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Equity Stripping

EQUITY STRIPPING: THE GOOD, THE BAD, AND THE UGLY

By W. Ryan Fowler

Copyright © 2005 The Privacy & Financial Shield LLC. All rights reserved.

Although equity stripping can be an effective (and sometimes the only) means to protect assets, it requires much skill to implement properly. Poorly designed programs are often either vulnerable to fraudulent transfer rulings, or are costly from a tax and/or economic perspective. This article seeks to identify potential flaws in certain equity stripping programs, along with creative solutions that sidestep these problems.

WHAT IS EQUITY STRIPPING?

Equity stripping is the process of encumbering an asset with a lien(s) as a means of protecting the asset from future creditors (a creditor being anyone who lays claim to your property, including a judgment creditor, ex-spouse, bankruptcy trustee, the IRS, etc.) As defined by the Uniform Fraudulent Transfers Act (“UFTA”), a lien is “a charge against or an interest in property to secure payment of a debt or performance of an obligation, and includes a security interest created by agreement, a judicial lien obtained by legal or equitable process or proceedings, a common-law lien, or a statutory lien.” In layman’s terms, this means a lien includes any collateral you give to someone in order to ensure you repay a loan or fulfill an obligation. Technically the lienholder owns an interest in your property, which means if you default on your loan or obligation, he may force the sale of your property via auction (foreclosure) and use some or all of the proceeds to pay off the balance of the debt or obligation.
In an asset protection context, liens are extremely useful. This is because a properly completed (a.k.a. “perfected” ) lien will, with very few exceptions, take precedence over all future liens as long as it is in effect. If all of a property’s equity is attached to existing liens (“equity-stripped”), then all future liens placed on your property will essentially be worthless to the creditor. This is because there is no equity left for the subsequent liens to attach to, which means if a junior lienholder (whose lien doesn’t attach to any equity) tried to foreclose his lien, he would get nothing from the sale, since every prior lienholder would be paid first, with nothing left over except for thousands of dollars in expenses for arranging the auction. Even worse, if the property owner sold his property to a bona fide third party for fair market value, in most circumstances all liens would be wiped out, notwithstanding the fact that some lienholders come away empty-handed.
As mentioned previously, sometimes equity stripping is the only viable means of protecting an asset. For example, financed property usually can’t be transferred into an LLC or other limited liability entity without triggering a loan agreement’s “due-on-sale” clause. If the clause is triggered, then the lending institution typically reserves the right to accelerate the loan, making the entire balance payable within 30 days; f0ailure to repay the entire loan may result in foreclosure on the property. Even though a lender may not exercise their rights if the due-on-sale provision is triggered, I strongly recommend against playing with fire! Another situation where equity stripping is desirable is when one is protecting their home. Under §121 of the Internal Revenue Code, a property that is a person’s home for two years in any five year period qualifies for an exemption on gain if the property is sold. This exemption is $250,000 for an individual or $500,000 for a married couple. Although placing the home in a single member LLC (SMLLC) or other entity with “disregarded entity” tax status will preserve this exemption, placing the home in a family limited partnership (“FLP”) or family LLC (“FLLC”) will not. Therefore, it may instead be more appropriate to strip the equity to the FLP or FLLC.
Now that we understand the basics of how equity stripping works, let’s examine programs that are vulnerable to failing under court scrutiny (the Bad), programs with painful tax and economic consequences (the Ugly), and programs that have neither shortcoming (the Good.)

