A common concern of estate planning and business planning clients is protecting their assets from a future creditor claim. These claims can arise in the operation of a business, the provision of medical or other professional services, irresponsible or accidental actions of an employee, family member, or other beneficiary, and countless other contexts. Fortunately, North Carolina individuals and businesses have numerous strategies they can employ now to limit their exposure to these future creditor claims should they arise.
Note that North Carolina law generally does not allow an individual or business to transfer assets to avoid liability for current creditor claims or future claims that could be reasonably foreseen. Thus, it is important for clients to consider asset protection planning early and before having knowledge of potential creditor claims to maximize the chance that any asset protection planning strategies will be successful.
While the strategies below may reduce exposure of assets to creditors, they may also have significant tax consequences. Clients should only implement these strategies after consulting their legal, tax, and business advisors to ensure they have a full understanding of all the implications of these strategies.
Clients should also insure their assets with adequate liability insurance regardless of whether they implement any of the strategies discussed below. Furthermore, if any asset protection strategies involve the transfer of an asset, the transferee (including a trust) would need to maintain adequate insurance for the transferred asset.
Irrevocable Trusts
Irrevocable trusts offer a great creditor protection tool for clients to protect assets from creditor claims against their beneficiaries. An individual establishes an irrevocable trust by transferring property to a trustee, who then holds and administers that property for the benefit of one or more beneficiaries pursuant to the guidelines established within the trust. As the name suggests, irrevocable trusts may not be modified or revoked by the person who establishes the trust, known as the grantor, trustor, or settlor.
Irrevocable trusts frequently grant broad discretion to the trustee to administer the trust and make liberal distributions to the beneficiaries, but also generally exclude trust assets from the reach of a beneficiary’s creditors. Some trusts, referred to as “special needs trusts” and “supplemental needs trusts” interchangeably, allow the trust’s property to benefit an individual who qualifies for a government benefit program, like Medicaid or Supplemental Security Income (SSI), without rendering the beneficiary ineligible for such program.
In some cases, a beneficiary may even serve as the trustee without exposing the trust’s assets to creditors. Clients, however, should take care to ensure trusts are properly drafted to allow for maximum creditor protection, which requires specific language if a beneficiary will also serve as trustee. Clients should also carefully consider trustee selection and ensure they choose a financially responsible person or corporate trustee who is up for the job, as the improper administration of a trust can undermine its creditor protection benefits.
The asset protection offered by a properly drafted irrevocable trust is not absolute. North Carolina courts may in some circumstances compel a trustee to distribute trust assets to a beneficiary to fulfill his or her child support obligations.
North Carolina law does not currently allow an individual to establish a trust for the benefit of himself or herself that is protected from his or her creditors, commonly referred to as a “domestic asset protection trust” (DAPT). Some states do allow DAPTs to varying degrees, so North Carolina residents could consider establishing a DAPT in another state. DAPTs are a relatively new concept, however, and it is unclear the extent to which a North Carolina court would recognize the asset protection benefit of a DAPT established by a North Carolina resident against a creditor claim in North Carolina. Thus, North Carolina residents should proceed with caution in establishing a non-NC DAPT.
If a North Carolina resident expects to receive a gift or inheritance from someone else, he or she could request that the gift or inheritance be given to him or her in a trust instead of receiving the property outright. This should allow the gift or inheritance to be protected from the North Carolina resident’s creditors if the trust is properly drafted.
Limited Liability Companies and Corporations
Limited liability companies (LLCs) and corporations generally offer liability protection to their owners in two ways: first, the liabilities of the LLC or corporation generally do not extend to the personal assets of the owners; second, the liabilities of any one owner generally do not extend to the corporation or the other owners. Some, but not all, types of partnerships in North Carolina offer much of this liability protection as well.
In order for this liability protection to apply, the owners must respect the separate legal existence of the LLC or corporation. This means, among other things, that business should be conducted through and under the name of the entity, the entity should be adequately capitalized, and meetings of the owners and management should be held and documented pursuant to the governing North Carolina statute and/or the Operating Agreement or Shareholder Agreement of the entity. This is generally known as “following the corporate formalities.”
Assuming the owners and the entity follow the corporate formalities, North Carolina residents and businesses should be able to separate the liabilities of any particular assets or businesses by holding those assets or businesses in a separate a LLC or corporation. For example, a North Carolina family could consider owning its rental property in an LLC to reduce the family’s exposure to the rental property’s liabilities, and a North Carolina business could consider owning and operating separate business lines through subsidiary entities to separate the liabilities of each business line from each other. Note that if a creditor’s claim is against a physician for malpractice for services provided through a medical services entity, that entity does not provide the usual “entity shield” that an LLC or corporation would generally provide to the owner. Physicians should ensure they have adequate medical malpractice insurance to better protect against medical malpractice claims.
