Asset protection requires that you understand how liens arise and what property is protected from the reach of your creditors by federal or state law. Many times, the fact that your assets are exempt from seizure makes a creditor reconsider filing a lawsuit against you.
You've heard it dozens of times: "the best defense is a good offense." This definitely holds true for asset protection. In addition to shielding your assets when attacked, asset protection planning has another ancillary benefit that serves your goals: the more judgment-proof you make yourself, the less likely it will be that a creditor will bother to pursue a case against you. Or at the least, you may be able to influence a settlement, possibly sooner rather than later.
Avoiding liens through the power of persuasion
Many times, judicial liens can be avoided through the power of persuasion. That is, you may be able to avoid a lien by convincing the other party that any lawsuit would be a waste of time. The amount of time and money saved in avoiding litigation is substantial!
In a court proceeding, there are three parts to a lawsuit:
- factually proving the elements of the case (e.g., negligence),
- proving the existence and amount of monetary damages, and
- collecting the judgment.
The plaintiff has the burden in each of these three parts.
In many cases, the first part is not an issue. For example, if an employee making a delivery runs into the back of a vehicle stopped at a red light, there really is no issue as to whether the employee was negligent: The employee was negligent. However, the amount of monetary damages suffered will almost always be an issue, but the court will eventually determine the amount.
Of the three burdens the plaintiff carries, collecting a judgment can be the most difficult, particularly where there are no assets to attach--either because there are no significant assets, or all of the assets are protected by exemptions and other means.
Judgments expire. Most states provide that a judgment expires after 10 to 20 years. This may seem like a long time. However, judgment creditors rarely continue to pursue the collection of a judgment after an initial attempt fails when they realize that the effort will be fruitless.
In fact, the proceedings may stop far short of judgment. If someone with a claim learns that the other party has no reachable assets, usually the matter will be dropped, and no lawsuit initiated. Generally, few lawyers will take a case on a contingent fee basis for a plaintiff if it's clear that the defendant doesn't have any collectible assets (if they are "judgment proof.") Thus, the plaintiff will be faced with the prospect of paying his or her attorney by the hour (at rates of $150 and upward per hour), with the likelihood that he or she will collect nothing. Faced with these dim prospects, even individuals who would otherwise sue on principle will usually choose not to pursue the matter further.
Informing the other party that the lawsuit will be fruitless, before it is filed, can be a very effective strategy. If you do not have resources that could be reached by a judgment creditor, let the other party know immediately of your situation. Because of the costs and time involved in bringing a lawsuit, most parties will forego the claim when presented with these facts.
A word of caution is necessary, however. Phrasing can be important. Don't elaborate on the asset protection plan you have in place. General statements usually are better. Simply tell the other party, or his or her lawyer, that you will defend against the lawsuit if necessary, but that you don't have any assets that would be available in any event.
When questioned, simply point out that your only real asset is your ERISA-qualified retirement plan, which is exempt. Tell the other party that you will vigorously defend against the lawsuit, but it will be a waste of time anyway. If you do not feel comfortable doing this, hire a lawyer. The fees spent will usually be worth the results achieved in this situation.
If you are not successful at discouraging a legal action, or if you are already facing liens against your property, it is important to examine whether those liens can be invalidated. If not, you need to consider whether they can be eliminated or reduced.
Lien defects or FTC rules can invalidate liens
Your strategy for attacking a lien placed against your assets and your chances of success depend upon the type of lien that you are facing. If the lien was not properly created, you may be able to invalidate it. But, most likely, you will need to challenge it based on the fact the assets are exempt from lien.
Search for defective lien creation or perfection
When battling liens, a small business owner may be able to win by establishing that the lien is invalid. Liens that are invalid cannot impair any assets: it doesn't matter whether those assets are exempt or nonexempt.
Statutory liens, such as mechanics' liens and tax liens, are invalid unless they have been:
- filed with the appropriate government office ("perfected"), and then
- foreclosed on within a certain period of time.
