ComplianceLegalFinanceTax & AccountingSeptember 19, 2020

Effective exemption planning protects your assets

Property that is "exempt" is untouchable in the eyes of the law should you find yourself in the undesirable position of having a creditor's lien liquidating your assets.

Effective use of state, and possibly federal, asset exemptions is one of the primary strategies you should use to protect your assets from being seized by creditors. Every state has a list of assets considered "exempt" from legal judgments and unreachable by creditors. However, no state has one single dollar exemption that covers all of your property. Rather, the exemptions are "pigeon holes," into which you must try to fit as many items of property as possible.

State asset exemption statutes vary widely—from the very generous to the incredibly stingy (from the debtor's point of view.) For example, Florida and Texas, two debtor-friendly states, each offer numerous separate exemptions. Knowing what the exemptions are, and fitting a particular item of property into an exemption, can be a very effective asset protection strategy, because the exemptions can be quite generous. In contrast, federal rules are straightforward.

Which exemptions apply.  The federal asset exemptions are only available:

  • if you file bankruptcy and
  • if your state allows you to use the federal exemptions.

In a state court proceeding, only your state's post-judgment asset exemptions will be available. States vary on which exemptions are available in bankruptcy. In the following states, you may substitute your state's exemptions for the federal ones in a bankruptcy action.

States allowing choice of either federal or state exemptions

  • Alaska
  • Arkansas
  • Connecticut
  • District of Columbia
  • Hawaii
  • Kentucky
  • Massachusetts
  • Michigan
  • Minnesota
  • New Hampshire
  • New Jersey
  • New Mexico
  • New York
  • Pennsylvania
  • Rhode Island
  • Texas
  • Vermont
  • Washington
  • Wisconsin

If you reside in one of these states, you should examine both your state's post-judgment asset exemptions and the federal bankruptcy exemptions, in comparing your inventory of assets to the exemptions.

In the other states, you can use only your own state's post-judgment assets exemptions in a bankruptcy proceeding for most of your assets. These states have opted out of the federal exemption system. However, certain federal exemptions, most notably those related to pensions, are allowed in all states.


A California physician, who operated his practice as a corporation, filed a Chapter 7 (liquidation) bankruptcy proceeding. In Chapter 7, "all" of the debtor's assets are sold, with the proceeds used to pay the creditors.

The physician had accumulated nearly $2 million in a retirement plan. Federal law exempts all qualified retirement funds from a creditor's reach, even if you live in a state where you can not use federal exemptions for other types of assets.

The physician's creditors challenged the $2 million exemption, on the grounds that it was unfair. While agreeing with the creditors that the exemption was unfair, a court acknowledged that it was powerless to ignore the exemption.

As a result was that the physician eliminated all of his debts and walked away from the "liquidation" bankruptcy proceeding with $2 million.

Had the physician simply withdrawn the $2 million from the business and invested it in a personal portfolio outside of a retirement plan (as many small business owners would have done), he would have lost $2 million.

To effectively plan for maximum asset protection, you'll need to understand both the limits of exempt asset status and know your asset exemption options in your state. 

The following example illustrates some of the more general rules about how asset exemptions work, and what they can and can't do for you.


John Smith's a home is worth $110,000, with a first mortgage of $100,000. John's home state exempts a residence in the amount of $125,000. Unfortunately, this exemption will not help him keep his house if he defaults on his mortgage.

Although, the home is an exempt asset, consensual liens, such as first and second mortgages, cannot be eliminated in state court or in a bankruptcy action even when they are secured by an exempt asset.

However, if John also has a judgment lien of $30,000 against his home, up to $25,000 of that lien may be able to be eliminated.

Only humans can claim asset exemptions

A small business owner must keep in mind that asset exemptions are available only to "natural persons" (i.e., real human beings.)  Although corporations, LLCs and even partnerships are considered "persons" for many purposes in the law, they are not considered "persons" for asset exemption purposes.


Mary Black forms an LLC to operate her new business. She contributes a car to the LLC, subject to a lien against it for a car loan. The car has a value of $9,000, and the amount owed on the loan is $8,000. Thus, there is $1,000 equity in the car.

Black concludes her car is an exempt asset, because her home state exempts the first $1,500 of equity in a car. She is confident that the car will be protected if her business experiences financial difficulties.

Black is wrong. Asset exemptions are available only to "natural persons"(i.e., real people.) Black's car is fully subject to the claims of the business creditors.

Asset exemptions were designed to ensure that families could emerge from a financial crisis with the ability to provide for their basic necessities, such as food, shelter and clothing. Artificial entities have no such needs and, accordingly, cannot use the asset exemptions.

