Alan S. Gassman
is one of LISI's most prolific
commentators. Alan is a partner in Gassman, Bates & Associates, P.A.
in Clearwater, Florida.
Alan is joined in this
commentary by Alberto F. Gomez, Jr., a shareholder in the law firm
of Morse & Gomez P.A., in Tampa. The majority of his practice is in
the area of bankruptcy laws, insolvency, assignments for the benefit of
creditors and all other aspects of debtor/creditor law. Alberto lectures
frequently on the fundamentals of bankruptcy, assignments for the benefit
of creditors, the interplay between bankruptcy law and environmental law
and other related topics. Alberto is a member of the Hillsborough County
Bar Association, The Florida Bar, the Tampa Bay Bankruptcy Bar
Association, the Federal Bar Association and the American Bankruptcy
Institute.
LISI
extends appreciation to Alan and
Allberto for their most useful and organized explanation - and would also
like to thank Justin Pikramenos and James Ross, both of whom
are law students at Stetson University, for their assistance in
researching, drafting, and footnoting.
We've hyperlinked the
topics for LISI Members' convenience:
EXECUTIVE SUMMARY:
FEAR THE "B" WORD
THREE MAJOR TYPES OF BANKRUPTCY:
CHAPTER 7 "SNAPSHOT"
CHAPTER 13 - INDIVIDUALS ONLY:
CHAPTER 11 - BUSINESS ENTITIES:
THE
VERSE DEPENDS ON THE CHAPTERS:
INVOLUNTARY BANKRUPTCY
WHY
CREDITORS MAY FORCE THE ISSUE:
THE 12 OR MORE – 3 OR MORE RULE:
WHY
CREDITORS SHOULD THINK TWICE ABOUT FORCING INVOLUNTARY BANKRUPTCY:
THE
FIVE "BAD FAITH" TESTS:
ASSETS ARE PROPERTY OF THE BANKRUPTCY ESTATE: SHOULD A SACRIFICIAL LAMB
BE STAKED OUT?
A
DIFFERENT CREDITOR; TRUSTEE WITH "STRONG ARM" POWERS
COURTS CAN DISREGARD TRANSFERS MADE FOR ESTATE
PLANNING PURPOSES
SUBSTANCE OVER FORM - APPLIES HERE TOO!
Timing is darned near everything!
BADGES OF FRAUD:
Timing Rules Under the 2005 Bankruptcy Act.
STRATEGIES TO LIMIT RISK
PLANNING FOR LIFE INSURANCE AND ANNUITY CONTRACTS:
OTHER FACTORS TO CONSIDER IN FORMING OR DEFENDING PLAN:
THE Paper CHASE
SINGLE MEMBER LLC'S/ FLP'S
ADDITIONAL FRAUDULENT TRANSFERS ISSUES
PREFERENTIAL TRANSFERS
DISTRIBUTIONS FROM "INSOLVENT" ENTITIES
WAGE
STATUTE INTERACTION
TEN
YEAR RULE FOR ASSET PROTECTION TRUSTS &
SIMILAR ARRANGEMENTS
Does the Ten Year Rule Apply to Annuities and Life
Insurance Products?
IS
YOUR HOME STILL YOUR CASTLE?
CONCLUSION:
I. EXECUTIVE SUMMARY:
Many estate planners are familiar with asset
protection mechanisms, such as state law exemptions, family limited
partnerships, offshore asset protection trusts, and domestic asset
protections trusts. Most estate planners are also familiar with some
creditor protection rules, such as state fraudulent transfer acts, as well
as ethical considerations relating to creditor protection planning.
Most estate planners who are familiar with
asset protection planning concepts are also well aware of the United
States Bankruptcy Code ("Bankruptcy Code" or "Code") and many of its
primary aspects.
Many planners are not,
however, aware of several provisions of the Bankruptcy Code that can have
a catastrophic effect upon an estate plan, and its inter-working.