The time limitations vary from state to state. In the case of mechanic's liens, these periods are very short. Typically, these liens must be filed within 60 or 90 days after the work is performed, and then foreclosed on within one year. Tax liens usually have to be filed within 2 to 3 years, and expire after 10 or 15 years.
Even judgment liens have time limitations. Usually, judgment liens must be foreclosed on within 10 to 20 years. If any liens have not been filed, or foreclosed on, within the prescribed periods, the liens are invalid and unenforceable.
Peter Jones has a contractor put a $40,000 addition on his residence, but has not yet paid the bill. Jones' residence, worth $120,000 after the addition, is subject to a $100,000 first mortgage.
The residence is an exempt asset in Peter's state under these facts. However, mechanics' liens are valid, even when they impair an exempt asset.
Fortunately for Peter, the contractor failed to record his mechanic's lien of $40,000 within 90 days of the job being completed, as required by state law.
Accordingly, the contractor's lien is invalid and therefore of no consequence. Peter's home is completely exempt from the claims of the contractor, based upon the mechanic's lien statute. However, he could still be sued and ultimately subject to a judgment lien on his assets.
FTC credit practices rule may invalidate lien
The Federal Trade Commission's (FTC) Credit Practices Rule can be used to invalidate certain types of liens against household property. Remember, an invalid lien can be eliminated whether it is attached to exempt or nonexempt property.
Under the FTC Rule, certain non-purchase-money, non-possessory security interest liens are invalid: specifically, liens attached to household necessities and goods.
This provision affects only consumer goods and not liens on business property. Most importantly, because consumer goods often would be entitled only to limited protection as exempt assets, the rule can offer real protection.
Lien must be non-purchase-money lien. A non-purchase-money security interest lien arises where the proceeds from the debt were not used to purchase the property. In other words, this type of lien arises when you use property that you already own as collateral for a loan, the proceeds of which are used for some other purpose. Loans involving purchase-money security interest liens (where the creditor finances the purchase of the asset that is the collateral for the loan) are more common, and are not invalid under this rule.
Lien must be non-possessory. The lien must also be non-possessory to be invalid under the FTC Rule. This means that the debtor, as opposed to the creditor, has possession of the property. In contrast, an example of a possessory lien would be a pawn shop loan, where the creditor holds the collateral. Possessory liens in these types of property also remain valid under this rule.
Lien must be for household goods. The rule's definition of household goods includes household necessities such as clothing, appliances and linens, and some items of little economic value but of unique, personal value to the owner. These may include items such as family photographs, personal papers, the family Bible, and household pets.
The following types of property are excluded from the definition of household goods:
- works of art,
- electronic entertainment equipment (except one television and one radio),
- items acquired as antiques (more than 100 years old),
- jewelry (except wedding rings),
- pianos or other musical instruments,
- boats,
- snowmobiles,
- bicycles, and
- cameras.
Liens on these types of property remain valid.
In practice, most commercial lenders and merchants will steer clear of liens that come under this rule because they are aware the liens would be invalid. However, some lenders who are either unscrupulous or ignorant of the rule may try to attach a lien to these assets. Therefore, you should be aware that liens that fall within the rule are invalid, and thus cannot impair any exempt or nonexempt assets.
Non-purchase-money, non-possessory liens on household items and certain other property can be eliminated in some bankruptcy proceedings as well.
Liens can not attach to exempt assets
When battling liens against you, the ability to eliminate judgment liens by establishing that the assets are exempt can spell the difference between financial ruin and success.
Generally, a lien can be eliminated only if three conditions are met:
- the lien is a type of lien that can be eliminated;
- the lien is against a class of assets known as exempt; and
- the amount of the lien impairs the exemption.
Determine the type of lien
The first task is to determine whether liens are the type that can be eliminated. This is determined under the law of your state or under federal bankruptcy law.
As a general rule, consensual liens and statutory liens cannot be eliminated, even when they are attached to protected assets. In contrast, when a creditor attempts to enforce a judgment lien against your protected property, in a state court or bankruptcy proceeding, that lien may be invalidated or eliminated. Alternatively, you may be able to bifurcate the lien, stripping away some of its value, in bankruptcy court.
