Asset protection 101: the domino theory
When it comes to asset protection principles, the number one thing you need to know is actually a simple well known theory that we were all probably taught as children; don’t put all your eggs in one basket.
In the asset protection space, this concept is often described as the ‘domino theory’. The domino theory essentially refers to the philosophy that you should segregate assets of different risk profiles.
Consider a discretionary trust which owns cash, listed shares, business real property and also carries on a business; the trust owns a combination of at risk assets (business real property and the business) with passive assets (cash and shares) which exposes the passive assets to claims against the risk generating assets. This structure fails the domino theory test.
‘High risk’ assets are those which could create liability exposure over and above the value of the asset i.e. if there is a claim against the business for product failure or breach of contract resulting in harm to a consumer, the claim could be for an amount well in excess of the value of the business.
‘Passive assets’ are assets where you cannot lose more than the value of the asset, such as shares or loans i.e. the worst thing that could happen is that the asset value is reduced to $0. As a general rule of thumb, passive assets include listed shares, cash holdings, shares in private companies (while directors can be held personally liable for the debts of a company in some instances, shareholders cannot be) and receivables like loans.
Grouping high risk assets with passive assets contravenes the domino theory, because it unnecessarily exposes the passive assets to claims generated against the risky assets.
When implementing the domino theory, the number one rule is to make sure that all passive assets are grouped in a different ownership entity to the high risk assets, so that they are not exposed to claims from the high risk assets. It doesn’t matter how many passive assets are grouped in one structure.
When it comes to grouping high risk assets, it is often better to separate the ownership of high risk assets from each other via different entities, to segregate risk between each asset.
Looking at our scenario of the discretionary trust above, in addition to holding the passive assets in a separate discretionary trust, I would also recommend that the business real property and the business should be held via separate entities.
People often don’t think of business real property and investment properties as being particularly risky, unlike the risk that most people associate with carrying on a business. They often prefer to keep things simple and don’t want to create a new trust to own each separate property. To take a pragmatic approach without over complicating the structure with too many entities whilst still achieving a reasonable level of asset protection, it can be sensible to place a cap on the value of assets which you are willing to expose when grouping multiple assets in a single entity. For instance, if the decision is made to expose no more than $1.5 million of assets, then once a structure has assets of approximately $1.5 million, a new structure would be established for further property acquisitions.
Follow these basic principles by segregating your risk and make sure your entire wealth is not exposed due to one bad egg.
So why does structuring assets in different entities work to segregate the risk? Because of the separate legal entity principle under corporations law, which means that only the assets held by the entity are available to satisfy the debts arising against that entity. There can be some weakening of the separate legal entity principal due to personal liability of directors, which can expose personally held assets of directors, however this is a topic for another post.
If you’re not sure if your structure achieves the best protection for you, or require assistance with an asset protection audit or tax and stamp duty concessions which might be available on restructuring your assets, please get in touch.