ADVANCED USE OF STRUCTURES
Are your Assets Properly Protected?
Is your wealth foundation safe from creditors or lawsuit-hungry predators who’d eagerly plunder your wealth to “reap where they have not sown”?
You may be in for a rude shock …
Did you know:
- New South Wales is the third highest jurisdiction in the world for lawsuits per person, behind California and Texas in the USA? And Victoria is not far behind?
- The average person in NSW and Victoria gets sued 3 times in their lifetime?
- By using a partnership (the most common way accountants set you up), you can be liable for someone else’s debts, and there are better ways to do it?
- Your insurance may not cover you if you get sued (tip: if you haven’t read the fine print of your policy, you’re putting all your trust in the insurer)?
- As an employee, you can be sued for being careless (as confirmed by the High Court in 1996)!
These are sobering facts we face in the world today.
On this page, we’re going to teach you a few gold nuggets about protecting your wealth. But before we do, I want to emphasise the importance of protecting your assets by a relevant example.
You May Have Car Insurance. But Have You Insured Your Wealth?
Let’s think of it this way …
Do you own a car? And if so, do you have car insurance?
Why do you need car insurance? Is it because you expect to crash your car? Obviously not! Yet you want to ensure if you do meet with a nasty accident, you are protected, and won’t have to fork out $50,000 you don’t have. (Especially if you owe $50,000 to a car lease or finance company!)
It’s the same with health insurance. Most people don’t expect to get cancer, for example. Yet bad things happen to good people, as they say. And once you have cancer, it is very hard to cure it.
Similarly, once you have financial “cancer”, it’s very difficult (and ridiculously expensive) to fix it.
You see, there are strict laws to stop people moving assets around to avoid creditors or lawsuits.
So the time to move money or assets around, and structure yourself to avoid financial cancer, is now. You want to do it while you’re financially healthy, and doing well.
Anyway, let’s get on with it.
- The FACTS of Lawsuits
If you consider yourself as safe from a lawsuit, think again.
Let me give some real life examples of lawsuits that have happened …
- In California, a woman slipped on a beverage in MacDonalds and successfully sued them. This was despite the fact she’d thrown the drink at her boyfriend 30 seconds earlier!
- A woman tripped over a rampant toddler in a furniture store, sued the store and won compensation for her injuries. Do you blame the owners for being surprised considering the toddler was her son?!
- A burglar broke into a house and when attempting to leave with the spoils, got trapped in the remote garage. He lived for 8 days on a small chocolate bar he found in the garage before the householders returned from their holidays. The burglar proceeded to sue the householders because he got locked in by the remote garage. Guess what? He successfully won damages for his mental pain, anguish and distress!!
That’s all very well, you say. That’s what you’d expect in America.
Let me give you some real life examples in Australia …
- In Western Australia, a hotel barman refused to give a drunk man his car keys. When the drunk man became abusive and threatening, the barman reluctantly returned the keys. The drunk man jumped into his car, drove off, and went straight into a pole. He was injured. He sued the hotel for giving him back his keys when he was drunk. And you guessed it, he won the case.
- In Queensland, a church discovered one of its minister was a homosexual. Being against the teachings of the church, the church immediately dismissed him. The homosexual minister sued for unfair dismissal and won. (This example by the way is not about moral issues in so much as most churches would not expect to encounter litigation problems in this situation.)
Quite outrageous you say. But unfortunately it’s what’s happening right now in the real world.
It’s becoming an epidemic problem.
In USA in 2005 for example, according to a survey by consulting firm Towers Perrin, the statistics show the cost of all liability torts (including damages, lawyers’ fees and administrative fees) accounted for nearly 2.09% of gross domestic product, or $261 billion. This contrasts to 0.62% in 1950. (A tort case involves a civil wrong and seeks damages for harm done to people or property.)
In 2004, the median jury award in product-liability cases was $1.8 million, estimates the National Small Business Association, a lobbying group.