Statutory and consensual liens can effectively nullify the idea of "exempt assets" granted under the law. The result is really no different than if the asset were not classified as exempt. Clearly, this understanding is important, as an examination of the asset exemption tables alone can lead to a conclusion that an asset is exempt and thus protected, when, in fact, it is fully subject to the claims of certain creditors.
Certain judgment liens cannot be eliminated. Although, most judgment liens cannot be enforced against exempt property, there are several exceptions to this rule. These exceptions generally apply across all the states and in bankruptcy proceedings.
Judgment liens arising in the following situations usually cannot be eliminated:
- alimony or child support
- an order of restitution based on a criminal case
- a judgment based on a prior consensual lien (e.g., a mortgage) or a prior statutory lien (e.g., a tax lien).
State lien exceptions are based on case law. It is surprising that most states do not expressly describe, by statute, the types of liens that can be eliminated in state court when the liens impair an exemption, as this is obviously such an important issue.
North Carolina is one of the few states that do provide clear-cut rules by statute. Other states, which typically do not have such express provisions, usually rely on court decisions, coupled with limited statutory provisions, to define the types of liens that can be eliminated. The general rules we've outlined above are usually good guidelines.
However, in a few states, the courts may have developed narrow exceptions to the general rules. For example, Alabama courts have ruled that a judicial lien arising from a tort judgment cannot be eliminated. While an exception such as this will be rare, you should still be aware that, due to the vagaries of the law in each state, exceptions may exist in a few instances.
Bankruptcy law. Generally, the bankruptcy code follows the rules described above for eliminating liens that impair exempt assets. In addition, however, the code allows for the elimination of certain liens that impair exempt property that cannot be eliminated in a state court proceeding.
If you face any type of lien, don't automatically assume it can or cannot be eliminated. Always consult an attorney. In rare instances, an exception may exist to the rules discussed above that will not allow lien elimination in your particular state.
On the other hand, sometimes an argument can be made that will allow lien elimination when it first appeared that this was not possible.
Do state or federal exemptions protect assets?
If a piece of property is "exempt" it can not be seized by a creditor to pay off a debt you owe. Both federal and state governments allow debtors to keep certain items property, so that they are not left completely destitute by their creditors. Thus, you need to determine whether the asset is exempt from the reach of the judgment.
Whether you use your state's exemptions or the federal exemptions to protect your assets depends upon your answer to these two questions:
- Are you in, or about to be in, bankruptcy?
- Does the state require that its exemptions be used, even if you are in bankruptcy?
If you are not in bankruptcy, you need to analyze your situation using your state's asset exemption statutes. In a bankruptcy proceeding, compare the federal and state exemptions, unless the state has opted out of the federal exemptions.
State exemptions govern in non-bankruptcy cases
Each state provides its own exemptions. These exemptions are sometimes referred to as "post-judgment asset exemptions." In a state court proceeding, after a judgment is rendered against you, you will have to rely on your own state's exemptions.
Asset exemptions vary widely from state to state. Some states have developed reputations for writing laws that favor either debtors or creditors.
For example, Florida, Texas and Iowa have generous exemptions that favor debtors. These states provide debtors with, among other things, basically an unlimited homestead exemption. Thus, in these states, it is possible for a debtor to protect a fully owned home worth millions of dollars in either a state court proceeding or a bankruptcy proceeding. In contrast, Illinois has a reputation of having laws that favor creditors. It provides a debtor with only a $15,000 homestead exemption. Illinois has also opted out of the federal exemption system, so its residents don't have the option of using the more generous federal exemptions in bankruptcy.
Changing your residence (e.g., from Illinois to Texas) used to be an effective asset protection strategy because you used to only have to reside in a state for six months to claim that state's protections.
However, the bankruptcy code was amended to provide a 730 day (two-year) waiting period. If you haven't lived in the state for two years, then the laws of where you lived for the greater part of the six months prior to your move will apply. Needless to say, residence changes and asset conversions must be approached cautiously.