There is some concern that LLCs with only one owner, known as “single member LLCs,” may offer less asset protection from personal liabilities than an LLC with multiple owners. A few courts in other states have provided that an owner’s creditors may reach the assets of a single member LLC. The reasoning of these decisions focused on the public policy behind the creditor protection offered by an LLC, which is intended to protect the LLC and the other owners from the liabilities of any one owner; with a single member LLC, there are no other owners to protect, and the sole owner has the exclusive right and power to liquidate the LLC to pay the owner’s creditors. No courts have yet applied a similar rationale in North Carolina, and North Carolina’s LLC statute contains strong creditor protection language, so a single member LLC presumably should offer good creditor protection in North Carolina. However, clients may want to consider using LLCs with multiple owners instead of a single member LLC if this would be feasible under the circumstances and the client’s risk tolerance is low.
Tenancy by the Entirety
Married couples in North Carolina may own North Carolina real estate as “tenants by the entirety” (TBE). Like real estate owned jointly with a right of survivorship, the surviving spouse becomes the sole owner of TBE property at the death of a spouse. However, unlike any other form of real estate ownership, TBE property is not subject to the claims of a creditor of just one spouse; generally, only a creditor of both spouses may force the sale of TBE property to satisfy its claim.
Note that TBE ownership is the default ownership for married couples who acquire North Carolina real estate during their marriage unless the deed expressly states otherwise, so many married couples in North Carolina benefit from TBE creditor protection with respect to their home or other North Carolina real estate without any extra steps needed. If a married couple acquired North Carolina real estate prior to the marriage or in some other ownership structure, they may execute a new deed to themselves to obtain TBE creditor protection.
TBE ownership is not offered in every state, and the asset protection rules for TBE property vary in the states that do allow it. Some states allow TBE ownership for personal property, including financial accounts, but North Carolina does not. In addition, TBE protection is not absolute. For example, the federal government may be able to reach TBE property to recover one spouse’s unpaid taxes, and healthcare providers may be able to reach TBE property to recover one spouse’s medical bills under a legal doctrine known as the “doctrine of necessaries,” which imposes an obligation of support for each other upon spouses.
Premarital and Postmarital Agreements
Premarital agreements allow individuals contemplating marriage in North Carolina to specify each prospective spouse’s rights and obligations with respect to the marriage, including each prospective spouse’s rights in and to the other party’s property in the event of separation, divorce, and death. Without a premarital agreement, spouses in North Carolina have certain statutory rights to receive property from each other upon divorce and death, which could force an individual or his or her estate to give assets to a spouse at such time. In a premarital agreement, the parties may waive those statutory rights. This could be important for individuals who are a part of successful family businesses that would prefer to “keep things in the family,” or who have children that predate the marriage or other family members that they would want to leave significant property to at death.
Postmarital agreements are similar to premarital agreements, but instead of being entered into before the marriage, married couples enter into postmarital agreements during the marriage. While individuals may use postmarital agreements to preserve their ability to dispose of certain assets as they please, spouses typically cannot waive rights to alimony or post-separation support in postmarital agreements.
Retirement Accounts
Retirement accounts (401(k)s, IRAs, Roth IRAs, 403(b)s, etc.), including inherited retirement accounts, are exempt from the claims of creditors in North Carolina, so a North Carolina resident generally does not need any special planning to protect his or her own retirement accounts from creditors. However, these accounts are not protected from equitable distribution in a divorce proceeding or from a surviving spouse’s rights at death, so individuals may want to consider entering into a premarital or postmarital agreement to address this issue.
In addition, not all states have full creditor protection for retirement accounts and inherited retirement accounts. North Carolina residents could consider using a trust as the beneficiary of these assets to protect them from a beneficiary’s creditors since there is no guarantee that beneficiaries will live in North Carolina. Note that retirement accounts are riddled with tax traps for the unwary, particularly when they are left to a trust, so it is vitally important to obtain competent legal advice before implementing this strategy.
Life Insurance
The North Carolina Constitution protects life insurance from the creditor claims of the insured if the policy is payable to or for the sole use or benefit of the insured’s spouse or children at death. However, the proceeds would be subject to the creditor claims of the spouse and/or children if payable to them outright. North Carolina residents could consider using a trust as the beneficiary of life insurance to protect the policy proceeds from the creditors of a spouse or child.