The success rate of plaintiffs (people suing) in the US was 61%.
That is, there’s over 50% likelihood if you’re sued that you may lose (on a purely statistical level).
The seriousness of this threat has led to companies taking extreme measures. One is labels and warnings on products that border on insanity, and appear to be a practical joke, but sadly are true.
Here are just some of the warning labels US companies have introduced to ward off lawsuits.
EXAMPLES OF WARNING LABELS
- “Keep pet birds out of the kitchen when using this product” (Bialetti Casa Italiana’s nonstick pans) (NOTE: Polly may not have a thing for fancy cookware, but she might not like the fumes potentially given off by hot Teflon. Manufacturers are concerned about being sued for pet birds dying.)
- “This costume does not enable flight or super strength” (Frankel’s Costume Superman costumes)
- “Do not iron clothes on body” (Rowenta’s Irons)
- “Do not use for personal hygiene” (Scrubbing Bubbles Fresh Brush). (NOTE: This label won an award at the annual Wacky Warning Label Contest hosted by Michigan Lawsuit Abuse Watch, an advocacy group. Apparently the folks at S.C. Johnson are afraid that customers will go to any length to get those hard to reach spots on their backs, even by using a toilet brush!)
- “This product moves when used” (Razor scooter)
- “Ask a doctor before use if you have difficulty urinating due to an enlarged prostate” (Midol Menstrual Complete)
- “Do not eat” (Apple’s iPod shuffle) (NOTE: When Apple introduced its digital music player in 2005, the company added this warning on its Web site. Parody or paranoia? The company wouldn’t comment.)
This raises the question: what can you do about it.
There are a number of things you can do about it.
One is warning labels. But another possibility is to understand the principles of asset protection … how YOU can regain control of your assets and protect your wealth.
To ensure you CONTROL your assets but don’t OWN them
This is the ultimate secret of high net worth people. So I will say it again. Control not own assets.
We consider the principles of asset protection below.
- Principles of Asset Protection
When building wealth, you need to look at two issues:
- How we make your money and build your wealth. This looks at things like building businesses, cashflow strategies, and investing in shares, properties and other growth assets
- How we manage our wealth and keep it safe. This looks at money management, cutting costs, tax minimization, and most importantly, protecting our wealth from being plundered by unscrupulous people with sue-happy lawyers, creditors and governments gone feral.
One of my favourite ways to protect assets is the “strawman” and “person of substance” method. This works brilliantly with couples.
Who is the Strawman and Who is the Person of Substance?
A great strategy for married couples or business partners in certain situations
The Strawman is at risk of attack, and sign their name to everything. They are the company director, the trustee of a family trust, and put their name to all risky deals which can go badly wrong.
The Person of Substance is not at risk and signs their name to nothing, yet controls all the assets. They are the trust appointor, the company shareholder, and stay in the background.
So in simple terms, the strawman is at RISK. But controls NOTHING. By contrast, the person of substance is NOT at RISK. But controls EVERYTHING.
Can you give me an example?
Egbert is a doctor and his wife Edwina stays at home with their 17 kids.
Because Egbert is a doctor, he is the one at risk of being sued. Edwina is not at risk of being sued, as she stays at home with the kids.
Egbert is the “strawman” and Edwina the “person of substance”.
(This is not intended to stereotype. However, this kind of situation is still common today. It could easily be the other way around, eg. Edwina could be running a business, while Egbert has a government job looking after the kids. In that situation, Egbert would be the person of substance, and Edwina the strawman.)
Let’s look at assets and businesses, and how this works …
With the family home, although Egbert and Edwina could use a family trust, or company, they lose the capital gains tax exemption for family homes if they do. The other option is for Egbert to ensure the house remains in Edwina’s name as she isn’t at risk.
This second option is better in my view. And any equity can be protected by a second mortgage.