Federal exemptions may govern in bankruptcy
In a bankruptcy proceeding, certain assets are also exempt, and thus outside the reach of creditors. The federal bankruptcy law includes its own list of exemptions, which differ from the state lists. However, under the bankruptcy code, each state may allow its residents to choose between the federal bankruptcy asset exemptions and the state's post-judgment asset exemptions, when a federal bankruptcy action is filed.
Alternatively, a state may "opt out" of the federal exemptions and give its residents only the right to use the state's exemptions in a federal bankruptcy proceeding.
John Smith forms an LLC to operate his business. Smith's major supplier allows him to use an open account, but requires that he personally guarantee his LLC's contract on the account.
After two years, John experiences serious financial difficulties and defaults on the open account. At that time, the balance on the account is $80,000. John's LLC has no assets. His only personal asset is his residence, which has a value of $100,000 and a first mortgage with a balance of $40,000.
The supplier sues John personally based on his guarantee, receives a judgment of $80,000, and places a judgment lien on John's residence in this amount.
However, John's home state allows an asset exemption for a residence in the amount of $125,000. Thus, Smith's residence is an exempt asset. The judgment lien cannot be enforced.
Calculating asset impairment to avoid liens
The final step in lien elimination is to calculate whether the amount of a lien actually impairs an exemption. If all of the liens encumbering the property are of a type that cannot be eliminated (e.g., consensual purchase-money security liens), there is no need to proceed with the calculation: None of the liens can be eliminated. However, once a determination is made that elimination can be done, the exact amount of the lien that can be eliminated must be calculated.
Calculation of the amount that a lien impairs an exemption becomes especially important in a bankruptcy proceeding, because there is a greater opportunity in that situation to eliminate non-purchase-money, non-possessory liens.
Liens that are dischargeable can be eliminated to the extent that they "impair" an exempt asset. The bankruptcy code provides that a lien shall be considered to impair an exemption to the extent that the sum of all the liens on the property, plus the amount of the exemption, exceeds the value of the property. As a rule, this formula also will be followed in state courts.
Another simpler way of looking at the calculation is this:
(value of property) minus (exemption amount) equals (amount of lien that cannot be eliminated)
When a particular item of property is subject to an unlimited exemption (e.g., an unlimited homestead exemption in Florida), all of the liens on the property can be eliminated (provided, of course, the liens are of a type that can be eliminated.) If the exemption is unlimited, the value of the property will equal the exemption. Thus, the formula will always yield a result of zero for the amount of the liens that cannot be eliminated.
Unfortunately, when there is a cap on the exemption amount, what appears to be a lien that can be eliminated will not be deemed to impair the exemption. Thus, an "exempt" asset may be lost.
John Smith owns an item of property valued at $40,000. This property qualifies as household goods in a state that allows him a $20,000 exemption. There is a $10,000 judgment lien on the property
To determine if any of the lien can be eliminated, the amount of the exemption ($20,000) is subtracted from the value of the property ($40,000.) This leaves $20,000 in value to which a lien can attach.
None of the $10,000 can be eliminated.
If the lien was $30,000, and the property still had a value of $40,000, then $10,000 of these liens would be deemed to impair his exemption, and, thus, could be eliminated.
There can be variations among the states with respect to laws governing liens and calculation of the exemption impairment. In the last example, where the liens totaled $30,000, it may be possible in some states to eliminate the entire amount of the liens, on the grounds that elimination of liens is an all or nothing proposition: i.e., if there is any impairment of the exemption (here, impairment is calculated at $10,000), then the total amount of the liens is eliminated.
John Smith personally owns an item of property that qualifies as a tool of the trade in a state that allows him to use his state's exemption, which is $20,000. The value of the property is $40,000. Purchase-money liens on the property total $30,000. This type of lien cannot be eliminated in, or out of, a bankruptcy proceeding.
Smith suffers a judgment in the amount of $10,000 from a lawsuit for negligence. The judgment creditor places a lien on Smith's tools of the trade. Judgment liens of this type can be eliminated. Further, the judgment lien impairs Smith's exemption under the formula, and can be discharged.