The interaction of an
estate plan with the Bankruptcy Code can be significantly affected by the
timing and logistical and communicative structure of an estate plan. Many
estate tax and income tax oriented planning structures face the risk of
being dismantled by a bankruptcy judge, notwithstanding that the primary
purpose of the planning had nothing to do with creditor protection. For
purposes of convenience, such structures will be referred to generally as
"Plans" or "Plan" unless otherwise noted.
The purpose of this LISI commentary is to
introduce estate planning and "asset protection" lawyers to several
Bankruptcy Code provisions and principles, which are not commonly known or
are often misunderstood.
II.
FEAR THE "B" WORD
Every estate planning client could end up in
a bankruptcy proceeding, whether voluntarily or involuntarily.
In few cases would a client "choose"
to file a voluntary bankruptcy petition.
All too often, clients may be forced
into a bankruptcy proceeding on an involuntary basis.
The impact of a bankruptcy filing on even
the most carefully executed estate plan can be devastating, especially in
view of the 2005 Bankruptcy Abuse Prevention and Creditor Protection Act
(The 2005 Bankruptcy Act), which imposes more stringent requirements on
consumer debtors to be eligible to file a petition.
In general, there are three types of
bankruptcy that arise in most cases. A detailed discussion of the
differences between the bankruptcy chapters is beyond the scope of these
materials, but a basic understanding is helpful:
THREE MAJOR TYPES OF BANKRUPTCY:
Chapters 11 and 13 contemplate a Repayment
plan.
Chapter 7 is essentially a liquidation
mechanism.
A Chapter 7 debtor must meet a "means
test".
CHAPTER 7 "SNAPSHOT"
Upon filing the petition, the "automatic
stay" against creditor actions, a Chapter 7 Trustee is appointed and the
assets become property of the estate, many of which may qualify as
exempt. In a Chapter 7, the court essentially takes a "snapshot" of the
debtor's assets and liabilities on the date of filing. This is significant
because the debtor's post petition earnings are not "property of
the estate".
As a further example to illustrate the point
of the importance of the snapshot would be the debtor winning the lottery
– after posting the Chapter 7 petition. The lottery winnings would not
be property of the bankruptcy estate.
Generally, after 90 days from filing, the
debtor obtains a "discharge" from responsibility for pre-bankruptcy debt.
That is certain debts; mainly unsecured debts are wiped out. The debtor is
afforded what is referred to as a "fresh start".
CHAPTER 13 - INDIVIDUALS ONLY:
Chapter 13 is only available to individuals
(not corporate or other business entities).
To be eligible to file a Chapter 13, an
individual must have unsecured debts of less than $336,900 and secured
debts of less than $1,010,650.
Chapter 13 repayment plans are typically
three to five years and are funded by the debtor's disposable income.
In exchange for paying under the Chapter 13
plan, a debtor keeps her assets.
Chapter 13 is prospective as opposed to the
snapshot concept of the Chapter 7.
The Chapter 13 Trustee administers the
payments under the plan once the plan is "confirmed" by the court.
At the conclusion of the Plan, after
payments are made, the debtor obtains a discharge.
CHAPTER 11 - BUSINESS ENTITIES:
Chapter 11 is used primarily for business
entities. But individuals with significant assets or who do not meet the
debt limits for Chapter 13, may file for Chapter 11.
Instead of a Trustee, the debtor becomes the
"debtor in possession" ("DIP") and is afforded an opportunity to propose a
plan. The DIP remains in possession and control of his or her assets.
Chapter 11 requires the debtor to obtain the
vote of creditors in order to confirm its plan unless the debtor is able
to "cramdown" the plan as authorized by the Code.
THE
VERSE DEPENDS ON THE CHAPTERS:
Significantly different
results occur - depending on which Chapter applies.
EXAMPLE:
In the case of the
lottery winnings, if winnings were obtained post petition in a Chapter 7,
the debtor would keep the winnings. On the other hand, if the winnings
occurred while in a Chapter 13 or Chapter 11, the winnings are property of
the bankruptcy estate.
