Keep a clear perspective
Asset protection is a big issue for GPs.
Failed insurers, record court pay outs, a media frenzy and increasingly opportunistic litigants mean that much of every GP’s day is spent proving they did what they ought to have done, and did not do what they ought not have done.
Not surprisingly GPs are asking what can be done to protect their assets, both now and in the future, to make sure that they are safe.
Often the cure is worse than the complaint, and GPs have been led into transactions of dubious merit and efficacy, but great cost, in the name of protecting assets.
We believe that in most cases the concerns are overstated. A GP, and any other professional for that matter, who follows sound procedures and uses common sense, is unlikely to be involved in court case. And the minority who are will be well supported by their professional indemnity insurer. Yes, one or two insurers did get into financial trouble ten years ago. But you can safely assume that the shaky insurers have been flushed out and those remaining are financially solvent and able to pay claims.
If by chance this is not the case, serious public policy issues are at stake. It is unlikely that the Federal Government will let a GP who made a mistake be bankrupted because an insurer cannot meet its commitments.
It has not happened, yet
We often ask GPs “if anyone has heard of a GP losing his or home in a negligence action?” The answer is always “no”. To the best of our knowledge this answer is correct.
So perspective is needed. Whilst it is probably true that every GP, indeed every professional person, will be involved in at least one legal type matter in his or her working life, few of these will get to court, and even fewer will involve an insolvent insurer.
It is a small risk, and not one that should trigger sleepless nights.
But take common-sense precautions
Having said this, we would hate to see one of our clients defy the odds and face an uninsured legal action. To guard against this we routinely recommend basic precautions be taken. These precautions boil down to not owning valuable assets in a GP’s personal name, and instead owning them through spouses, family trusts and super funds. In each of these cases the assets will not be directly up for grabs in any professional negligence action against the GP. The GP does not legally own the assets, although he or she may control them, and you cannot lose what you do not own.
The most important step: pay your premiums on time
The most important step in protecting your assets is to pay your professional indemnity insurance premiums on time. The rest is almost certainly unnecessary, but nevertheless recommended, for completeness’ sake if nothing else.
Using a safe haven such as a spouse, a family trust or a super fund is easy with future assets, ie assets that you have not yet acquired. It’s simple to own them in someone else’s name from the beginning. You register the shares in the name of the company that is the trustee of your super fund, you put your spouse’s name on the title of your family home (assuming he or she is not also in an exposed occupation) and you buy your surgery in the name of the trustee of your family trust. This is simple stuff and familiar ground and logic for most GPs.
But what happens if your spouse is also in an exposed occupation? For example, is an obstetrician or a heart specialist? It’s out of the pan into the fire to buy a home in your spouse’s name. For assets other than the home this is not a problem: just acquire them in the family trust or the super fund. But for the home it is a problem: the CGT principal residence exemption is not available if the home is owned in a family trust.
A decision has to be made. The GP has to decide whether the CGT advantage of owning the home in his or her own name is worth the risk of losing it in a professional negligence action. The analysis is complicated by case law allowing family trusts to negatively gear homes leased to beneficiaries, provided a market rent is paid, and the inherent uncertainty of the CGT advantage; that is, what if there is no capital gain? What if we never realize the capital gain? And what if we can effectively tax plan for any capital gain?
Each GP’s decision will be made for different reasons. Two rationale decisions are:
- where the spouse is in a lower risk area of medicine, say dermatology or psychiatry, and is only working part time due to family commitments, then the already small legal liability risk becomes much smaller again, and even less of an issue. Here it can make sense to buy the new home in the spouse’s name; whereas
- if the spouse is in a high risk area of medicine, say obstetrics, and is working full time, or more than full time, then it can make sense to buy the new home in the family trust’s name. This is particularly where there are large potential depreciation, building allowance and interest deduction claims, so that the tax benefits of using the family trust are enhanced, and where the home is regarded as a “never to be sold” core asset, so that the loss of the principal residence exemption is not an
If the home is owned by a person in an exposed occupation it can make sense to encumber it with a mortgage and a high level of debt. This means the mortgagee, ie the bank or other financial institution, has first claim on the proceeds of any sale: the loan has to be re-paid and the mortgage released before the purchaser can get good title. The loan can be a loan owed by another person, such as the trustee of a family trust. But make sure the repayment does not create another asset, in effect a loan to the other person, which can be recovered by a litigant.