THE BAD

Bogus Friendly Liens

By far the most commonly used of the flawed equity stripping strategies is the bogus lien. A bogus lien involves a friendly party (either a relative, LLC, Nevada corporation, or other entity) filing a lien against the target asset. The lien is “bogus” because the owner of the target asset receives no compensation in exchange for granting the lien. In other words, there is no loan or bona fide obligation as a basis for the lien. Per the Uniform Fraudulent Transfer Act, any transfer that occurs with no exchange of equivalent value is highly susceptible to a fraudulent transfer ruling , meaning the lien will likely fall apart if challenged in court. What’s worse, under the UFTA bogus liens fall in the category of fraud-in-fact, which is much easier to prove than constructive fraud. Consequently, although the bogus lien is easy to implement and maintain, it is also the easiest program to attack and eviscerate. Should a bogus lien occur shortly before a creditor threat arises, a knowledgeable attorney should have little problem convincing a judge to invalidate the lien. Yet despite the weakness inherent in bogus liens, they may offer limited asset protection if they are implemented with subtlety, far in advance of any creditor claims.

THE UGLY

After the Bad, we must examine the Ugly. Ugly programs usually work as far as asset protection is concerned, but they can be quite painful from an economic perspective. Let’s examine these Ugly programs, so that you can avoid potentially painful hidden costs and tax traps.

Tax Consequences of Certain Valid Friendly Liens

Not all friendly liens are bogus. If a friendly party gives you an actual loan that is equivalent in value to the lien, for example, and he is not an “insider” as defined in applicable fraudulent transfer law, then the lien may well survive a court’s scrutiny. However, there may still be problems with such a lien. First, you need to find a friendly person or business entity (which you may or may not have funded with your own cash) that is willing to loan you money on friendly terms. My experience is that people generally have more wealth placed into hard assets than liquid assets. Therefore, you may find it difficult to find enough cash to equity strip your $500,000 home, unless you happen to have some rich friends. Second, the interest payments may not be tax-deductible by you, but they will almost certainly be considered taxable income to the lender. If your friend is really making a buck off of interest payments, then he shouldn’t mind paying the tax. However, if he intends to gift your interest payments back to you, so that you aren’t losing money in the arrangement, then someone is going to have to foot the tax bill.
Finally, remember that if you receive a cash loan, you now need to protect the loan proceeds from creditors, and also make sure to structure the promissory note (a.k.a. loan agreement) so that the loan is not paid down gradually over time.

Equity Stripping via Commercial Loans: Outrageous Interest Expenses and a Possible Super-Nasty Surprise

The strength of any lien held by a legitimate commercial lender is that is practically impossible to invalidate. The weakness is everything else, especially from an economic standpoint. To illustrate the point, let’s look at the drawbacks of taking out a 2nd mortgage to equity strip a home. In this example, the home has a fair market value of $500,000 and an existing mortgage of $200,000. The problem with taking out a 2nd mortgage to equity strip is threefold. First, commercial lenders usually only loan up to about 80% of a property’s value , leaving 20% of the equity exposed. Securing additional loans to completely encumber the property usually involve very high interest rates (typically 15% or so.) Second, as the loan gets paid down, the property becomes less and less encumbered and therefore more equity becomes vulnerable. Third, the cost of making interest payments on the loan can be quite expensive. For example, say you take out a $200,000 2nd mortgage on the property, to equity strip it to 80% of its value. If this was a 30 year loan repaid in monthly installments at 7% interest, you would pay $195,190.00 in interest before the loan was paid off. If you take out another loan for $100,000 in order to strip the property of all equity, you may pay 15% interest. Under the same repayment terms as before, the interest payments equal an additional $355,198.40. Inflation notwithstanding, this is a very expensive means of asset protection! Of course you could invest the loan proceeds in government bonds, annuities or life insurance, but you will still likely end up paying more than you would earn with these investments. Riskier investments (such as stocks) could provide a greater return, but you could also lose money and end up worse off than if you hadn’t invested the proceeds at all.
Even from a non-economic standpoint, there are still problems with commercial equity stripping. For example, mortgages are typically paid down over time, leaving more and more equity exposed to a creditor. Furthermore, if you find yourself under creditor attack, you may very well lose the means to make loan payments. Therefore, if you don’t have cash set aside outside of a creditor’s reach, you may find yourself defaulting on your loan, resulting in foreclosure of the very property you were trying to protect! Although these last 2 problems may be overcome, other commercial equity stripping shortcomings may be difficult or even impossible to remedy.