EXAMPLE:
In the case of the
attorney client privilege, when a Chapter 7 bankruptcy petition is filed,
the Chapter 7 trustee may become the owner of the attorney client
privilege, as well as all client files for purposes of asserting or
waiving the privilege. There is a split authority on this point.
Therefore, correspondence to the client that may reveal significant
risks or adverse issues with respect to potential creditor planning might
cause irreparable damage to the client, and the estate planner, if and
when a bankruptcy petition is filed.
However, the
attorney-client privilege issue would not arise in the context of a
Chapter 13 or Chapter 11 bankruptcy.
III. INVOLUNTARY BANKRUPTCY
It takes only one creditor to force a
debtor into involuntary bankruptcy where the debtor has fewer than twelve
(12) creditors!
Under 11 U.S.C. 303, where a debtor has
twelve (12) or more creditors, an involuntary bankruptcy can be commenced
only where there are three (3) or more creditors who file a petition, with
each such petitioning creditor holding a claim that is (a) not contingent
as to liability, and (b) not subject to a bona fide dispute as to
liability or amount.
A creditor cannot be counted in the three
(3) or more creditor requirement if it holds a lien on the property of the
debtor, unless its claim exceeds the value of the property liened by at
least $12,300. Generally, employees and "insiders" are not counted as
creditors in determining whether twelve (12) creditors exist.
WHY
CREDITORS MAY FORCE THE ISSUE:
Because of the stricter bankruptcy rules,
which are now applicable, more clients with large judgments against them
will be rendered insolvent, yet will attempt to avoid or delay bankruptcy
while maintaining their creditor-exempt assets. Creditors may respond by
utilizing the involuntary option.
THE
12 OR MORE – 3 OR MORE RULE:
As noted above, a debtor with 12 or more
creditors may be forced into bankruptcy by a joint action filed by three
or more creditors. In Denham v. Shellman Grain Elevator,
the bankruptcy court refused to count small and recurring claims as
"countable" under the 12 creditors requirement.
One Florida bankruptcy case, In re
Smith, cited Denham and excluded creditors holding de minimis
claims for $20-$275.
Other cases have permitted claims of $65 and $10 to be countable under
Section 303. The aggregate claims must equal or exceed $12,300 for the 12
or more creditor rules to apply.
The courts that have chosen not to follow
Denham, and to instead allow small and recurring claims to count, have
dismissed the de minimis exception as an argument to disqualify one
or more creditors, based upon the argument that Congress has not
explicitly ruled out small and/or recurring debts and the statute,
therefore, should be applied literally.
Some courts, however, such as the court in Matter of Runyan have
indicated that a $25 debt would not be sufficient, and will evaluate the
claims on a case-by-case basis.
WHY
CREDITORS SHOULD THINK TWICE ABOUT FORCING INVOLUNTARY BANKRUPTCY:
Filing an involuntary
petition is an aggressive creditor strategy. There may be serious and
costly consequences if the petition is dismissed.
A creditor who files
for an involuntary bankruptcy "in bad faith" can be forced to pay the
debtor's fees, costs and actual and punitive damages.
THE
FIVE "BAD FAITH" TESTS:
In In re
Cannon Express Corporation,
the US Bankruptcy Court for the Western District of Arkansas awarded
compensatory damages and punitive damages where three creditors filed
involuntary bankruptcy proceedings against debtor and the court found them
to be in bad faith.
The decision was based
on a combination of five (5) tests identified in In re
Landmark Distributors, Inc.
The Cannon court combined
and restated the tests finding that;
1.
the claims were not well grounded in
fact because the creditors did not speak with an attorney, talk to other
creditors or attempt to collect the money from the debtor directly;
2.
the creditors could have advanced
their own interests in a different forum by using a collections agency or
setting up a payment system with debtor or other forum, instead holding
that using bankruptcy courts is an improper use of judicial resources.
