What about professional corporations, limited liability companies and limited liability partnerships? How about going bare?

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2 What about professional corporations, limited liability companies and limited liability partnerships? These fairly new forms of professional practice do provide a level of protection against claims resulting from the conduct of colleagues in the organization. Members of these types of entities are typically liable only for their own conduct and acts of others under their direct supervision. 3 Unfortunately, the statutes that authorized these forms of operation do nothing to shield or limit liability for claims and judgments against individual physicians. Unlike shareholders in other types of corporations, physician members of professional corporations, limited liability companies and partnerships remain subject to unlimited liability for business creditor and liability claims. How about going bare? The idea of dropping all professional liability insurance bubbles up from time to time when the insurance market hardens. The theory of "going bare" assumes that uninsured physicians are not desirable "deep pocket" targets for personal injury plaintiffs and their lawyers. Although that theory may have some superficial appeal, the approach is extremely dangerous and frequently backfires when a physician is drawn into litigation with inadequate defense resources. Even "frivolous" lawsuits must be defended to avoid a default judgment. These defenses take time and money. Unless a "bare" physician has salted away $250,000-$500,000 as selfinsurance," a lawsuit, particularly one involving multiple parties, can take an enormous economic and psychological toll. In a serious injury claim, hundreds of thousands of dollars could easily be consumed by defense and expert costs, leaving no indemnity protection. "Going bare" relies on the assumption that an uninsured physician is not an appealing litigation target. That may be a fairly reasonable assumption if the physician has no personal assets, but in most instances the decision to practice without insurance exposes all of the physician's assets to creditors, including successful malpractice plaintiffs. Although this approach may initially "feel good," it tends to lose its appeal rapidly in the face of a claim or lawsuit. May I minimize my spouse s exposure from professional liability claims? Yes, under Arizona's community property laws the assets of a marital community may be separated to protect the less exposed spouse from professional liability claims. In Arizona, claims arising from the conduct of a business or profession are generally treated as community obligations. A professional liability judgment creates a debt that is collected first from community assets and, if those are insufficient to satisfy the obligation, from the separate property of the spouse whose conduct led to the obligation. The separate property of the uninvolved spouse is not exposed to the malpractice judgment creditor. If, as is typically the case, a physician and spouse have co-mingled community property, the family's cumulative exposed "pot" is substantially larger than it would be if the community property were separated. The separation of community assets can be accomplished through the process of "transmutation," which allows the transfer of community assets to the separate estate of the spouse with the least liability exposure. This approach could provide considerable protection to a married couple's larger assets, leaving a substantially reduced "pot" for creditors. Transmutation is not, however, without its limitations and risks. First, the spouse who receives the bulk of the community assets as separate 2

3 property is in a financially advantageous position. This can be particularly significant in the event of a divorce. Transmutation will also have income and inheritance tax consequences. If more than fifty percent of community property is transferred to a spouse, there could be potential gift tax consequences. In addition, the transfer of a disproportionate percentage of the community estate could be viewed as a fraudulent transfer. Despite these limitations, a "fiftyfifty" split of community property could shield a substantial portion of a family's assets. Before undertaking a transmutation process, spouses should confer with experienced counsel and other advisors on the taxation, inheritance and control implications of dividing a community estate. Do limited partnerships limit professional exposure? Limited partnerships are very versatile business entities that serve a variety of operational and family objectives. A valid limited partnership, that is not designed to "hinder, delay or defraud creditors," can protect partnership assets from the liabilities of general and limited partners. A creditor may only access partnership funds through a "charging order," which is a court order directing a trustee to transfer to a creditor distributions to which a partner was entitled. Under a charging order, the creditor is treated as an assignee of a partner's right to receive a partnership distribution. A carefully drafted limited partnership agreement can substantially minimize a partner's exposure to creditor charging orders. Will a family limited partnership protect assets? Family limited partnerships have been used for many years to manage family businesses and property. In addition to being flexible, continuous and expandable to encompass many forms of property and business, this type of entity provides significant asset protection. Unlike stock in a corporation, a partnership interest is generally not subject to distribution or accessible to creditors except in a claim against the partnership entity. The assets of a partnership are not subject to the obligations of individual partners. As with other forms of partnerships, a family partnership may be served with a charging order in favor of a creditor who would become entitled to whatever distribution a specific partner-debtor becomes entitled to receive. Charging orders are a tedious process for creditors, and family partnership agreements are often written in a manner that discourages attempts to obtain charging orders. Unless a limited partnership is set up for a fraudulent purpose, even a federal bankruptcy trustee would face serious impediments in attempting to force disgorgement of partnership assets. 4 Will a trust protect my assets? Trusts are perfectly legitimate estate planning vehicles that have been recognized and enforced by countless courts for many years. There are many types of trusts and some commentators suggest that their varieties are only limited by the imagination of lawyers. In certain circumstances, assets placed in trust can be sheltered from creditor claims if the assets are irrevocably transferred for a purpose that does not violate the Fraudulent Conveyance Act. A lawful and effective conveyance to a trust cannot be made with intent to hinder, delay or defraud any creditor. "Spendthrift Trusts". This type of trust expressly prohibits the beneficiaries from voluntarily transferring to anyone else their rights to receive trust income or principal. Arizona recognizes spendthrift trusts and provides that a beneficiary's interest in a spendthrift trust "is not subject to enforcement of a money judgment until paid to the beneficiary." 5 Arizona courts have 3