Accounts Receivable Equity Stripping Through Premium Financing: Variable-Rate Loan Traps, Disappearing Tax Deductions, and So-Called “Exempt” Life Insurance Products

The concept behind accounts receivable (“A/R”) premium financing for the purpose of asset protection is relatively simple. Essentially a business uses its A/R as collateral to obtain a loan, which is then used to purchase a life insurance product or annuity. Because many states protect such policies from creditors, the reasoning goes, the loan proceeds have been protected while also protecting (via equity stripping) the A/R. Furthermore, because the policy accrues interest, this helps offset the loan’s interest payments.
Equity stripping in such a manner has become a very popular asset protection technique. But I need to make it clear that the biggest reason these programs are popular is not because they work (although the best programs do work.) The reason these programs are so popular is because they make the promoters tons of money. For example, an asset protection planner convinces you to take out a loan for $100,000, using your A/R as collateral for the loan. Then, he tells you to invest the money in a universal life insurance policy, because your state exempts these policies from the claims of creditors, and furthermore you could always borrow cash from the policy in the future if you needed to, right? Sounds like a great way to protect your A/R, right? Well, what the promoter didn’t tell you is that he just made up to $55,000 from this arrangement, and although this program may very well protect your A/R from future creditors, A/R equity stripping through premium financing contains many traps and pitfalls, and most programs out there do not avoid these pitfalls. Consider the following:

• Contrary to what many believe, interest payments your company makes on a loan it took out to purchase an annuity or life insurance policy for you are often not tax deductible. (Although you may or may not be able to overcome this problem if you work with a competent tax attorney.)
• Almost all loans secured by A/R are variable rate loans, whereas your life insurance product or annuity will grow at a fixed rate. In other words, three months after you take out your loan, you may be unhappily surprised with rising interest rates on your loan, which makes your A/R financing program much more expensive than you thought it would be, and now you’re stuck between a rock and a hard place. That’s ugly!
• Although the policy you bought may be exempt in your state, if the company that sold you a policy operates in other states, then a judgment creditor could enter their judgment in a state where your policy is not exempt. Because the insurer operates in that state, and your policy is not exempt there, the creditor could seize your policy in the non-exempt state. Congratulations, you just lost your $100,000 policy, but you still have a $100,000 loan to pay off. Super Ugly!!!
• Above all, remember this: a life insurance rep. can earn up to 55% commissions by selling you a life insurance policy. In other words, he makes up to $55,000 by selling you a $100,000 policy as part of an asset protection program. Do you think some of these insurance reps. might be looking to fatten their pockets, rather than set up a plan that’s best for you? Can you say conflict of interest, boys and girls? That’s great, I knew you could.

Now I must emphasize that equity stripping A/R through premium financing is not always a bad way to go; it is sometimes possible to overcome all A/R premium financing shortcomings if you use a planner that really knows what he’s doing (most don’t.) But, considering that many people who’ve done this type of equity stripping were afterwards very unhappy, make sure you’ve addressed all the potential traps and pitfalls before committing to such a program.

THE GOOD

Now we come to the Good ways to equity strip. I need to emphasize that even a Bad program may protect assets, and some Ugly programs can avoid their Ugliness (though most don’t.) The reason that the following programs are Good is because these programs sidestep equity stripping pitfalls much more easily. However, keep in mind that proper equity stripping requires much skill, and even a Good technique can turn Bad or Ugly if done wrong.

As we’ve seen, anytime a lien involves cash, there tends to be several pitfalls awaiting the unwary. However, a re-reading of the legal definition of the word “lien” gives us valuable insight into how these traps may be avoided:

“lien” means charge against or interest in property to secure payment of a debt or performance of an obligation; [emphasis is mine.]

