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Equity StrippingOne of the oldest asset protection strategies is equity stripping. From the minute a person determines that he has equity in an asset, he probably started thinking about how to tie up the equity so that his creditors could not reach it. The concept is simple: even though you continue to have the control and enjoyment of an asset, there is little or no equity in the asset for creditors to get. Usually, this is accomplished by borrowing against the asset and giving another party a lien for the debt obligation. But equity stripping comes in other and more sophisticated variants, too. For example, let’s say that you live in a $500,000 home in a state with a $100,000 homestead exemption. If your home was paid off, that would expose $400,000 (the difference between the sale value and the exemption) to creditors. Instead, you just never pay down the mortgage to where you have more than $100,000 in equity. If something happens and you have a judgment entered against you, the creditor will probably look at your property records, estimate the value of your house, and decide that it is not worth his time to foreclose because the homestead exemption would protect the rest of your equity. Because foreclosure is time-consuming and expensive, in terms of up-front costs for an auctioneer and advertising, the creditor is apt to forget about your house and look for easier assets to grab. The bank’s mortgage gives it a“ priority lien” over the judgment of the creditor. The concept of the“ priority lien” is central to most equity stripping strategies. Congratulations, you have just successfully equity-stripped your home. Not rocket science, was it? Yet, even with such a simple equity strip as a home mortgage, there are difficulties for the debtor. The main difficulty is that the bank will of course want to be paid on the mortgage, meaning that you will have to come up with dough every month to make your payments. If the creditor has been successful in freezing your free cash and garnishing your pay check, you might not be able to make these payments; thus, resulting in the bank foreclosing on its loan. Thus, we are confronted with one of the main problems with equity stripping, which is how to provide protected cash flow to make the loan payments as they come due. Many equity stripping arrangements fail because no one considered the cash flow requirements. Friendly Loans Because you don’t want to end up in foreclosure if you have to miss a few payments, you may decide to arrange a “friendly” loan with a business entity or trust controlled by you or someone close to you. Even though your brother has loaned you money, he is not likely to foreclose if you get behind in your payments. Friendly loans often help alleviate the cash flow problems, but they introduce problems of their own. The first problem is that for equity stripping to work, the loan that gives rise to the priority lien has to be a real loan. There has to be a compelling economic or financial reason why the loan was made in the first place, and the explanation must be one capable of being made with a straight face. Further, the loan must be properly documented, the lien immediately filed, and, most importantly, payments on the loan need to be regularly made according to its terms. It is this last requirement that torpedoes most “friendly loan” arrangements. (i.e., people set up the loan and place the lien, but then they never make any payments or otherwise respect the loan as a real one). Note to File: In any given year, the average civil judge sees dozens of attempts by distressed debtors to equity strip their property. Most judges can spot bogus loans a mile away. They look to see if the loan was treated as a real loan with real payments, or whether the lien was simply placed on the property and the entire arrangement was disregarded until the creditor showed up. Bogus liens can be set aside by the court as shams or as fraudulent transfers. Fraudulent transfer laws specifically target this type of friendly insider transaction. A similar problem involves control. Many equity stripping arrangements are set up so that the wife is extending a loan to the husband and receiving a lien on the husband’s assets. In some states, this arrangement can work, or at least create a hurdle that the creditor will have to spend some time and money overcoming. Thus, friendly liens work, so long as your friend stays friendly to you. Equity Stripping and Taxes Of course, where there is interest – even deferred interest and balloon payments - taxes are an issue. Taxes must be paid on interest payments (and on accrued but unpaid interest too in most cases), and the interest, may not be deductible to the payor. So, even in the case of a husband and wife who are lender and borrower, the lending spouse will have interest income, and the borrower spouse may not get an interest deduction. This is an issue whether or not the spouses file a joint return. If the interest payments are not deductible, then a tax liability that did not exist previously may have been created. Certainly, if the interest income is being reported correctly to the IRS, it may help establish the validity of the loan. Conversely, if there is no such reporting, the arrangement will appear to be a sham. Indeed, many equity stripping arrangements are unwound because of the tax treatment of the interest on the loan. To avoid the tax problems, equity stripping arrangements might be implemented using a grantor trust as the counter-party, so for tax purposes, it is a nullity. Of course, this gives a later creditor the chance to come in and argue, “Well, if it is a nullity from a tax standpoint, then it should be a nullity from a civil standpoint too.” Though logically suspect, this sort of rationalization may appeal to judges. With a personal residence, keep in mind that for a home equity line of credit, only the interest on the first $100,000 is deductible. This may substantially impair the economics of many