In many small businesses, the distinction between business assets and personal assets is somewhat blurred. In dentistry and other medical professions, in which malpractice suits are a consideration, this ambiguity can expose practitioners to a high risk of liability. If malpractice insurance is insufficient, one lawsuit could derail a dentist’s long-term financial plan and jeopardize his or her family’s financial stability. With liability exposure, as with other types of risk, an ounce of prevention is worth a pound of cure. However, dentists, like many other professionals, often fail to develop an asset-protection plan until it is too late and a lawsuit is upon them.
In this article, we discuss techniques that dental professionals can use to minimize their liability exposure and protect their personal assets.
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ASSET-PROTECTION PLANNING
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Contrary to popular belief, asset-protection planning is not a way to exploit legitimate creditors or hide assets. The purpose of asset-protection planning is to segregate and insulate liabilities from valuable assets to the maximum extent allowed under the law. For instance, a person may conduct a lawful asset freeze by shifting valuable assets to other family members (through a trust or otherwise) at a time when the debtor has no existing or foreseeable claims.1 Again, asset-protection planning is not meant to take unfair advantage of legitimate creditors. A clear line exists between legal asset-protection planning and criminal actions that are meant to defraud creditors. For that reason, it is essential to have an attorney guide dental professionals through the process.
The purpose of asset-protection planning is to segregate and insulate liabilities from valuable assets to the maximum extent allowed under the law.
When deciding whether asset-protection planning is necessary, and to what extent, dentists should consider some essential factors:
- – the degree of exposure to risk of liability;
- – the type of assets owned;
- – one’s total net worth;
- – one’s tolerance for complications and risk associated with asset-protection planning.
The more assets a dentist owns and the more risk exposure he or she has, the more likely that asset-protection planning may be necessary.
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ASSET-PROTECTION STRATEGIES
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Professionals often believe that a malpractice claim represents their principal exposure to risk. Horror stories abound of liability judgments or settlements that exceed liability insurance amounts and that require the professional to tap into family assets. In fact, however, wealth is lost more often to former spouses, business partners, bad investments, bad tax planning or a combination of these. Even losses due to these other factors can be mitigated with careful planning. For instance, prenuptial and postnuptial agreements can make it more difficult for a divorcing spouse to receive certain assets. With respect to poor business decisions and poor investments, we cannot overemphasize the importance of conducting a comprehensive due-diligence review of each business or investment opportunity (for example, conducting research, consulting with advisers, assembling the necessary legal agreements). A comprehensive asset-protection plan typically consists of multiple components and must address all of these risks. Strategies discussed below focus primarily on limiting exposure to third parties, not necessarily to a divorcing spouse. The following strategies are not exhaustive.
Documentation.
One of the best actions a dental professional can take to better serve patients and avoid malpractice claims is to refine examinations and office procedures. Proper procedures and documention help to ensure that clinicians deliver appropriate care. Well-defined and executed business policies and procedures, as well as a solid business structure, also can provide a strong foundation to diminish the potential for liability.
Lifetime gifts.
Many traditional forms of estate planning may be used effectively as asset-protection techniques. Gifts of property to a spouse or child (not intended to defraud creditors) can achieve both asset-protection and estate-planning goals. A gift-giving program should not, however, be implemented without proper estate-planning coordination.2
Insurance coverage.
Adequate insurance coverage remains a key component of asset-protection planning. We recommend that dentists periodically review with their insurance carrier the adequacy of malpractice insurance. Dental professionals should make sure not only that they have sufficient malpractice insurance, but that all of their other insurance policies—including life, disability, automobile, homeowner’s, umbrella coverage and coverage for employee-related claims—are adequate. When making decisions with respect to insurance, dentists should consider the strength of the carrier, the amount of insurance coverage and the premium cost.
Exempt assets.
By simply knowing what is protected by law, dental professionals can take advantage of the simplest form of asset-protection planning: ownership of exempt property that state law considers unreachable by creditors. Certain assets have considerable built-in asset protection. Each state’s laws define exempt and nonexempt property. For instance, in certain states with "homestead" exemptions, such as Texas and Florida, some portion or all of the value of a home may be exempt from creditors’ claims.