Quite frankly, it amazes me that other asset protection planners fail to capitalize on the fact that liens are commonly used to secure obligations, and are every bit as valid as cash loans. Furthermore, it amazes me that other asset protection planners don’t realize a lien securing an obligation is superior in many ways to a lien securing a loan. For example:
• There is generally no negative tax or economic consequence to fulfilling an obligation.
o No worrying whether or not your interest payments are tax-deductible.
o No interest expenses at all, for that matter.
o No worrying whether your variable rate loan will exceed your fixed-rate (or risky variable rate) investment.
• It’s very easy to structure a security agreement so that the lien is not reduced or paid down until your obligation is completed in full. You can even structure the agreement so that the lien grows until the obligation is fulfilled.
• Your secured obligation almost certainly has absolutely no value to a creditor, whereas the cash proceeds of a loan always have lots of value to a creditor, meaning you’ll have to jump through more hoops to protect the loan proceeds.
• If you’re in trouble with creditors, your liquid assets may be unavailable for loan payments, meaning your “protected” property is in danger of foreclosure. However, since creditor troubles should not affect your ability to fulfill non-monetary obligations, (or rather we could arrange a monetary obligation with a “friendly” entity) foreclosure is not a problem.
• You don’t have to worry about “how am I going to get $625,000 to equity strip my $500,000 home?”
• Cash loans are easy to quantify, making it very difficult to justify a large lien securing a small loan. However, certain obligations can be difficult to quantify, given us more leeway when we are structuring an obligation to be of “equivalent value” to the cash value of a lien.

With the above in mind, let’s examine some ways in which a bona fide obligation may be used to place a valid lien on your property.

Equity Stripping via LLC Capitalization

One of my favorite methods of equity stripping is via LLC capitalization, which is a method I developed to rectify the shortcomings of other equity stripping programs. The concept goes like this: two people form a Limited Liability Company (LLC) in order to run a business (which could be some legitimate yet easy-to-do activity such as investing in stocks and bonds.) Under the LLC Acts of every state, each member (member being the LLC equivalent to partner) can obligate the other, per a written agreement, to contribute capital (assets) to the company so that it has a means to operate. One of the members contributes a smaller amount of assets up front to capitalize the company, in exchange for a small but significant ownership interest (usually 1-5%). The other member promises to make a large capital contribution over time, in exchange for an upfront large interest in the company (95-99%). Because the first member contributed his capital up front, but the second one did not, the LLC places a lien on the second member’s property to ensure he fulfills his obligation to capitalize the LLC over time. As long as the LLC is not considered an insider under applicable fraudulent transfer law, and the obligation is valid, its fulfillment demonstrable, and it “makes sense” in a business context, a rock-solid lien has been created on the 2nd member’s property. Such an arrangement is illustrated in Figure 1, below.

FIGURE 1

It’s important to note in this scenario that Member 2’s promised contribution could take many forms. It could be a promise to contribute cash, services, equipment, or other property. And after the lien expires, the members could dissolve the LLC and typically all returns of capital will revert back to them tax free. Furthermore, almost any type of asset could be equity stripped via this method, whether it be accounts receivable, real estate, or personal property. Indeed, the flexibility of equity stripping via LLC capitalization is so great, that practically any type of asset could be protected, according to practically any terms that fit within the realm of normal business practice.

