My good friend, Paul, is a lawyer. A personal injury lawyer at that. A man visited him the other day because he wanted to initiate a lawsuit. "I've heard that people are winning lawsuits for all kinds of things today," the man said. Paul wondered where the man was going with this conversation. "So tell me your story," Paul said.
"Well, I've been in debt for a long time now," the man said. "I want to sue the credit card company. I figure that's the only way I'm going to be able to pay them back."
The truth is, we live in a litigious society. Families with significant net worth need to think about asset protection strategies, but even those with modest wealth are taking steps today to protect their assets.
The problem
There are more reasons for being concerned about asset protection than you can shake a stick at. Some of the more common situations that can place your assets at risk include: Being a director of a corporation (which can expose you to certain obligations of the corporation in some cases), acting as a trustee or executor (a potential breach of trust can result in litigation), and being a guarantor (you may become liable for the obligations of others).
Other scenarios include: simply being a party to an agreement (representations and warranties can give rise to liability), being in professional practice (concerns over malpractice lawsuits), being a partner (general partners may be liable for the debts of the partnership), having a concentration of assets (a threat to those assets – perhaps a family business, for example – may also threaten the financial stability of a family), and marriage breakdown (a former spouse may have claims on certain property).
The solutions
There are several strategies to consider to protect your assets, and many of these ideas come with tax opportunities at the same time. Why not achieve some tax savings while also protecting what you've worked so hard to accumulate? Consider these ideas:
1. Make use of holding companies.
Many Canadians have accumulated assets thanks to private business ownership. In most cases the business represents the most significant asset of the family. You should be concerned if you've been accumulating cash or other assets inside the operating company since those assets are exposed to creditors of the business. Consider using a holding company that would own shares in your operating company. Cash or other redundant assets can be paid up to the holding company as dividends, generally without tax, where you can separate those assets from the operating business.
If the business needs the capital, your holding company can lend it back on a secured basis. Holding companies can also allow you to defer or save tax by providing a vehicle in which to make other investments with the excess cash you've accumulated. Without the holding company you'd have to pay the cash out to yourself first, pay tax on the income, and then reinvest what's left over after taxes.
2. Use discretionary trusts.
A trust allows the use and enjoyment of the trust assets to be separated from legal ownership of the assets. Specifically, a trust beneficiary may benefit from use of trust assets, but a creditor of the beneficiary may be unable to place a claim on the assets of the trust where the trust agreement is drafted properly. It's important that the trust is irrevocable, and that the beneficiaries have no vested rights in the trust assets; otherwise creditors may gain access to all or a portion of those assets. It may also be a good idea to draft the trust agreement so that distributions can't be made to any beneficiary who is insolvent. Trusts can also save tax by providing the ability to split income with family members.
3. Place assets in appropriate names.
It often makes good sense to place assets in the name of your spouse or another family member who is less likely to face the claims of creditors. A business owner, for example, will often put the family home in the name of his spouse. Before you jump to move title to your assets, remember that a transfer to anyone other than your spouse is considered to be a disposition at fair market value, so you might trigger a tax bill. Also, don't forget that you may be giving up control when you give up title to assets.
I'll share more ideas next time.
Tim Cestnick