Retirement plans also have substantial built-in asset protection as a result of federal and state laws. Federal law provides that most creditors cannot attach assets held by qualified retirement plans, including pension, profit-sharing and 401(k) plans.3 Plans for self-employed people and individual retirement accounts also may be protected from creditors, depending on state law. In addition, life insurance may be exempt property, depending on one’s state of residence (much like the homestead exemption). Given states’ differing treatment of certain assets, dental professionals must consult a knowledgeable attorney in their state of residence.
Retirement plans have substantial built-in asset protection as a result of federal and state laws.
Entity protection.
Many dental practices have inherent liability risk. By placing the practice into an entity that limits the liability, such as a limited partnership (LP), a limited liability company (LLC) or an S corporation, a dentist can take advantage of certain asset-protection benefits associated with these entities. (We should point out, however, that putting one’s practice in an LP or LLC format may lessen the practice’s attractiveness for selling purposes, because there may be restrictions on creating new partners, as well as potential conflicts between old and new partners.)
First, the creditor’s relief is limited to the assets held within the business, thereby preventing the creditor from pursuing a professional’s personal assets. Second, the only way a creditor can attach the assets of the entity is through a charging order. A charging order limits a creditor’s remedy to a lien against the distributions from the entity without giving the creditor any voting or management rights. Because the debtor frequently remains in control of the entity and can defer distributions, the creditor has no way of enforcing a judgment against the debtor’s LLC or LP interests or assets owned by these entities. In essence, the creditor must wait for the entity to make a distribution.
The entity may even succeed in passing along income tax liability to the creditor. As flow-through tax entities, LPs and LLCs do not pay income tax. Rather, the partners or members individually report any income generated, regardless of whether any income is distributed by the entity. The Internal Revenue Service (IRS) has stipulated that as long as a charging order is in place, the judgment creditor takes the place of the debtor for all tax purposes, including the recognition of income.4 Therefore, the entity could retain all income and issue an IRS Schedule K-1 to the judgment creditor. The Schedule K-1 requires the creditor to report the "phantom income" on his or her tax return.4 As with any asset-protection planning strategy, however, nothing is ironclad, and dentists should discuss the advantages and disadvantages of entity protection with their attorneys.
Spendthrift trusts.
Leaving assets to a beneficiary in trust, commonly known as a "spendthrift" trust, has been the traditional method of shielding assets from the claims of the beneficiary’s creditors.5 A spendthrift trust is created for the benefit of a person, but it gives an independent trustee full authority to make decisions with respect to how the trust funds may be spent for the benefit of the beneficiary. The trust laws of nearly all states authorize the formation of a trust with spendthrift provisions, which protect, to one degree or another, the trust’s assets from creditors and spouses of the beneficiary. (Spendthrift trusts usually contain language stating that until actually distributed to the beneficiary, the principal or income of the estate cannot be used to satisfy any debt, contract or engagement of any beneficiary and cannot be subject to assignment, transfer or anticipation.) The beneficiary of such a trust generally is prohibited from anticipating or assigning any of the trust’s assets to creditors. As a result, creditors generally cannot attach the funds in the trust, and the funds are not actually under the control of the beneficiary. Typically, the beneficiary of a spendthrift trust is not the creator of the trust.
Although a spendthrift trust may provide protection, traditionally in the United States, the rule of law has been that a self-settled spendthrift trust—that is, a trust created and funded by a person who also is a beneficiary of the trust—does not protect the trust’s assets from creditor claims against that person. Dental professionals who would like to protect their own assets further have two options for creating a self-settled trust: a domestic asset protection trust (DAPT) and an offshore asset protection trust (OAPT).
Domestic asset protection trusts (DAPTs).
Several states (Alaska, Delaware, Nevada, Oklahoma, Rhode Island, Utah, Missouri, Tennessee and South Dakota) have enacted DAPTs within the last decade. DAPT laws within those states typically require that a trust be subject to that state’s laws, that at least part of the trust’s assets be held in the state, and that part of the trust’s administration also occurs there.6 We should point out that DAPTs have associated risk in that their constitutionality (and, therefore, their effectiveness) is unclear, because the statutes have not yet been tested in the courts.