3.
The creditors used the bankruptcy
proceedings to gain a disproportionate advantage over other creditors
because the creditors, who were unsecured, testified that they thought
filing involuntary bankruptcy proceedings would put them ahead of other
unsecured creditors, thus gaining priority.
4.
The creditors were motivated, the
court held, by an improper use because the creditor "knew that he was not
going to be paid" but thought filing would force the debtor to pay on its
debt to him.
5.
the court held no other reasonable
person would have filed the same or similar claim without first
investigating whether or not the debtor was paying its debts on time or
attempting to collect the debts in some other fashion.
For the improper filing
the court awarded more than $14,000 compensatory damages and $35,000 in
total punitive damages. Had the debtor proven losses in sales by
preponderance of the evidence, the court would have awarded these damages
as well, which were to be $2,768,288.00 according to the debtor.
In re Adell, 321 B.R. 562 (Bankr. D. Fla. 2005) is another good
example of an involuntary bankruptcy filing that backfired on the
petitioning creditor and resulted in the petitioning creditor becoming a
debtor! In Adell, a bankruptcy court in Michigan dismissed an
involuntary petition which was filed by Mr. Adell against his former
builder. The Court awarded sanctions in the amount of $6,413,230.68
against Adell.
Adell then quickly moved to Naples Florida
and filed a chapter 11 bankruptcy petition, and substantial litigation
ensued resulting in the conversion of the case to chapter 7 and ultimately
the dismissal of the chapter 7 case for substantial abuse.
IV.
ASSETS ARE PROPERTY OF THE BANKRUPTCY ESTATE: SHOULD A SACRIFICIAL LAMB
BE STAKED OUT?
The Bankruptcy Code provides in general that
upon filing a bankruptcy, assets of the debtor become property of the
bankruptcy estate under 11 U.S.C. 541. Some assets are specifically
excluded, such as an interest in a spendthrift trust, as defined in 11
U.S.C. 541 (c)(2) or social security or veterans benefits under 11 U.S.C.
522(d)(10)(a) and (b).
If your client is a debtor, a recipient of a
transfer from a debtor, or has an interest in a debtor, then bankruptcy
law can dramatically affect the estate plan.
One consideration is whether to leave assets
that would become accessible to the trustee in bankruptcy when
pre-bankruptcy planning occurs. On one hand, there is less likelihood
that transfers made before the filing of bankruptcy would be considered as
"fraudulent" where remaining assets that would be usable to pay creditors
were, arguably, sufficient to pay a substantial portion of expected debt.
Also, courts may be sympathetic to situations where debtors have lost
"sacrificial lambs" as a part of their bankruptcy filings.
On the other
hand, if the trustee has funds to spend on attorney's fees and costs to
pursue a debtor or recipient of a transfer, it may be more likely that the
bankruptcy or pre-bankruptcy transfers will be challenged. Often
creditors do not want to "throw good money after bad", so some planners
believe that only enough money to pay a small distribution would be an
appropriate amount to leave in the debtor's name in the event of a
bankruptcy.
V. A DIFFERENT CREDITOR; TRUSTEE WITH
"STRONG ARM" POWERS
Bankruptcy courts have consistently found
that they are "courts of equity", and have acted accordingly. This does
not mean that a bankruptcy court judge will ignore the law; but a
bankruptcy court judge can fashion broad and extensive remedies which will
typically not be available to a state court judge.
For instance, bankruptcy trustees are
empowered with certain "strong arm powers" under the Bankruptcy Code.
Presumptions concerning fraudulent transfers and avoidance of transfers
are built into the Code, for instance in 11 U.S.C. 548 (fraudulent
transfer) and in 11U.S.C. 547 (preference), which are described below.
A trustee is the equivalent of a
hypothetical judgment creditor and may step into the shoes of creditors to
exercise statutory strong arm powers to set aside and recover transfers.