programs that are designed to equity strip personal residences. At any rate, you should never equity strip a primary residence unless there are funds immediately available somewhere with which to make mortgage payments. Cross-Collateralization To avoid taxation of the loan interest, sometimes equity stripping deals are created where there is no loan. Instead, the asset to be stripped is used as additional collateral for an existing loan or for some other guarantee of an obligation. This situation usually occurs between two subsidiaries of the same business. Assume that Subsidiary A has borrowed money from a bank to finance the purchase of a new warehouse. For a fee, Subsidiary A obtains a guarantee from Subsidiary B that it will stand good for the loan in case Subsidiary A runs short of cash. To secure this guarantee, Subsidiary B allows Subsidiary A to take a loan on Subsidiary B’s equipment. The equipment held by Subsidiary B thus has been stripped of its equity. Often such arrangements are done back-to-back between subsidiaries, so that Subsidiary A guarantees Subsidiary B and allows Subsidiary B a lien on Subsidiary A’s assets. Simultaneously Subsidiary B guarantees Subsidiary A and allows Subsidiary A to obtain a lien on Subsidiary B’s assets. Sometimes there are even arrangements where the two subsidiaries “swap checks” so that even though the money clears each subsidiary’s account at the same time, the appearance of each account by itself is that its assets have been tied up as part of a guarantee agreement. This practice is known as“ cross-collateralization” and is in fact almost a standard business planning procedure in many high-risk businesses, such as oil & gas production. Premium Financing For individuals, a common variant of equity stripping is a life insurance funding strategy known as “premium financing”. This strategy involves borrowing money to purchase a life insurance policy, with the loan being repaid at death. The idea is that equity which is otherwise dormant in an asset can be freed up and made to grow tax-free within the insurance policy. Premium financing can work for asset protection if a valuable unprotected asset, usually a residence, is used as collateral. This then has the effect of equity stripping the residence while the policy is in effect. The downside is that when the insured passes away, the death benefit pays off the loan which then releases the collateral and makes it available for creditors. However, even if the creditor is then able to get at the residence, there will be an even greater amount of wealth created outside the debtor’s estate that creditors cannot touch (assuming the death benefit is not paid to the debtor’s estate). From an economic perspective, premium financing often makes sense when the loan interest rates are low. The tax-free build-up within the policy will usually provide a large enough death benefit not only to pay off the loan, but also to benefit heirs substantially. Plus, the premium finance loan ties up the residence against creditor, since the loan will have priority over any subsequent judgment liens while the insured is still alive. Accounts Receivable Financing For businesses that carry accounts receivable, the financing of those receivables has the effect of equity stripping the A/R. A typical arrangement would involve the business taking a loan against the A/R, distributing the loan proceeds to the business owner, and then having the business owner purchase an annuity or life insurance policy (protected in many states) within an asset protected structure In the long run, the business owner not only will have asset protected the A/R, but also will have created wealth from an otherwise dormant balance sheet asset by leveraging the tax-deductible simple interest paid on the loan against the tax-deferred compound interest earned in the annuity or life insurance policy. In the last year, accounts receivable financing has become a hot topic, and it is discussed more fully in Ron Adkisson’s article in this issue and in his upcoming book. Can Equity Stripping be a Fraudulent Transfer? An equity strip is in many ways a simple transfer of property, in the form of a security interest, from the debtor to the lender. This means that the fraudulent transfer rules can apply to equity stripping arrangements as they do to other transfers. Thus, prior to undertaking an equity strip, careful analysis and planning must be done to help ensure that the transfer will not later be set aside as a fraudulent transfer. This planning includes not having any promotional materials or other planning documents that discuss “asset protection” as one of the principal reasons for doing the equity strip. Such discussion would possibly be prima facie evidence that the purpose of the planning was to hinder or delay creditors, which in fact is the primary reason for doing equity stripping, but also what is exactly prohibited by the fraudulent transfer laws. What this means is that equity stripping must be done for some reasonable personal or business planning purpose other than asset protection. Unfortunately, the marketing materials of many programs that involve equity stripping, such as accounts receivables financing programs, discuss asset protection at great length; and, thus the marketing itself probably defeats the very result that they are trying to sell. Summary Equity stripping can be a very powerful asset protection tool when planned with foresight and implemented with care and subtlety. Many business owners can build it into their business structures. Even individuals can use it through such strategies as premium financing. Yet, when implemented poorly or overtly, equity stripping arrangements may be set aside by a court. Equity stripping strategies require the guidance of skilled counsel. Avoid canned programs that promise equity stripping benefits, especially if the marketing materials indiscreetly identify asset protection as a stated goal of the program.
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