This rationale, while reasonable for mega-corporations, ignores certain realities of smaller businesses. Small business owners do, in fact, rely on their business's assets to provide for their family's basic necessities. However, the asset protection laws make it essential that you think ahead, account for all contingencies and obtain solid financial planning advice before making asset transfers to your business.


In a Texas case, a family claimed that the unlimited Texas homestead exemption protected their family farm, which consisted of their home and several large tracts of land.

Unfortunately, the family had previously transferred ownership of the farm to a family limited partnership as an estate planning device. The creditor produced copies of the deeds proving the limited partnership, and not the family members, owned the farm.

Accordingly, even though the farm was the family's home, the court ruled that the homestead exemption was not available. Instead, of a "homestead," the family had only an interest in the limited partnership. This was an item of personal property, which would have to be protected as such, subject to the less generous exemptions available for interests in personal property.

As a general rule of asset exemption planning, a home should never be transferred to a business entity, such as a limited partnership, LLC or corporation, because usually the homestead exemption offers one of the more important and useful asset exemptions. This rule, of course, does not apply to a commercial building.

In contrast, if you transfer your home to a revocable living trust, you should not face this problem. Such transfers are common estate planning tools where the goal is to avoid probate court or federal estate taxes.


On the surface, the availability of asset exemptions only to natural persons may seem to be an argument in favor of operating a business in the form of a sole proprietorship (if there is one owner), since the sole proprietor is automatically deemed to be the personal owner of all the business's assets. It also may seem to be an argument in favor of the owner personally owning and leasing all of the assets to the business.

Either of these approaches, however, would be a mistake. The sole proprietor has unlimited, personal liability for all of the business's debts. This one fact makes the sole proprietorship untenable as a form in which to operate a business with maximum levels of asset protection planning.

Business entities have no asset exemptions

A business entity, such as a corporation or LLC, is not eligible for asset exemptions. However, such an entity must be funded with assets. And, if you don't contribute any assets to the business entity (i.e., you fund the entity entirely with leases and loans), you would be likely to lose the limited liability ordinarily enjoyed by the owners of these businesses forms.

Even in the absence of asset exemptions, you can safeguard business assets by strategic structuring and funding practices, including:

  • the use of a holding entity and a separate operating entity;
  • leases and loans; and
  • the encumbering of the operating entity's assets with liens that run in favor of the owner or holding entity.

The fact that business assets can be protected from liability, even though asset exemptions are not available to a business entity, illustrates an important point in asset protection planning: If you are to effectively protect your business and personal assets, a comprehensive, or multi-layered, approach is required. One strategy alone, such as exemption planning, will usually be insufficient.

Advance planning can increase utility of asset exemptions

Transferring your assets into exempt categories will be effective only if the transfers are done well in advance of the onset of financial difficulties. In addition to running the risk of being found guilty of fraud, the transfers may be set aside. Also, both the federal bankruptcy law and state laws, have toughened up the residency requirements that you must meet to take advantage of a state's exemptions, making advance planning even more essential for your strategy to be effective.

Think ahead

When considering an overall asset exemption plan, you may wish to evaluate whether there is an advantage to changing your state of residence.

A change in residence can be very effective because states vary widely in terms of the exemptions they offer (see the exemptions list for details on state-specific information). Most states are silent on the time requirements to establish residency for purposes of claiming asset exemptions.

However, there, is a two-year residency requirement under the bankruptcy code, which limits the effectiveness of this strategy if you are already in financial distress.

Convert unsecured assets into secured assets

Consensual liens, such as mortgages and car loans, generally cannot be eliminated even when they impair an exemption. When executing a comprehensive asset exemption plan, another effective strategy consists of paying down secured debt with unsecured debt. This can be especially effective prior to a bankruptcy action (if planned far enough in advance).

For example, you could make a mortgage payment with a credit card. The amount of cash represented by the payment is effectively converted to an exempt form (equity in your home, which is presumably protected by the homestead exemption). Because the unsecured credit card debt can be discharged in bankruptcy, the debtor protects this amount of cash as if it were an exempt asset.

Think ahead

John Smith, a Texas resident, is carrying a $160,000 mortgage on a home worth $180,000. Smith's monthly mortgage payment is $1,600.

Smith is short of funds, and anticipates, sometime in the future, that he may have to file for bankruptcy.

He makes two mortgage payments using his credit card's "access checks," for a total of $3,200, and files for bankruptcy 14 months later.

Smith has converted the $3,200 to an exempt form. The credit card debt, including the $3,200, will likely be discharged. In short, Smith has protected and saved $3,200.