If the family home is in joint names, or Egbert’s name, he could transfer it to Edwina.
But he should be VERY CAREFUL before doing so as bankruptcy clawback rules mean the transaction can be reversed. Further, if it’s done at a time when he is at risk, he could be seen as attempting to avoid creditors. This has other consequences.
With investment properties, ideally, they would own them in a family trust. The only reason they would not was if Egbert had heavy negative gearing losses, and no income coming through a family trust. In this situation, he may buy the properties in his own name, and create a second mortgage to protect the properties.
With businesses, they should be in trusts or companies where Egbert is the main director or trustee. Edwina should not be a director, and should be kept out of the trust, other than as an appointor and beneficiary.
(Obviously these are general principles. There may be other factors which change things, depending upon how the transaction is structured, but you need to be careful in this regard. See a professional expert to discuss in more detail.)
As a general rule, however, the most effective way to protect assets is through companies and trusts.
Using a COMPANY to protect assets
First, we will provide a brief outline of a company, and how it works.
A company is a separate legal entity from its shareholders. This was confirmed by UK House of Lords in Saloman v Saloman (1895) and followed by Australian courts.
What this means is in the artificial commercial world, the realm of “fiction”, it is a real person.
- It can sue and be sued
- It can enter into contracts
- It has a legal name and its own ABN
- It has limited liability, ie. if the company gets into financial trouble, shareholders only have to pay up any amounts they still owe on their shares … except in certain limited situations (eg.. breaching directors duties or trading insolvent under the Corporations Law, some tax debts, personal guarantees by directors of the company), they cannot be forced to pay company debts from their own personal assets.
Companies have 2 main players:
- Directors. The directors manage the company’s daily business for the shareholders
- Shareholders. The shareholders are the owners of the company. They have a fixed interest in the company assets in direct proportion to their shareholding
Companies offer asset protection to their shareholders and to the directors.
As a general rule, for a company trading in its own right (without being trustee for a trust), the directors are at risk. The director should be the strawman, or an entity controlled by the strawman. The shareholders are NOT at risk. They should by the person of substance, or an entity controlled by the person of substance.
We will refer to our example with Doctor Egbert and his wife Edwina.
Egbert is the “man of straw” and Edwina is the “person of substance”.
Doctor Egbert has a high risk of being sued. His partner Edwina has a low risk of being sued at home with the 17 children and not working.
If Doctor Egbert operates his medical practice through a company, as a doctor, he is at high risk of being sued.
- Director. Doctor Egbert should be the sole director of the company. Edwina should not sign cheques or attend company meetings to avoid being a deemed director under Corpations Law.
- Shareholders. Edwina should be the sole shareholder as she is not conducting any business activities where she may be sued.
Using a TRUST to protect assets
Trusts have been around since medieval times, and are wonderful vehicles to save tax, protect assets and create estates for your family for many generations.
Knights originally created trusts to protect themselves from vicious landlords.
I love trusts, because as well as protecting assets, they can significantly reduce your tax.
What type of trust do we use?
There are various types of trusts.
The main trusts used in business are discretionary trusts and unit trusts. There are also hybrid trusts (which are a mixture of discretionary trusts and unit trusts) but I don’t really like them, except in very limited situations (which I won’t talk about now).
Family discretionary trusts are an ancient way of building and preserving wealth. They protect assets because no-one actually owns the trust assets, ie. the Trustee holds the assets on trust for a number of beneficiaries and can give the assets and income to whoever the Trustee desires at their discretion. They are a tremendous vehicle to use in business or investment.
That is, you CONTROL not OWN the assets.
The parties to a standard family discretionary trust are:
- Settlor. The Settlor creates the trust
- Trustee. The Trustee holds the assets for the benefit of the Beneficiaries and manages the trust
- Beneficiaries. They benefit under the trust.
- Appointor. The Appointor is the puppet master; the Trustee is the puppet. The Appointor ultimately controls the trust with most trusts.
