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Wealth Planning News
Vol. V, No. 3
Asset Segregation Concepts
"Asset segregation” is ownership of assets in distinct and separate entities, so that a single “hot” asset cannot create a liability that would result in loss of any other assets. Example: Ownership of a rental house in its own entity that owns only the rental house.
A “hot” asset is one that is likely to generate legal claims against its owner in our litigious society. Examples: Rental properties, both residential and commercial; automobiles (especially those driven by teenage drivers who are family members); aircraft. By contrast, a “hot profession” is one that is likely to generate legal claims, such as malpractice or professional liability claims.
An “inside claim” is a legal claim against the owner that could arise out of ownership of an asset. Example: Ownership of a rental house where the owner fails to maintain the furnace properly, and the owner is sued when the house burns and a tenant dies in the fire.
An “outside claim” is a legal claim against the owner that could arise from any source other than, or outside of, ownership of an asset. Example: A surgeon owns a rental house. When he is sued for malpractice that exceeds his insurance coverage, he could lose the rental house because of a claim totally unrelated to ownership of the rental house.
Why Asset Segregation?
We live in the most litigious society in history. For a short overview of why every American should consider planning for asset protection please request a copy of Newsletter 4.1 entitled “Asset Protection.”
Asset segregation is needed because a claim could arise against an owner merely because of ownership (as opposed to a personal claim for some other reason). The resulting judgment may exceed the value of the asset in question. In that case the owner could lose other assets such as bank funds, investment accounts, and even a personal residence.
In considering the possibility of such a loss it is not helpful to rely only upon liability insurance to cover any potential loss. Two problems exist with respect to insurance coverage: First, the claim may exceed the limits of liability. Second, the coverage may be denied or it may not extend to the claim in question. In fact, insurance companies are notorious for trying to find ways to deny payment of claims. The larger the claim the more likely the insurance coverage will try to find a way to avoid paying the claim.
Inadequate insurance coverage can occur more often than one would think in our society where juries sometimes give incredibly high awards. A Robin Hood jury may well make a reward of millions in a case where a tenant is raped in a rental unit, or in a parking area of a commercial building.
Denial of insurance coverage can result from many things, including failure to give notice of known problems with an asset, or failure to inform the insurance company of a claim early enough, or acknowledgement of some fact that would help to establish liability where the owner or representative of the owner spoke with a claimant and made some admission before any actual claim was made.
Asset segregation does not replace liability insurance, it merely provides supplemental protection against loss of other assets in the event an inside claim results in some catastrophic judgment against the owner of an asset.
In This Issue
Why Asset Segregation?
How to Segregate Assets
How To Segregate Assets
The essential key to asset segregation is to put each hot asset into an entity that becomes the “owner” of that asset alone. So any inside claim stops with the loss of only the asset that generated the claim.
The choice of entity is a separate question. The entity should normally be a flow-through entity for income tax purposes, which rules out a normal corporation. An S corporation is usually a poor choice for reasons outside the scope of this newsletter. The better choice is a limited liability company that is a flow-through entity for income tax purposes, and limits the liability of owners to loss of their investment in the company.
Imagine you own four rental properties in your own name. Any inside claim in excess of or outside the coverage of your liability insurance could result in loss of not only the rental property from which the claim arose, but also the loss of the other three rentals, your home, and your other assets. So you create an LLC to own rental property.
Are you satisfied with only one LLC? If you put all four of the rental properties into one LLC, then a claim arising out of any one of them could result in your loss of all of them. So you should normally put each rental property into its own LLC, one that owns only that rental.
You may balk at the hassle of creating an LLC for each entity, with resulting start-up legal fees for each company, and annual state fees for each company, not to mention the need for separate income tax returns for each company.
But the costs to create each company can be minimized after the design for the first such company is determined. Documentation thereafter is usually very inexpensive in terms of legal fees. And annual state fees for an LLC are reasonable in many states.
The annual income tax return can be avoided if each LLC has a single owner that elects to have the LLC taxed as a sole proprietorship. In that case no partnership tax return would be due for each entity, and income or losses from each would appear directly on the entity owner’s income tax return.
The issue of who or what should own each asset segregation entity is another topic. The answer will depend upon many other factors involved in your own plan design. But consider this idea: Wouldn’t it be great to own one entity that could be the sole owner of each LLC you make for purposes of asset segregation? And wouldn’t it be great if that single overall entity could also provide you with a significant degree of asset protection from “outside” claims that could arise against you, and thereby help to preserve investment assets inside that entity even if you face some huge outside claim?