The value of the property is $40,000, but only $20,000 is exempt. Thus, $20,000 in value can be encumbered by liens. In this case, the liens total $30,000. The purchase-money lien can not be eliminated, but the $10,000 judgment lien can be eliminated in its entirety.
In any case involving lien impairment of an exempt asset, it is wise to consult with an attorney before concluding how much of a lien can be eliminated in the particular state in question.
In some cases, encumbering an asset with a consensual lien may make a subsequent judgment lien dischargeable.
When is lien impairment calculated?
Most states calculate lien impairment only when there is an attempt at a forced sale of the property (i.e., foreclosure of the lien). In some states, however, the calculation may be done at the time the property is attached. In this situation, the judgment debtor may be able to have the lien removed in advance of any foreclosure proceeding. This would allow the owner to sell the property free of the judgment lien.
For the most part, judgment liens will represent the most significant example of liens that can be eliminated when they impair an exemption. But the fact that a judgment lien is usually valid for 10 to 20 years can have planning implications.
A crafty judgment creditor could attach a debtor's home while the home was exempt, but wait to foreclose until the value of the home went up and the amount of the first mortgage went down, so that, according the formula used to calculate lien impairment, the judgment lien no longer impaired the exemption.
In that case, the best solution for the debtor may be a Chapter 7 bankruptcy proceeding. There, calculation is determined as of the date the proceeding is filed. This strategy eliminates the waiting game that some creditors may play.
Of course, in states such as Florida with an unlimited exemption for residences, this strategy would not be necessary, as the home will always remain immune from judicial liens, regardless of how long the judgment creditor waits.
Note, however, that the Chapter 7 filing also eliminates a related problem. If a judgment creditor places a lien on property (e.g., a home), the debtor will find it impossible to sell the property. Because liens run with the property, any buyer would take the property subject to the judgment lien. Thus, there would be no buyers. A bankruptcy proceeding terminates the judgment lien, which allows the owner to sell the property at a later date.
The following case study illustrates different results due to specific state laws.
Sheila Wagner owns a residence worth $150,000 with a first mortgage of $100,000. Her home state exempts a residence in the amount of $125,000.
A judgment is rendered against Wagner in the amount of $80,000. At this time, the judgment creditor cannot foreclose on the property because the lien impairs the exemption, and could be eliminated: the value of the residence, $150,000, less the exemption, $125,000, equals the amount of liens that cannot be eliminated, $25,000. Already, the first mortgage exceeds this amount. Thus, the judicial lien can be eliminated in its entirety.
Now let's say that 10 years later the home is worth $250,000 and the first mortgage totals $30,000. The results are different: the value of the residence, $250,000, less the exemption, $125,000, equals the amount of liens that cannot be eliminated, $125,000. The first mortgage totals only $30,000. Thus, another $95,000 of liens cannot be eliminated ($125,000 less $30,000). This means that no part of the judicial lien can be eliminated, and Wagner will lose her home to foreclosure.
In this situation, Wagner should have considered filing a Chapter 7 bankruptcy proceeding 10 years earlier, when the entire judicial lien could have been eliminated.
Now let's say that Wagner is a Florida resident. Florida has an unlimited exemption for a residence.
Due to the unlimited exemption, the home will always be exempt. A waiting strategy by a judgment creditor would be ineffective. The value of the home, and the value of the exemption, will always be equal. As a result, the calculation will always result in the full value of the judicial lien being subject to elimination.
In this situation, Wagner would only need to consider a bankruptcy filing if she were interested in selling the home, and she were unable to have the lien removed before a forced sale of the property by the judgment creditor. However, luckily for her, Florida is one of the states that provide that creditors cannot attach an exempt asset. Judgment debtors do not have to wait until there is a forced sale to calculate lien impairment or have a lien removed. Thus, the lien can be removed immediately, making a bankruptcy action unnecessary.
As you can see, it helps to understand how liens arise and what property is protected from the reach of your creditors by federal or state law.