- Guardian. The Guardian controls the Appointor (although in virtually all trusts the Guardian and Appointor are the same person in the trust)
The Trustee is the PUPPET. The Appointor is the PUPPET MASTER. The Appointor can SACK the Trustee at any time.
For asset protection, the Appointor and Guardian of the Trust is the “person of substance” and the Trustee is the “strawman”. Therefore, the Appointor and Guardian should be the person of substance, or an entity controlled by the person of substance, while the Trustee should be the strawman, or an entity controlled by the strawman.
It is common with family trusts (and highly recommended in most cases) for the trustee to be a company. It creates an extra “firewall” of protection between your creditors and your assets.
The director of the trustee company, of course, should be the “strawman”.
Going back to Egbert and his wife Edwina, Egbert will be the trustee or the director of the trustee company, and Edwina will be the Appointor and Guardian of the Trust.
This way Edwina can sack the company as trustee if there is any risk of a lawsuit.
As a final comment, we need to look at court decisions in recent times, such as the Richstar Federal Court decision (dealing with Westpoint and Norm Carey), and the High Court in Kennon v Spry.
These decisions may have ramifications for asset protection.
In Richstar, Norm Carey had used family trusts to shelter his assets as creditors. ASIC tried to find a way to break his trusts to get the money back for the disgruntled investors.
In the Full Federal Court, Justice Hill said in exceptional circumstances, a trust could be penetrated. He said the trust was clearly the “alter ego” of Norm Carey, and for all intensive purposes, was just a shell. Therefore, he allowed access to the trust.
That said, the court decision was only an interlocutory one, meaning it didn’t have a lot of bearing on things. It didn’t change the law.
Similarly with Kennon v Spry, although the High Court allowed the family trust to be penetrated, it was limited to Family Law contexts. (You can find Warren Black’s paper on Kennon v Spry and it’s impact on the law in our members page.)
Whether this will change the law remains to be seen. The Full Federal Court did stress that it would only be in exceptional circumstances that this would occur.
So in my view, it is unlikely to change it.
That said, the virgin walls have been breached, which means it can happen again. So we need to be on red alert to think ahead in protecting their assets.
Getting proper advice to protect your assets becomes more critical than ever.
- Businesses and Asset Protection
If you’re in business or likely to be in business, ensuring your assets are well secured are critical.
Once you enter the business arena, you’re entering a litigation minefield. Immediately you become a target. You’re responsible for what goes wrong in your business.
If your employees make errors you can be sued.
By taking steps to ensure your personal assets are protected from business lawsuits, you can be assured your business, family home and other assets remain safe.
Some years ago, a client came to see us. He and his wife had nearly $3 million of assets. He’d worked hard all his life as an investment advisor.
One day, he made an error of judgment in advising a client. Just one. However the consequences were disastrous.
It turned out he was unlikely to be covered by his professional indemnity insurance because he didn’t follow the strict conditions of his policy. If he’s sued, most of his assets are exposed because they are in his own name. Even his wife’s assets are at risk because she was a director in his company until recently.
Suddenly his hard earned wealth didn’t seem secure anymore …
It isn’t just your personal assets that need protection …
You also need to ensure your business assets are protected.
Let’s say you spend years building up a valuable client list, goodwill or intellectual property. Imagine how you’d feel if one lawsuit wiped out years of hard work when it could have been avoided.
(As an aside, in the example above, the investment advisor lost his marriage, and much of his retirement savings. A heavy price to pay for poor structuring …)
Some simple planning can forestall all of this.
Let’s take an example …
Dick Dastardly is starting business in finance consulting. His business is called “Show me the Money Honey”.
Dick is confident his business will develop substantial goodwill and a strong brand name. He’ll have a number of finance consultants working for him on a commission basis. He plans to use the internet and social media in marketing his business, with an online facility for instant loan approvals.