Interestingly a case can be made for owning heavily geared residential investment properties in the GP’s own name, where the GP but not the GP’s spouse faces the top tax rate of 48 cents in the dollar (about $70,000 pa in 2004/5 and about $80,000 pa in 2005/6, according to the 2004
Federal Budget announcements). Here the certainty of the deductible tax loss: rental yields, particularly after repairs, rates and so on are considered, are notoriously low, can mean maximizing the tax benefit by having the loss in the hands of a 48% tax payer is the best way to go. Even if there is some asset protection issues.
The asset protection issues can be minimized by maintaining a high level of deductible debt on the investment property, and hence minimizing the exposed equity. Choosing interest only loans and even capitalized interest loans can make this strategy work even better. But make sure an appropriate amount is saved elsewhere in your structure, say as gifts of capital to the family trust, or else the GP may end up owing more than the house is worth. This can, of course, be a good tax planning strategy: build up the level of deductible debt in the highly taxed hands of the GP, while moving wealth and the income that follows it to the lower tax environment of the family trust.
Existing assets are more problematic than future assets, because the transaction costs connected to transfers, mainly stamp duty
and capital gains tax, have to be considered.
One preliminary question is always relevant where a GP owns a valuable asset in his or her name. And this is “how long do you plan to keep it?”. Take the situation of all or part of a family home being owned in the GP’s name. Often it will turn out that an up-grading, or a down sizing, in on the cards in the next few years. It does not make sense to transfer it around now, triggering transfer costs, if it is then going to be sold to a third party soon after. It can make better sense to speed up the up-grading or the down sizing, and then simply gift the cash from the sale of the existing home to a spouse or a trust, and get it right from the beginning with the new home.
Watch out for asset protection spruikers
Every now and then we come across consultants scaring GPs with tales of terror on asset protection. Its chaos theory on steroids: one small chink can see a lifetime’s accumulation lost in a never ending patient litigation.
Strangely, every time there is a solution to the problem and the spruiker has it and it costs tens of thousands of dollars.
One tip: only solicitors can advise on asset protection issues. Any one else is breaching the Legal Profession Practice Act and their advice is not insurable.
Always check your position with an experienced and independent solicitor.
Another preliminary question is relevant too. It is “what are the costs of a transfer?”. An example may help. A GP came in to see us about a suggested transfer of a rental property to a family trust. The property had been bought for
$300,000 using 100% debt, and was now worth $500,000, which meant there was $200,000 of “exposed equity” to consider. The GP had been told he should transfer the property to his family trust and that he had a serious asset protection problem.
We considered the matter. Our deliberations focused on what were the costs of transfer and what was the probability of a legal action? The costs of transfer were pretty easy to compute. They were:
|Stamp duty on market value of $500,000||$24,000|
|Income tax on a taxable capital gain of $100,000||$48,000|
|Other costs, ie solicitors, transfer fees, etc,||$2,000|
|Total cost of the transfer||$74,000|
The cost of $74,000 was not deductible, although the stamp duty and the other costs would be added to cost base for CGT purposes when the property was ultimately sold to a third party.
Think about it. Would you spend $74,000 to protect $200,000 of exposed equity? If you would, you must calculate that you have a 37% chance of losing the property in a legal action in the foreseeable future. That does not sound likely to us. Warren Buffet would leave the property in his own name for now. Whilst it would have been better to buy the property in the name of the family trust, it just did not make financial sense to transfer it to the family trust now.
The position can be different for family homes, where the principal residence exemption usually means there is no CGT on a transfer. And in some states, such as Victoria, if the transferee is a spouse there is no stamp duty either. Sadly there is no such exemption in NSW, where stamp duty values tend to be the greatest.
It is not uncommon to encounter a valuable share portfolio in the GP’s hands. This is an obvious asset protection problem.
Here the same logic applies as applied for the property in the above example: what are the costs of transfer and what is the probability of a legal action? The mechanics are little different though: stamp duty, if it exists, will be minimal and capital losses can be offset against capital gains. The idea is to transfer as much value as possible without triggering a significant net capital gain. It’s just a case of playing with the possibilities and seeing what can be done.