4 discretionary power to order trustees to "satisfy money judgments after an amount of principal becomes immediately due and payable. 6 Although this type of trust can shelter substantial amounts of principal and interest for extended periods, its asset protection benefits are not available if the settlor is the sole beneficiary. 7 "Self-Settled Trusts". The person whose assets are placed in trust is called a "settlor." Except in states, which specifically protect the assets of self-settling trusts (discussed below), when the settlor is also a beneficiary of the trust, the settlor's interest in the trust can generally be reached by creditors. This is particularly true in trusts that allow the settlor to transfer or control his interest in the trust. 8 In most states this rule applies even when the settlor has a legitimate reason to establish the trust and no intention to defraud creditors. "Discretionary Blended Trusts". In this type of trust the settlor has a beneficial interest in the trust assets, but an independent trustee has discretion to distribute income and principal for the benefit of the settlor and one or more other beneficiaries. 9 The trustee's absolute discretion in deciding whether to distribute and, if so, to whom and in what amount, protects the beneficiaries' interests from creditor claims. Under Arizona law, a creditor "may not compel the trustee to pay an amount that may be paid only in the exercise of his discretion." 10 This type of trust can be an effective asset protection vehicle so long as the settlor is willing to include additional beneficiaries in the trust. This type of trust does, however, have potential gift, estate and income taxation implications that should be considered with the advice of an experienced tax professional. 11 Are offshore trusts the ultimate shield? Trusts located in foreign countries that offer debtor friendly laws have become a popular media topic. Although various types of foreign investments can offer currency devaluation protection, access to foreign markets, and convenience in a global economy, offshore trusts are principally designed to maximize asset protection. A substantial number of debtor friendly countries vie with each other to attract wealth with promises of anonymity and security from creditors, nosy regulators and litigants. The countries that offer asset protection advantages are typically out-of-step with the worldwide trend toward enforcement of international judgments and awards through treaties or "comity," the principle of international law that recognizes the judgments of foreign tribunals. Several small countries are becoming known as asset protection havens. The Cook Islands government has plainly rejected the general rule of comity and creditors face monumental challenges in that jurisdiction. 12 There are many other examples of traditional tax havens passing legislation creating significant barriers to creditor efforts to reach assets located in a trust device sited in their jurisdiction. One of the leaders in this area is Bermuda, which in 1993 passed the "Conveyancing Amendment Act of 1993" to protect assets in a trust from creditors' claims against the trust settlor. This further enhances the ability to have a self-settled trust under Bermuda's Perpetuities and Accumulation Act of 1989 and the Trusts (Special Provisions) Act of 1989, which severely limits the ability to pursue fraudulent conveyances into a trust and renders the trusts immune from the judgments of foreign courts 13. Other excellent examples of debtor friendly laws are found in Cyprus 14 (International Trusts Law of 1992) and the Nevis International Exempt Trust Ordinance of the Isle of Nevis in the East Caribbean. Nevis has become a new darling of the asset-flight crowd, along with Jersey, the Turks and Caicos Islands. 4

