ARTICLES

SUIT PROOF YOUR LIFE

by
Christopher Manes

To paraphrase Andy Warhol: In the future, everyone will get sued for fifteen minutes. In fact, that's not too far from the truth now. Following a trend that goes back decades, the number of civil lawsuits in California has continued to climb during the past few years, surpassing half a million a year, especially in the area of business litigation, where more than a hundred new cases are filed each day. It sometimes seems if you want to go to the grocery store to buy a can of Folgers, you better bring a phalanx of Alan Dershowitzes to negotiate the deal. Of course, real-life lawsuits are measured not in quarter hours, but years, with the legal expenses for the most routine case averaging at least $25,000, not to mention ulcers and sleepless nights. For difficult cases, the sky's the limit.

In a wading pool filled with circling litigious sharks forced to slurp Slimfast for a week, how does an average person not get bit?

There are avenues to a least minimize your exposure to lawsuits. The best strategy depends on each individual's particular circumstances. A business person who makes one big financial transaction after the next obviously faces more risk of getting entangled in a lawsuit than a retired couple living on a pension. Only a professional can give specific advice about which strategy might work for you. But here are the broad brushstrokes.

First and foremost, (and I know no one wants to hear this) is to use an attorney's services before you find yourself in a lawsuit. Lawyers are like auto mechanics: you can pay them a little money for preventive maintenance, or you can wait until the engine blows and pay them a lot of money. Most lawsuits stem not from bad motives, but misunderstandings that a good attorney can often avert before everyone gets dragged into court.

A portrait of a typical business lawsuit goes like this. Jack, without benefit of an attorney, strikes a dealt with Jill, also attorney-less. It doesn't matter if the agreement is to sell widgets, provide services, or loan money - they think they have a meeting of minds, when in fact they've failed to discuss or clarify important terms. Jill performs what she thinks are her contractual obligations based on her understanding of the deal. Jack claims she hasn't followed the agreement at all, based on his understanding. Jill turns around and accuses Jack of trying to back out of the agreement. Accusations fly, litigation lawyers are hired, and a lawsuit takes wing.

The moral of the story is, where significant money is involved, a prudent person should consult an attorney to insure all the important terms of the agreement are clear and all the parties understand their obligations. This is the surest way to stay out of court. As to the attorneys' fees for this precautionary work, yeah, they hurt, but consider them the cost of doing business in the modern litigious world. Although this is what should be done, the fact is most people don't hire an attorney to do the preventative medicine likely to ward off lawsuits, even where hundreds of thousands of dollars are at stake. Therefore, another approach to suit proofing your life involves how you arrange your assets.

Lawyers have a phrase: "judgment proof." In layman's parlance, it means being so poor that suing you would be a waste of time and money. No pot of gold from a jury award awaits the plaintiff at the end of a long, expensive suit against a judgment-proof defendant. (Perhaps the only solace of poverty is this freedom of lawyers). Of course, unless you're a monk, going broke is an extremely unpleasant way to avoid litigation. But the principle applies: assets not held in your name may be out of your creditors' reach, and potential plaintiffs have no incentive to sue. A number of asset protection arrangements - irrevocable spendthrift trusts, Alaska trusts, family limited partnerships, and offshore accounts - achieve this goal. Each has its advantages and downside.

The most tried-and-true form of asset protection is the irrevocable spendthrift trust. A trust is an entity that holds assets in the name of one person (the trustee) for the benefit of another (the beneficiary). The person who puts his assets in trust (called the trustor, settlor, or grantor) gives up title to the property. Many people are aware of revocable living trusts as an estate planning tool to avoid probate and reduce estate taxes. But additionally, in some situations, a trust can also protect assets, making the grantor "judgment proof" as far as the trust property is concerned.

First, to shield assets, the trust must be irrevocable - that is, the grantor cannot retain the right to terminate it and take his property back. Second, the trust must have a "spendthrift provision," which states that trust assets are not subject to the claims of a beneficiary's creditors. Finally, the beneficiary must be someone other than the grantor; for instance, the grantor's children.

This type of trust, called an "irrevocable spendthrift trust," is safe from creditor claims against the grantor. That's because the property in the trust no longer belongs to the grantor, so plaintiffs gain nothing by suing him or her to get at it.

The drawback is you give up ownership of the assets in an irrevocable spendthrift trust forever. Normally, such trusts are set up for children, who are going to get the assets anyway, as gifts or by inheritance. But things change. A wealthy parent suffers financial reversals, kids get rich on their own right, a father and son have a falling out. Whatever happens, the parents who set up an irrevocable spendthrift trust are stuck with their choice. The assets are out of their control.

Moreover, because the grantor cannot be a beneficiary of the trust for the spendthrift provision to work against creditors, grantors have to retain some other assets to live on, and these remain exposed to lawsuits. Along to the rescue comes the Alaska trust. While most states don't allow a spendthrift trust to name the grantor as beneficiary, Alaska is the exception. The Alaska Trust Act, which became effective in 1997, permits an individual to create in Alaska a trust from which the individual can receive distributions without exposing the trust to the grantor's creditors. To form such a trust, some of the trust assets must be held in Alaska (i.e., in a checking account, certificate of deposit, brokerage account, etc.); the trustee must be an Alaskan domiciliary; and part of the trust administration must occur in the glacier State.

Obviously, Alaska passed this law to encourage the trust business within its borders and to attract out-of-state investments. No doubt exists the law applies to judgments in Alaska. But because the law is new, no one knows for sure whether these trusts will be immune to judgments of creditors from other jurisdictions, like California. Therefore, until some court rules on the matter, the Alaska trust is a promising, but not foolproof, deterrent to litigants looking for deep pockets.

Where a family runs a business, a family limited partnership can also effectively shield assets, and hence discourage lawsuits. Typically, a family limited partnership involves the parents gifting an interest in a partnership to their children. If properly set up, a family limited partnership protects the business's property against creditors who sue a family member. The most a creditor can get from such a lawsuit is a "charging order," which translates into a right to receive from the partnership only what the partner is owed. Since the parent/general partners will normally retain broad discretion over cash distributions to the children/limited partners, the creditor can expect to collect at a snail's pace, if at all. It should be noted, however, that recent cases have punched some holes in the shield against creditors family partnerships once provided.

Family limited partnerships also have tax and estate planning benefits, but they aren't for everyone. Family limited partnerships must run a genuine business. Therefore, unlike irrevocable spendthrift trusts, non-business property, such as a residence, cannot willy-nilly be converted to a family limited partnership. Moreover, the IRS closely scrutinizes these partnerships for tax purposes.

Finally, at the extreme end of asset protection are offshore trusts and bank accounts. These strategies are complex, expensive, and entail their own particular risks (like sending your assets to a foreign land). They generally suit only very wealthy individuals and require extensive consultation with an attorney experienced in the field.

A warning. The methods for asset protection outlined here will only work if undertaken before you absolutely need them. In other words, if you put them into effect before a lawsuit is filed, they offer some protection. But once litigation begins, asset transfers to a trust or limited partnership are subject to "fraudulent transfer" laws. The rule is, if you transfer assets to someone with the intent to hinder, delay, or defraud your creditors, the court can nullify the transaction. Thus, putting all your property in an Alaska trust the day after you get sued will probably not protect your property, at least in the long run.

Suit-proofing your life through asset protection is based on the old adage that you can't get blood out of a turnip. But you can get turnip juice, and some litigants are irrational enough to go after even that. There are people litigious enough to sue a brick wall for standing in their way. Nonetheless, a well-crafted strategy to keep your property out of the reach of creditors can help you avoid that long, expensive climb up the courthouse steps.