In addition to these specific grants of statutory authority provided to a
trustee, the Code gives the bankruptcy judge broad equitable powers to
fashion appropriate relief under 11 U.S.C. § 105.
COURTS CAN DISREGARD TRANSFERS MADE FOR ESTATE PLANNING PURPOSES
A simple search on West Law or Lexis-Nexis
will reveal numerous bankruptcy cases where courts have disregarded
transfers that were ostensibly motivated by estate planning purposes.
Most of the cases where a court has set aside transfers are factually
specific and involve transactions that occurred when the creditor claim
was known of or should have been known of by the debtor.
The lesson learned is to get the plan
underway – as early as possible. Also, all factors which support
business, estate planning, tax, family planning, and other motives for
planning will be useful in helping to assure that the bankruptcy court
will not dismantle legitimate planning that occurs before the bankruptcy
petition is filed.
SUBSTANCE OVER FORM - APPLIES HERE TOO!
A number of bankruptcy court decisions make
it clear that bankruptcy judges have and will continue to apply substance
over form and equitable principles which will often favor the Trustee and
creditors in a Bankruptcy case.
Examples of these decisions include the
well-publicized Portnoy,
where the court basically ignored the law of the applicable offshore
jurisdiction and applied the law of the jurisdiction where the bankruptcy
court resided in determining that offshore trusts were not effective
creditor protection devices. Further, in the Anderson
and Lawrence
cases, contempt citations resulted in the debtors going to jail for not
turning over offshore assets. These decisions were upheld on appeal by
the Ninth and Eleventh Circuit Courts of Appeal in far reaching decisions.
In too many cases, plans have either ignored
crucial facts or are missing key bankruptcy protections, which if the
unthinkable happens, will jeopardize a client's Plan. Below are some
examples:
In the case of
In re Agnew,
a farmer owned an undivided one-fifth (1/5) interest in farmland as well
as some farming equipment. His mother, in trust, owned the remaining
four-fifths (4/5) undivided interest in the land. The farmer leased the
4/5 parcel from his mother for farming purposes and to live on.
Prior to filing
bankruptcy (the farmer was indebted by over $130,000), he transferred his
1/5 interest in the land and his farm equipment to his mother's trust in
exchange for the parcel of land on which he lived.
Years prior to the
transfer the farmer and his mother had discussed making the transfer to
ensure he would not be evicted from the home by his siblings on his
mother's death. Just prior to making the transfer he was counseled by an
economist at a local university who was working in a creditor counseling
program to engage in this transaction.
The judge found that
the values were reasonable. The question in this case was whether this
transfer should be defeated by Bankruptcy Code '522(o)(4) that authorizes
the reduction of the amount claimed by a bankruptcy debtor in the amount
of any such property that was disposed of in a 10 year period prior to the
filing of the bankruptcy petition, if the transfer was made with the
intent to hinder, delay, or defraud creditors. Thankfully for the debtor,
the court found that there was no intent to defraud creditors, since the
farmer's intent was to ensure he was not evicted from his home when his
mother died and the anticipated bankruptcy filing was not the reason for
the transfer. Upon finding no intent to defraud, the court held the
transfer was appropriate and the farmer could rightfully exempt his
homestead.
In In re Lacounte,
husband and wife debtors were found to have violated '522(o) by
selling assets to intentionally divert funds away from creditors.
Anticipating bankruptcy, the debtor's
daughter sought counsel of an attorney who advised the husband and wife to
sell off what they didn't need and put the proceeds into their home
mortgage.
The Debtors sold 3 family cars and the
husband's future interest in his mother's 680 acre farm. They used the
proceeds from these sales to pay down the mortgage on their home even
though debtors had run up more than $180,000 in gambling debts on their
credit cards.
The Debtors also transferred the wife's
future interest in her mother's home back to her mother because they
understood that in bankruptcy proceedings she would most likely lose this
family asset to creditors.