Offshore asset protection trusts (OAPTs).
No discussion of asset protection is complete without mention of offshore planning. OAPTs seek to take advantage of cross-jurisdictional issues, both in conflicts of law and enforcement of judgments. At one time, financial advisers, attorneys and accountants believed that the only effective method for protecting assets was to transfer them offshore into a foreign-asset–protection trust or a foreign corporation. Much has changed in this area of law since the September 11th attacks, which brought heightened scrutiny of financial transactions, particularly those involving offshore havens. Offshore planning for U.S. citizens and other legal residents now involves extensive reporting and filing obligations. Since 2001, the IRS has been aggressively pursuing offshore tax shelters, and U.S. judges have been imposing jail time until money is brought back to the United States for debt payment.7 Given the hostile environment for offshore planning, it is critical that practitioners properly report to the IRS all offshore transactions.
It is important to keep in mind that with respect to both DAPTs and OAPTs, one generally must relinquish complete control over the assets that need to be protected. DAPTs have gained favor in recent years over OAPTs, because people can rely on the political and economic stability of the United States while avoiding the uncertainties involved in transferring property to a jurisdiction that has a different language, political system, legal structure and currency, as well as the rigorous reporting obligations required for OAPTs.6 Nevertheless, as we noted above, DAPTs and OAPTs both carry significant risk, complexity, cost and loss of financial control. Therefore, neither of these techniques generally makes sense for most dental professionals, who have a low-to-moderate risk of liability.
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FRAUDULENT TRANSFER
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Because of the widespread misunderstanding about the purpose of asset protection, any discussion of these techniques must include a discussion about fraudulent transfer. Asset-protection planning, like tax planning, must be done within the parameters of certain rules—in this case, the laws of fraudulent transfer. Most fraudulent transfer issues arise when people begin planning only after they have incurred debts or received an unfavorable judgment. Much like life insurance, asset-protection planning needs to be implemented before the need arises.
Intentional fraudulent conveyance.
Fraudulent transfers generally come in two forms. The first is intentional fraudulent conveyance, whereby a debtor makes a transfer with the intent to defraud, hinder or delay his or her creditors.8 For example, if a dentist has reasonable anticipation that a judgment will be ordered against him or her and then transfers assets to a third party with the intent to defraud creditors, a judge may deem such a transfer to be an intentional fraudulent conveyance and order that the transaction be unwound.
Constructive fraudulent onveyance.
The second form of fraudulent transfer is the constructive fraudulent conveyance, whereby a debtor transfers property without receiving "reasonably equivalent value" in exchange for the transfer and, therefore, is insolvent at the time of the transfer, becomes insolvent or is left with unreasonably small capital to continue in business as a result of the transfer.9
A judge’s determination of whether an action is a fraudulent transfer is highly fact-intensive. Intent is not always necessary, and, under the law, intent easily could be inferred. Adkisson and Riser1 succinctly described the law regarding fraudulent transfers: "You can’t do anything which would impair the rights of your unsecured creditors; if you do, then the courts will simply ignore what you have done." When we add to this the possibility of criminal charges, fines, restitution orders, probation and/or incarceration, it becomes clear why it is essential to have an attorney’s guidance throughout the asset-protection process.
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CONCLUSION
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When contemplating asset-protection planning, dental professionals should keep in mind a few key considerations. First, do not procrastinate; asset-protection planning is useless once a claim arises. Second, think beyond malpractice concerns. Wealth is lost more often to former spouses, business partners, bad investments, bad tax planning or a combination of these. Third, asset-protection planning should not be done in a vacuum. Rather, it should be part of a holistic family wealth plan that takes into consideration estate planning, tax planning and financial planning. Finally, asset-protection planning should be implemented only under the guidance of an attorney well-versed in the topic. Trying to save a few dollars during the planning process could be costly later if the planning is not done appropriately.
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ASSET-PROTECTION PLANNING