5 Asset protection trusts are typically established in countries like those listed above that do not recognize or effectively enforce foreign judgments and legal processes such as discovery orders, divorce decrees or subpoenas. These trusts reduce the size of the settlor's estate that is vulnerable in the United States and add a layer of privacy that can shield assets from income and estate taxation accountings. A fundamental premise of the offshore trust device is the assumption that a reduced US estate will enhance negotiation leverage and discourage lawsuits. Although these types of trusts are not impenetrable, they sometimes provide a sense of vindication to some, who believe that the American legal system is stacked against them. Offshore trusts can certainly complicate and add expense to creditor collection actions. When funds are housed in a debtor friendly jurisdiction, creditors are forced to litigate in a hostile foreign environment. With myriad procedural disadvantages and much less access to information through judicial "discovery" than they would enjoy in the US, creditors face a calculatedly difficult path in pursuing collection efforts against offshore trusts. The debtor-friendly jurisdictions that welcome these types of asset protection trusts are typically receptive to very creative trust provisions that allow the settlor to maintain substantial control of assets with the flexibility to reassign control as necessary to minimize the jurisdiction of US authorities. In some countries, trustees may be authorized to transfer trust assets to other "safe" jurisdictions if things "get hot" in the initial jurisdiction. Like many other things in life, an offshore trust can be too good to be true. As with any asset protection strategy, a foreign trust will be vulnerable to attack, if it is created to defeat existing or reasonably foreseeable obligations. Trusts designed to protect against future presently unanticipated litigation rather than to shelter assets from known exposures have a much stronger likelihood of success if challenged in any judicial forum. They are, however, very expensive to establish and maintain. The initial set-up costs may range between $25,000 and $50,000. Annual maintenance fees are approximately $25,000 to $30,000 per year. Are domestic self-settled trusts a viable option? Several states provide substantial protection to assets placed in self-settled trusts in which the settlor may be the sole beneficiary. Nevada, Utah, Alabama, Rhode Island and Delaware presently authorize self-settled trusts, which may be established by both residents of the states and non-residents, so long as the trust is administered by a resident trustee. Unlike most states, these jurisdictions grant substantial asset protection to trusts in which the settlor maintains substantial control as the only beneficiary. This form of trust, which could be established in neighboring states by Arizona residents, offers a very beneficial option to offshore trusts and other more complex asset protection strategies. This approach could provide substantial asset protection with relatively modest start-up and maintenance expense. Conclusion "Going bare" by practicing without adequate professional liability insurance would be very risky in Arizona. Even the asset protection strategies described in this article leave exposure gaps that are best covered by insurance. Before initiating any asset protection strategy, think carefully about long-term objectives, foreseeable changes in your financial and marital status and get the advice of experienced tax, accounting and estate planning professionals. Although the laws of the jurisdictions that encourage asset protection trusts appear at first blush to provide a strong antidote to creditor claims, the tenacity and resourcefulness of US creditors and courts should never be under-estimated. Unless the settlor/debtor is prepared to abandon all ties with the US, the federal and state courts will retain substantial coercive power to compel disclosure of information and disgorgement of assets housed in other states or abroad. 5

6 The law of asset protection is in a period of transition. While many states continue to provide strong remedies to creditors, some jurisdictions are leaning toward a more even playing field in which legitimate business and estate planning vehicles, such as asset protection trusts can provide substantial advantages. While the tight professional liability insurance market may make these options attractive, it will take years to see how much protection these strategies afford in the face of committed and well-funded attacks by creative creditors, lawyers and bankruptcy trustees. The Arizona Medical Association is closely monitoring developments in asset protection law and working to provide Arizona physicians with useful information on planning options. As part of its ongoing law reform initiative, ArMA will recommend and support legislative changes to make more effective asset-protection vehicles available in Arizona. Notes 1. A.R.S A.1 2. E.R. 1.2 (d) 3. LLC/LLP Liability Provision 4. Restatement (Second) of Torts Restatement (Second) of Trusts A.R.S A 7. I.R.C. 676(a); 677(a); 2036; A.R.S A 9. A.R.S B 10. A.R.S B 11. Mitland Raleigh-Durham v. Myers, 807 F.Supp (S.D.N.Y. 1992) 12. W. Diamond, D. Diamond, and Barry Kaplan, International Trust Laws and Analysis Special Provisions Act, 11 (1989), Bermuda 14. International Trusts Law of 1992, Cyprus 6