The court held that selling the assets and
utilizing the proceeds to pay down the home mortgage was done solely to
keep the assets out of reach of creditors. The court found this violated
'522(o) and the debtor's homestead exemption was reduced by the amount
they received as proceeds from sales of their assets.
Keep in mind that in each of the cited
cases, the debtors chose to file voluntarily . In most cases, the debtor
may very well be judgment proof and would not have to defend against a
creditor with strong arm powers, such as a trustee.
If a debtor has implemented an estate plan
with creditor protection features, it is logical to ask, why voluntarily
file a bankruptcy? Often it will be best to "hunker down," live with
judgment and occasional depositions in aid of execution and continually
attempt to settle as the years roll on.
Timing is darned near everything!
The cases described above make it clear
that the timing of an estate plan is crucial to how it will fare in
bankruptcy court.
Obviously, if the planning or asset
protection plan is implemented after a demand for payment by a
creditor and/or entry of a judgment, a bankruptcy court will be more
inclined to find that the plan was a fraud upon creditors.
Clients must be advised that the risk of a
plan being disregarded or set aside by a bankruptcy court will increase
exponentially based upon the timing of the plan and the existence of a
creditor claim.
BADGES OF FRAUD:
While the burden is on the trustee in
bankruptcy to prove that a transfer can be set aside as "fraudulent,"
evidence other than the testimony of the debtor may be used to determine
if sufficient proof exists.
A court evaluating whether sufficient
"badges of fraud" exist to "prove" a fraudulent transfer may consider
factors such as:
·
The transfer is to an insider.
·
The Debtor has retained
control of the asset.
·
Transfer was concealed.
·
Before transfer Debtor had
been sued or demand was made.
·
Transfer was of substantially
all of the Debtor's assets.
·
The Debtor absconded.
·
The Debtor removed or
concealed assets.
·
There was no reasonable
equivalent value or consideration for the transfer.
The Plan
should be implemented before any creditor claim arises. Many
times, the timing of the Plan cannot be controlled, but will be a
significant factor.
Timing Rules Under the 2005 Bankruptcy Act.
Under the 2005
Bankruptcy Act, a debtor must maintain a domicile within a certain state
for the two years (730 days) prior to filing a petition in order to have
that state's exemption laws apply in the bankruptcy.
If the debtor's
domicile was not located in a single state for that 730-day period, then
it is necessary to determine where the debtor resided for the 180 days
before those 730 days (days 731 through 910).
In those situations the exemption laws of the state where the debtor was
domiciled the greatest number of days between day 910 before filing and
day 730 before filing will be the state law to apply in the bankruptcy.
Further, as discussed
below, a 1,215 day rule applies to qualify a "non-fraudulent transfer into
a homestead" for full protection in bankruptcy, even where the state
fraudulent transfer rules would not cause a set aside to occur (such as in
Florida).
A ten year statute, as
described below, will provide for loss of equity in homestead attributable
to fraudulent transfers made into the homestead within ten years of the
filing of the bankruptcy.
VI.
STRATEGIES TO LIMIT RISK
As a threshold matter, the first critical
decision is whether to file a voluntary bankruptcy petition. For many
clients, there is no need to file a voluntary petition. Creditor
protection is provided by the Plan, and the non-bankruptcy forum appears
to be a friendlier debtor forum. Moreover, outside of bankruptcy, there
is no trustee and no strong arm powers to contend with.
When an estate planning strategy is put into
place, the estate tax, income tax, and financial and family advantages of
the arrangement should be emphasized. While creditor protection may be an
important factor and motivation in determining what strategies to use, it
is best for creditor protection to not ostensibly be the primary reason of
the plan.
For example, if a family were to choose
between having an offshore protection trust or a domestic limited
partnership to hold significant long term assets, the family limited
partnership may be determined to be more desirable, given discounting for
tax purposes, control, and expense considerations. Offshore asset
protection trusts arrangements may be more reliable where resulting from
situations where there are significant businesses which prompt their use.
