Level 3: Equity Stripping
The concept of equity stripping is simple. The debtor borrows against an asset (i.e., a residence or commercial building) and gives the lender a lien or mortgage on the asset. The loan proceeds are then used to purchase exempt assets (i.e., life insurance or annuities), or are gifted to family members either outright, through irrevocable trusts, or through family limited liability companies.
Creditors will stand in line behind a lender who has a "priority lien" on an asset. Because foreclosures are both time consuming and expensive for the creditor, any remaining equity in the asset becomes less attractive for the creditor to chase. In order for equity stripping to work, however, the debtor must have some protected cash flow with which to make the loan payments. If a friendly lender is involved (i.e., the debtor's spouse or other family member), the lender must pay taxes on the interest. Moreover, the interest payments may not be deductible by the debtor-borrower. For example, on a home equity line of credit, only the interest on the first $100,000 borrowed is deductible.
Premium Financing. An increasingly popular variant of equity stripping is premium financing. This strategy begins with the debtor creating an irrevocable life insurance trust ("ILlT"). The ILlT then borrows the money to pay the premiums on a policy it will own on the debtor's life. Most lenders will want the debtor to guarantee the loan to the ILIT and will want the guarantee to be backed up with collateral, such as a residence. In such case, the equity in the residence is stripped. While the ILIT can borrow both the principal needed to pay the premiums plus the interest thereon, it is more common for the debtor to make annual gifts to the ILIT so that the ILIT can make the interest payments.
Normally, the premium loans are for a set term (i.e., five years), at which time they may (or may not) be renewed. In any event, the loan is due at the debtor's death and can be paid from the death proceeds the ILIT will receive - free of both income and estate taxes. While creditors may be able to get to the asset used as collateral when the loan is repaid, there will be an even greater amount of wealth inside the ILIT that creditors cannot reach. There are no tax advantages to premium financing since the interest paid will not be tax deductible.
Accounts Receivable Financing. Another example of equity stripping is accounts receivable financing. Professionals (i.e., physicians, dentists, lawyers, etc.) cannot limit their personal liability from malpractice claims even if they form professional corporations or professional limited liability companies to operate their practices. Moreover, the assets of a practice, including accounts receivable, are subject to the claims of malpractice creditors. One popular way to protect the accounts receivable of a professional practice is for the practice to take a loan against the receivables. The loan proceeds would then be distributed to the professional. Afterward, the professional would use the distribution to purchase an exempt asset (i.e., life insurance or an annuity) or would gift the distribution to family members (either outright or through an irrevocable trust or FLLC). Accounts receivable financing has an added benefit beyond asset protection. The transaction can create wealth from an otherwise dormant asset if the tax-deferred growth inside the annuity or life insurance policy, or the after-tax rate of return on the gifted assets, exceeds the interest paid on the loan (which may be tax deductible).