Dick’s personal wealth plan is to establish a business to generate cash flow and put the money into investments.
Dick intends to buy positive cashflow property, to trade shares, options, CFDs and Forex, international growth shares, currencies and gold bullion, among other things.
Dick could set up a trust (“I Hold Assets Trust”) to hold the business name “Show me the Money Honey”, the business premises, and any other valuable assets.
“I Hold Assets Trust” licenses the business name and premises to “My Trading Trust” which carries on the business. If anyone sues the business they’ll sue “My Trading Trust”. This does NOT own the business name. It is only licensing it. It only holds cash. There are no cookies in the jar. The assets are safe!
So Dick loses the money in that trust. However he simply terminates the licence agreement with “My Trading Trust” and sets up a new trust, has a new licence agreement, and continues on.
To protect his personal assets at the same time, Dick could set up a separate trust to hold his properties (Property Trust), and a trust to hold his investments and do his trading (Investment Trust).
Dick can protect his family home by putting it in a family trust or borrowing heavily over his family home and putting it through trusts.
What if Dick Wants to go into Partnership?
If Dick decides to go into business with his partner Muttley, there are other great strategies available for Dick.
Dick is silly if he goes into partnership with Muttley. He is guaranteeing Muttley’s debts. He’s better off to set up a structure to keep the affairs of Muttley and himself separate.
I see it this way …
If a car thief is looking for a car to steal, and has a choice between a Commodore with no alarm system or Mercedes with a high tech alarm system, he’ll usually steal the Commodore with no alarm system.
The beauty of asset protection is that it is not about avoiding moral responsibility if you make errors and cause losses to your client. It is giving you the empowerment to make the moral choice if you are responsible or not. Not the client, a court or somebody else.
- Investors and Asset Protection
If you’re an investor, although your risk is less than a person in business, you still are at risk.
For example, even though you’re at not at risk if you own shares, you can be sued by your tenants with respect to your investment properties.
And your insurance policy may not cover you.
John owns 3 investment properties in his own name.
A visitor to one of his properties sues him as the owner because he slips on a banana peel left by the tenant carelessly on the stairs. The rental property insurer has refused to cover him because of some fine print.
Suddenly all 3 of his investment properties are at risk …
Companies and trusts can give you your asset protection with respect to your properties.
- Employees and Asset Protection
Do employees need asset protection?
Most employees don’t consider themselves to be at risk. However, this is not necessarily the case. Although in practice most employers cover the liabilities of their employees, if there is a lawsuit, and most creditors sue the employer rather than the employee (as usually employees don’t have the “deep pocket” as the employer) there is no certainty of this. Employees are certainly at risk.
This is clear from the recent High Court decision in Houghton v Arns.
In Houghton v Arns, an employed internet website expert gave wrong information to a company client about internet capabilities. This error cost the client a significant amount of money. The client couldn’t sue the company as it was broke.
So they sued the web designer and another employee.
It was held the web designer and other employee were liable for the $58,000 losses. The court said the employee was negligent, careless and responsible for the losses.
This should put the “fear of God” in most employees, and show how critical it is to structure yourself to protect your assets.
You should also remember as an employee, you may go into business … and transferring assets out of your own name later on can be very costly (you’ll pay capital gains tax and stamp duty).
So better to suffer the pain now, set up right today and have family trusts to protect your assets.
In conclusion …
Asset protection needs to be done by everyone, especially those in business.
To summarise what we’ve learned:
- Companies and trusts are the wealthy’s biggest secret to protect assets … to ensure you CONTROL not OWN assets
- If you’re a couple, consider the strawman and person of substance principle before setting up any entities or buying assets.
- If you’re single, multiple companies or trusts are the best way to protect assets
- With your family home, you usually would not use a family trust, but instead, have it in the name of the least risky person.
- As the High Court has shown, employees who invest in property and shares, or other assets, also need to look at asset protection.
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