The Lessor’s Lien: A/R Equity Stripping Without Premium Financing Headaches

As a corporate officer of several companies, I am often tasked with reviewing various real estate lease agreements. Most of these agreements contain a lessor’s lien clause. These liens that I periodically review are not part of an intentional asset protection program; rather they are liens that arise in the normal course of business. As mentioned previously, a lien may be used to ensure someone meets an obligation. In this instance, the lessor wants to make sure that the lessee fulfills his lease, so oftentimes a UCC-1 financing statement is filed against the lessee’s accounts receivable, furniture, equipment, and other assets. Of course in this situation the lessor is not trying to protect the lessee’s assets against other creditors, but that is exactly what he’s doing.
The best asset protection planners understand how liens are used in such everyday business arrangements, and he capitalizes on such processes. Utilizing a standard business arrangement for asset protection is especially desirable because it appears that no intentional asset protection was done. Because normal business arrangements often use accounts receivable to secure a lease agreement, a lessor’s lien is an especially good way to protect this valuable asset.
The best type of lessor’s lien, of course, is one that is held by a company who is friendly towards the lessee, because we can then draft the lease and lien terms to best suit our needs. Often times I will take property in a business, sell it to another business, and lease it back to the original business. This is called a “lease-back” arrangement, and has two benefits: first you protect one piece of property by putting it in a separate entity, and then you lease back the property to the original entity, and put a lessor’s lien on a second asset. For example, an LLC could sell an office building to a 2nd LLC, lease the building back to the 1st LLC, and subsequently place a lessor’s lien on the 1st LLC’s accounts receivable. As simple as the concept sounds, a lessor’s lien in this or similar circumstances still requires a high degree of skill to do correctly. The trick is to transfer the original asset into a separate entity in a manner that won’t be considered a fraudulent transfer, among other things. Also, one must structure each entity so that they’ll be respected as separate entities if challenged in court. For example, sometimes if one entity is sued, and the managers of that entity also happen to manage the 2nd entity, both entities will be considered to be only one entity under the “theory of interlocking directors.” This “piercing of the veil” of the 2nd LLC will not only avail the 1st LLC’s creditor of the 2nd LLC’s assets, but also invalidate the reason for a lien on the company’s accounts receivable. Therefore if you wish to do a lessor’s lien between friendly companies, make sure you hire a skilled professional to assist you.

Multi-Stage Equity Stripping: The Solution to Traditional Equity Stripping Shortcomings

Despite the advantages of equity stripping via LLC capitalization and the lessor’s lien, these programs may not completely meet an individual’s needs. For example, if an individual wanted to protect their $500,000 free and clear home, they would have to promise a large capital contribution of either services or cash to the LLC. Honoring such an obligation might not be desirable. Furthermore, if the obligation was to manage the LLC, then the LLC that held the lien would be considered an insider under fraudulent transfer law. Although this does not necessarily mean a fraudulent transfer has occurred, it may somewhat reduce the lien’s chance of survival if its validity were attacked by a sophisticated and determined creditor. Fortunately, multi-stage equity stripping allows us to overcome these obstacles.
Multi-stage equity stripping is simply the process of placing two or more liens on a piece of property. If the target property is real estate (the most common asset I equity strip), I most often have my client use the property to obtain an Equity Line of Credit (ELOC). The benefits of an ELOC are fourfold. First, although the lien is filed when the ELOC account is opened, one need not pay interest or other fees until the ELOC is used. Only under severe creditor duress does the ELOC even need to be exercised . Second, oftentimes homeowners wish to “un-trap” equity in their homes, so that they may invest the proceeds for profit. An ELOC is an ideal means of doing this. Third, an ELOC can continuously strip a target property of 75-80% of its equity. Unlike a traditional mortgage, which will gradually be paid down, one can choose to only pay interest on the ELOC, thus ensuring, if necessary, that an increasing amount of equity will not be exposed to creditors. Furthermore, because much of the equity is stripped via an ELOC, it is easier to strip the remaining equity with an equity stripping via LLC capitalization program. Finally, even if a weakened equity stripping via LLC capitalization program is used, from a creditor’s standpoint the program will only attach to the least desirable equity. This is because if a creditor forecloses on a debtor’s real property, the property will likely only sell for 60-75% of its fair market value. Because the ELOC covers all this equity anyway (which lien has practically no chance of being invalidated in court), the creditor has little incentive to challenge the 2nd lien. Despite this fact, we still wish to place the 2nd lien on the property, to cover its equity in case the property appreciates, or if in the future the owner decides to sell the property for fair market value.
In summary, although equity stripping usually requires great skill to do correctly, creative and knowledgeable planners should have no problem finding an effective equity stripping method that meets their clients’ needs while minimizing the expense and effort involved in maintaining such a program.

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