Creditor Protect Yourself

Here's another one of my Profit Magazine columns. I wrote it 5 years ago. It is still good advice today.

Recently I had lunch with the poster boy for entrepreneurs who crash and burn but live - quite comfortably - to tell the tale. He thanked me for saving his financial life. A few years ago Bill (not his real name) came to see me for some business advice. Bill was anxious to expand his business. I listened intently to Bill’s story and his plans. I reviewed his business plan and financial statements. I then proceeded to provide him with comprehensive advice as to what I thought he should and should not do.

Unfortunately, Bill ignored virtually all of my advice and ended up in corporate and personal bankruptcy a few years later. Fortunately, he did listen to one important bit of advice that I imparted to him on that fateful day. The piece of advice that Bill did follow was to creditor protect himself. As a result, when he went through the bankruptcy process and lost his business, he managed to keep his house and all of his personal financial investments.

I want to share this advice with you too, so that if you ever end up in the same position as Bill, you too will have a nest egg with which to start over.

The nature of entrepreneurship is that we tend to be risk takers. Furthermore, to be successful we must be fully engaged in growing our business. Often this leads to the unfortunate result that we don’t look after our own personal financial needs in the most responsible and/or timely manner. On top of everything, we tend to be risk takers in our personal investments. Many of us fail to put basic financial planning tools in place in order to safeguard ourselves and our families. Simple things such as wills, powers of attorney, life insurance, etc., are often left to be addressed at a later date.

My advice to you is to make getting your personal house in order a priority.

The bottom line is that as an entrepreneur you are taking on tremendous risks. You are the officer and director of your company and, therefore, take on all of the statutory liabilities of your business such as tax and other source deductions, health tax, employment standards, workers compensation, HST and so on. You may have personally guaranteed all or part of your company’s debt. You may have even mortgaged your home to finance your business. If the s—t hits the fan, you could lose everything.

In most investments higher risks translate into the potential for higher returns. Obviously, you embarked on your business adventure with this goal in mind. However, typically (particularly in the early stages of your business) you either pay yourself very little or, in many cases, nothing at all. By reinvesting your profits in your business, the ironic result is that you are taking higher risks and receiving lower (current) returns.

Manage the Risk

What should you be doing to manage this risk? You can do some basic things like diversifying. Rather than leaving your profits in your business as retained earnings, take money out of your business from time to time and build a nest egg by investing conservatively. Resist the impulse to invest in other businesses in your sector or industry. Even  though this may be within you comfort zone, if there is a downturn, you could easily lose it all.

Other suggestions involve making sure that you have planned your estate. Do you have adequate life insurance? Disability insurance? Critical illness insurance? Is your will up to date? What about a living will? Do you have a power of attorney?

Separate Assets in Your Spouse’s Name

The first, simplest and least expensive credit protection strategy for your nest egg is to put assets in your spouse’s name (provided that he or she isn’t also an officer and director of a company, has signed personally at the bank or has other potential liabilities). When Bill went through personal bankruptcy, he and his family managed to keep their home because the title was in Bill’s wife’s name. Making your RRSP contributions into a spousal plan, rather than into an RRSP in your own name will safeguard your retirement savings from your creditors.

Segregated Funds

Bill was also able to retain his personal financial holdings because they were invested in segregated funds. Segregated funds are investments in mutual funds through an insurance company. Because these investments are insurance contracts purchased from an insurance company, they are governed by the insurance legislation in each province and are exempt from being seized by creditors. The same is true of a traditional insurance policy. Most major insurance companies offer a wide range of mutual funds so that you can select a portfolio that is consistent with your personal investment objectives. While the management expense ratios (MERs) for segregated funds are slightly higher than the management fees payable for the same mutual fund purchased outside of the insurance contract, consider the higher cost a small price to pay for “creditor protection insurance”. Segregated funds can be purchased in registered (i.e. RRSPs and RESPs) and unregistered investment accounts.

Individual Pension Plan (IPP)

Another relatively inexpensive way to creditor protect your retirement savings is to set up an Individual Pension Plan (IPP). An IPP is a defined benefits pension plan that you can set up for yourself. As a pension plan regulated under provincial and federal pension legislation, IPPs are administered as trusts and are creditor protected. A further benefit of an IPP is that the contributions are not fixed as they are with the maximum RRSP contribution. As you get older the tax deductible contribution increases every year. There is a lot more to IPPs than this simple introduction. Talk to a financial advisor who has an expertise with IPPs. Many financial advisors purport to know about them, few really know what they are talking about. You can always call me and I will refer you to someone!

Family Trust

A more expensive way to creditor protect yourself is to set up a family trust. In this instance, you would pay a lawyer to set up a trust naming you and the other members of your family as contingent beneficiaries. In other words, the trustee has complete discretion to decide whether to pay anything from the trust to you. You could be the trustee or you can name someone else as the trustee. As a contingent beneficiary you have no absolute right to the assets in the family trust. As a result, in theory your creditors cannot force the trustee to turn over the assets of the trust. There have been instances where a court has ordered the trustee to turn assets over, particularly where the trust was established on the eve of an insolvency.

Offshore Creditor Protection Trust

You can add a belt and suspenders and safeguard against an overly zealous Canadian court by going offshore and utilizing a foreign third party trustee for your trust. An advantage of this approach is that a Canadian court will not have any jurisdiction over the foreign trustee. In addition, depending on the foreign jurisdiction you choose, the foreign country will have a statute of limitations that provides that the claim must be commenced in the foreign country within a specific period of time. Usually, by the time your creditors complete their claim against you here in Canada and figure out that they will have to pursue your assets in another jurisdiction, the statute of limitations will have expired.

One caveat - If you transfer your assets into any of these vehicles when you are technically insolvent, your creditors may have the right to trace the assets and unwind the creditor protection steps that you have taken. Therefore, it is important to set up these protections well in advance so that they are part of your ongoing estate planning considerations and not merely a way to defeat your creditors.

Bill was able to buy me lunch because he took my creditor protection advice. He put his house in his wife’s name and moved his financial assets into segregated funds. Bill may have lost his business, but he still has his nest egg so he can start over again. Will you?