judgment is awarded, the claimant can take the assets of your corporation. Assuming you hold few assets inside the corporation, you might not lose much at all. Assets that you own personally, that is, outside of the corporation, would generally be protected from that claim.
For this reason, some farmers operate as a corporation—perhaps holding machinery in the corporation, along with operating debt—but keep their farmland, home, and savings outside of the corporation. The liability is “corked” within the corporate bottle, away from your personal assets.
But, what if you were the one driving the combine? Even if you are working for your corporation, who gets sued? You were driving, so you get sued. The judgment is awarded against you and your corporation. Now the claim reaches all of your assets, whether they are inside or outside of the corporation. The corporation did not protect anything. The claim against you personally, for your own driving accident, cannot be corked.
How to build a moat
For claims against you personally, you must build protections ahead of time around assets, like a moat around a castle.
If a claimant files suit and gets a judgment against you, they are then permitted to enforce the judgment against anything you own (with a few exceptions, like retirement accounts and life insurance). To enforce the judgment, they foreclose on real estate or obtain a garnishment order against other assets.
You think, “OK then, I’ll put everything in my son’s name so I won’t own anything!” Or, “I’ll wait, and if I get sued then I’ll give everything to my son.” Neither will work unless you enjoy imprisonment, for reasons I don’t have space to explain fully. Just rest assured that simplistic solutions don’t exist.
The moat of choice for many is a limited liability company (LLC). An LLC can be formed under Illinois law, or under that of another state, like Wyoming or South Dakota, with somewhat stronger liability protection statutes.
Laws concerning LLCs say that if the members (owners) agree in their LLC operating agreement to certain restrictions on how and to whom they can transfer their shares (ownership), then the shares cannot be taken by a claimant either. Your claimant would have a right to take the income you receive as a member, but not to take the shares you own.
So, before any accident occurs, you form an LLC and deed your land to it. You are a member of the LLC, along with your spouse, and perhaps a small percentage is held by each child. You own the LLC, and the LLC owns the land. The claimant will find it much more difficult to seize your LLC shares (as compared to seizing your land if you had not formed the LLC to hold the land). You are in a better position to get the claimant to settle the lawsuit. The LLC forms a barrier—a moat—between your farmland and the claimant.
Advanced moat building
A wider barrier can be created by a combination of two entities. You transfer your LLC shares into a special asset protection trust that can be established in other jurisdictions, such as Delaware, Alaska, Nevada, or certain foreign countries. Your LLC owns the land. The asset protection trust would own your LLC shares. When a claimant sees this, they get very discouraged and are much more likely to settle for what they can get from your liability insurance.
Without question, using an LLC and an asset protection trust will seem complicated, and so long as your life is smooth and you never get sued, you may wonder if it is worth the hassle. If a claim arises, however, you will have your answer!
Wait and see planning
In recent years, a type of “wait and see” asset protection technique has developed using what are called “powers of appointment.” Using these powers of appointment still requires advance attention, so you cannot wait until a claim arises and then rush to your attorney to implement it. However, it can be included in fairly simple forms of estate planning, such as living trusts.
To use powers of appointment, you must have someone in your life whom you trust unreservedly. We’ll call him “Protector.” In your planning documents, you give the Protector broad power over the assets involved. The Protector has the power to give your assets away without asking or notifying you. At his or her discretion, the Protector could give the assets to your children, your spouse, or to trusts for them. The Protector could create an asset protection trust for you, and put your assets in the trust. Actions the Protector takes would have tax and estate planning implications, not to mention that they might leave you destitute!
Why would you ever give anyone such power? Well, what is this article about? If you get sued, the Protector could, after considering all the pros and cons of doing so, remove your assets from the reach of the claimant. If you personally did the same thing, it would be considered defrauding your creditors, but a Protector could do it for you, legally. For the right people who have the right kind of trustworthy person to serve as the Protector, including a Protector in your estate plan might be the ideal asset protection plan.
©2010, revised 2014, Curt W. Ferguson, all rights reserved. Compiled from articles originally published in the June and July 2010 issues of Prairie Farmer® magazine.