Married couples may be able to double exemption amounts

States sometimes provide that each individual owner can claim an exemption for their property. Thus, a husband and wife can double the exemptions listed in the state's law, provided that:

  1. they are joint owners of the property, and
  2. each of them is liable on the debt in question.

Sometimes, a married couple is allowed to double only the homestead exemption. Some states only provide one singular exemption, regardless of how many owners there are for the piece of property (the exemption list indicates the states' positions on doubling of exemptions). Where doubling is permitted, take this into account when determining to what extent particular assets will be protected.

The bankruptcy code allows for the doubling of all of the federal exemptions, when a husband and wife file for bankruptcy together, regardless of who is the debtor. Who actually owes the debts is irrelevant when spouses file together, because both the husband and wife are parties to the same petition.

In a state court proceeding, normally only one spouse will be a party to the case, when only that one spouse owes the debt in question.

This feature of the bankruptcy code makes the federal bankruptcy exemptions preferable when a husband and wife file together, and the state's exemptions are not significant. Where the state exemptions are claimed, the state's laws on doubling would apply.

Leverage your state's exemption asset categories

Each state provides its own listing of property that is exempt from the reach of creditors. The types of property, as well the value of the property, exempted is highly state-specific. For example, some states provide an exemption for an automobile, but the amount allowed for that automobile range from only $700 to $20,000. Many states provide exemptions for the following types of property:

  • Automobiles;
  • Clothing;
  • Household goods and/or furniture;
  • Professional books, tools and implements;
  • Health aids;
  • Wedding rings;
  • Musical instruments;
  • Burial plots; and
  • Wild card exemption

"Tools of the trade" and "household goods" are asset exemption categories that provide good examples of the pigeon-hole concept, into which a particular item of property must somehow be fitted in order to be exempt in your overall asset exemption plan.

For example, individuals have successfully argued that valuable diamond rings are exempt as wearing apparel treated as protected household goods, rather than jewelry that would not be protected. Debtors in other courts have lost this same argument.

Tools of the trade and professional books. "Tools of the trade" are frequently exempt. This exemption can be widely interpreted to include any property reasonably necessary to carry out a business. Sometimes a vehicle can be qualified under this provision, but nearly always this will succeed if it is uniquely outfitted for the business, such as some delivery vans. If a vehicle were not qualified under this category, it would have to fit under a specific exemption for motor vehicles, which could offer less protection.

Keep in mind that the "tools of the trade" exemption will not ordinarily apply to the property owned by a business entity, such as a limited liability company (LLC) or a corporation, as exemptions are available only to natural persons. Thus, the exemption may not be as significant as first appears.

Work smart

As advocated in our discussion of using operating and holding companies, a business owner should own assets personally or in a holding company, and lease them to the operating company, to shield the assets from the claims of the business's creditors.

When the assets to be leased fit under one of the exemptions, the owner should consider personally owning them so that he or she can rely on the exemption for the assets. This can be done with respect to tools of the trade, including office equipment and motor vehicles used in the business.

The one exception to this rule may be assets that carry a high risk of causing injury. Here, the owner ordinarily should contribute these assets to the operating company, because liability may run to the owner. An example would be motor vehicles used by other employees of the business.

When only the owner uses a motor vehicle, the risk is reduced, and the strategy of personally owning the asset becomes more attractive.

The same reasoning applies to the other tools of the trade. Manufacturing machinery may be too risky to personally own, while office equipment may be an ideal candidate for this strategy.

In either case, but especially when the owner personally owns the asset, the owner should ensure that there is more than adequate liability insurance coverage on the asset.

Finally, this strategy does not apply to nonexempt assets such as a commercial building. In the case of a commercial building, the risks would usually be too high to justify this strategy in any event. Nevertheless, in many cases, a lease of a commercial building makes sense. However, the lessor (and owner) should be the holding company.

Household goods and furnishings exemption. The classification of exempt "household goods" usually involves various subcategories. States sometimes create separate categories for items that another state would include within the household goods category as a subcategory. As a result, the states vary widely in terms of what categories and subcategories they make available. Further, even with subcategories, the term "household goods" suffers from the same problem as the term "tools of the trade"–it is subject to court interpretation.

Subcategories are sometimes subject to caps, as are the controlling categories. For example, there is a federal bankruptcy exemption for household goods, but there is an overall cap of $12,250, and a separate cap of $575 per item. In some states, the categories have no caps. In others, the debtor has to prove certain items qualify as basic necessities.

In many cases, the dollar caps are relatively low. Nevertheless, all debtors will want to protect this type of property and, in particular, personal effects, many times simply for sentimental reasons.

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