For example, a GP had a share portfolio of nearly $500,000 in her name, made up as follows:
The object of the exercise is to transfer as much value as possible to the family trust without generating a significant taxable capital gain in the GP’s hands. We did this by transferring all the shares, except Share 4, to the family trust, so that a net capital loss of $1,000 is realized, and all but $100,000 of value is moved to the trust. Obviously there are many possible permutations, but the general approach is to transfer loss shares first, and to then transfer shares with capital gains up to or close to those losses, taking those with the highest value first. This normally means that a significant amount of wealth can be protected without unduly high transaction costs, particularly capital gains tax.
What about plant and equipment?
A GP’s plant and equipment, in the case of a group practice, the GP’s share in the group’s plant and equipment, is usually owned in a family trust based structure. This is actually the standard reason for using a Phillips Case style service trust, and it is routinely accepted by most commentators as a major advantage of a service trust arrangement.
But some times plant and equipment is not owned by a trust. For example, the plant and equipment may be owned by the GP, by a practice trust or by a practice company. Theoretically this is a problem, but in practice it is not. This is because the new value of a GP’s plant and equipment is rarely significant, and indeed the second hand value is almost always low, not much more than a few ten thousands of dollars, in the best of cases. And the value is dropping.
Litigation does not spring up unexpectedly. It takes years for the average case to see a court room. Over these years whatever value there was in the plant and equipment will almost always disappear. So plant and equipment in the GP’s name or the name of a practice trust or a practice company is not a problem.
Bear in mind that service trusts may not be the safe haven most people say they are. A popular, and pertinent, seminar question is “what happens if an employee of my service trust is negligent and a patient suffers as a result”? The answer is that the service trust can be sued and the service trust probably does not have professional indemnity insurance.
Again, because of the nature and market value of plant and equipment as a wasting asset this usually does not cause us any concerns. By the time the case gets to court any value that was once there will be well and truly gone. Of course there can always be an exception. For example, a practice may have invested in state of the art technology in a particular area. Here there can be a valid case for quarantining the technology in a special purpose trust and leasing the asset to the practice under a short term operating lease. But this will be an exceptional case, not the normal case, and is usually not an issue.
What about goodwill?
For most GPs goodwill values do not add up to much. Goodwill is not really an asset that can be taken from a GP. The successful transfer of personal goodwill requires, literally, just that, ie goodwill from both the transferor and the transferee. If the transferor chooses to not cooperate then there is not much anyone else can do about it.
In larger practices goodwill may be more of an issue, as here it is something more than mere personal goodwill. But at general law it is not possible to separate goodwill from the other assets of the business. So in most cases at least for larger practices goodwill will sit in the service trust: this is actually a lesson taught by the corporate sales of the late nineties and early 2000s: the cheques were written out to the service trusts and the goodwill was determined by who held the right to provide services to the GPs practising at a site.
In most cases protecting goodwill is not an issue for GPs.
Family trusts and asset protection
Family trusts can be used by GPs to put valuable assets beyond the reach of potential creditors, including litigious patients. We have seen family trusts save the day many times.
In most cases assets transferred to a family trust may not be able to be accessed by creditors if the transferor gets into financial difficulty or even goes bankrupt. This is because the transferor has no interest in the transferred property and has no interest in the family trust which is recognized at law.
For example, a GP acquired a home worth $300,000 through a family trust and rented it back off the trustee. The GP also acquired a share portfolio worth $200,000 as an inheritance from a grandparent: the GP’s family trust was the beneficiary under the grandparent’s will. Some years later the GP guaranteed a large business loan for his brother. The brother’s business collapsed and the bank called up the guarantee. The bank could not touch the family home and the share portfolio. These assets simply did not belong to the GP. They belonged to the trust. As a result the bank could not do anything to get its hands on these assets.
This asset protection can go on down through the generations. For example, if the GP dies and leaves the share portfolio and the family home to a daughter, these assets will be a marriage asset should the daughter’s husband one day divorce her. If these assets remain in the family trust they will normally not be marriage assets in a divorce situation. This means that the (ex) son-in-law gets nothing. The same thing happens if a son gets into business or investment difficulties and is sued by creditors.