These may include situations such as family
marital agreements where each spouse agrees to allow premarital assets to
be held in offshore trusts which follow the rules of jurisdictions which
will clearly uphold separate non-marital asset rights, and to require that
any dispute be resolved under the law of a jurisdiction that is more
inclined than the state of residence to allow for absolute protection of
premarital assets.
Also, clients from foreign countries will
commonly want their assets held in a jurisdiction that allows free
movement between the country where many of their relatives reside and the
jurisdiction where some portion of their wealth is held. An example would
be clients who have relatives that they support or may need to support in
the future.
One author has also recently found that many
spouses holding significant tenancy by the entireties assets want
"contractual assurances" from a surviving spouse that the assets will not
be mishandled or lost to a creditor of the surviving spouse. Married
couples may choose to execute agreements whereby the surviving spouse
agrees to immediately fund and become co-trustee of a trust established in
a "creditor protection trust" jurisdiction.
PLANNING FOR LIFE INSURANCE AND ANNUITY CONTRACTS:
Clients who have offshore asset protection
trust motivation factors, and particularly those who live in states that
provide protection for the "cash value" of life insurance policies, should
also consider offshore life insurance arrangements that can facilitate
holding the underlying policy investments in favorable jurisdictions while
offering income tax avoidance under the established life insurance
provisions of the Internal Revenue Code.
Annuity contracts with offshore life
insurance companies are also a popular way of attempting to defer income
tax on investments that cannot be held under United States sponsored
annuities because of insurance commissioner limitations that do not apply
in offshore jurisdictions.
OTHER FACTORS TO CONSIDER IN FORMING OR DEFENDING PLAN:
The age of the client, tax issues, current
stage in life or business and family support factors are all important in
fashioning and defending a legitimate Plan. At every opportunity, the
documents relating to the Plan should contain "recitals" or specifically
mention the non-creditor protection factors which result in the creation
of the Plan.
THE Paper CHASE.
In defending any Plan, it is important to
have a paper trail which justifies the estate planning purposes behind the
transfers. Again, assuming that the timing is in favor of the debtor,
having an appropriate paper trail whereby there is documentation to prove
adequate and reasonable non-creditor planning purposes for the transfers
may provide a bankruptcy judge with sufficient ammunition to defeat
efforts by a bankruptcy trustee to enforce a claim against the protected
assets.
For instance, if one factor which supports
the establishment of a Plan is the medical condition of the debtor, it may
be prudent to document this fact and to have supporting documentation such
as a letter from the treating physician.
Similarly, if one reason for a Plan is the
advanced age of the debtor this also would be a fact worth emphasizing.
SINGLE
MEMBER LLC'S/ FLP'S
It is well known that LLC's and family
limited partnerships (FLP's) have become popular vehicles for the holding
of valuable family assets, and are integral parts of many Plans.
As an example, Florida Statue 608.433(4)
safeguards the membership interest of an LLC owner or member by limiting
creditors of a debtor limited partner to a "charging order". A charging
order provides the creditor with the right to receive any distributions
that may be paid to the debtor limited partner, but does not allow
the creditor to exercise any rights otherwise held by the limited
partner.
A charging order may turn the creditor into
a partner for federal tax purposes, although the tax law is not clear on
this. The one Revenue Ruling reaching this result involved a situation
where the debtor limited partner voluntarily gave the creditor an
assignment of the limited partnership interest.
Many authorities believe that a creditor
will not be subject to federal income tax by reason of merely holding a
charging order.
If income is allocated but not distributed, then the creditor has the risk
of being taxed on income that is never received.
A January 2007 Florida Bar Journal
article indicates that the LLC operating agreement and limited
partnership agreements should impose affirmative obligations on members
and partners to make future capital calls, and to be involved in
management of the partnership .
This conclusion is based upon the Bankruptcy
Court decision in Ehmann
where a bankruptcy judge concluded that charging order protection does not
apply once a limited partnership interest is subjected to the Bankruptcy
Court's jurisdiction when the debtor limited partner has filed or has been
forced into bankruptcy if the partnership arrangement is non-executory. If
executory, a trustee is bound by the operating agreement.
Accordingly, agreements should state that
they are intended to be executory contracts, which is a term of art in
bankruptcy law. An "executory contract" is a contract where obligations
exist on both sides which are unperformed:
Limited
liability companies are relatively new statutory creations and there is
little law addressing the question of whether a limited liability
company's operating agreements are an executory contract……although the
Bankruptcy Code does not define the term "executory contract", legislative
history and case law cite with approval Professor Vern Countryman's
definition: "a contract under which the obligations of both the bankrupt
and the other party to the contract are so far unperformed that the
failure of either to complete performance would constitute a material
breach excusing performance of the other." Vern Countryman,
Executory Contracts in Bankruptcy: Part 1, 57 Minn.L.Rev. 439,
460 (1973).
Where a debtor is a limited partner in a
limited partnership with no affirmative duties to the partnership, the
contract may be considered non-executory, and thus not binding upon the
trustee In bankruptcy. On the other hand, if a debtor, as limited
partner, has affirmative duties to contribute money and to perform
services for the partnership, then the partnership agreement may be
considered executory, and may, therefore, receive charging order
protection in bankruptcy.
Moreover, members and partners should assume
a more active role in the management of the entity. Changes to the
limited partnership statutes in many states permit participation of
limited partners in the management of the entity with loss of limited
liability.
Another suggestion made in the article is to
include contractual provisions which are authorized by state statute to
require the consent of the remaining members when one member seeks to
transfer a membership interest.
Another example of bankruptcy court
"interjection" in this area is the case of In re Ashley
Albright
where a Colorado bankruptcy court in 2003 held that the trustee in
bankruptcy, as the successor of the LLC that had been owned by a debtor,
had the ability to provide consent to the transfer of member interest in a
single-member LLC, and could therefore exercise management control over
the LLC and liquidate the assets of the LLC to realize the value as the
sole member.
The bankruptcy judge concluded that the
purpose of the Colorado charging order statute was to protect other
members, even though the language of the statute itself had no mention of
the charging order protection only applying in a multiple member
situation.
It is therefore suggested by many planners
that a limited liability company have multiple members, so that if one
member ends up in bankruptcy the presence of other members would hopefully
strengthen the possibility of charging order protection applying.
Finally, given the discounting that can
occur for gift tax measurement purposes, it will often be inconsistent
with normal estate and gift tax planning not to transfer partial interests
in an LLC to family members and/or trusts for their benefit.
ADDITIONAL FRAUDULENT TRANSFERS ISSUES
A fraudulent transfer is defined
under the Bankruptcy Code as a transfer that can be avoided by a trustee
if the transfer was made with (1) the intent to actually defraud, hinder
and delay creditors or (2) in exchange for less than reasonably equivalent
value while the debtor was insolvent..
A fraudulent transfer can also be found to
have occurred when a debtor has assumed a creditor's obligation instead of
making a transfer.
If a debtor makes a transfer to a creditor
and does not receive equivalent value,
a fraudulent transfer exists if
1.
the debtor's business (or impending business) held assets
unreasonably low in value;
2.
the debtor incurred or believed it would incur debts beyond what
the debtor could repay; or
3.
at the time of the transfer, the
debtor was either already insolvent or became insolvent as a result of the
transfer.
Some transfers that are intended to defeat
creditors may be illegal, such as transfers intended to evade collection
of taxes by the Internal Revenue Service, under Internal Revenue Service
Code 26 U.S.C. ' 7206(4) and '7201.
Any person who 1) conceals a debtor's
assets, 2) receives the debtor's assets fraudulently, or 3) transfers or
conceals assets on behalf of a corporation intending to defeat the
Bankruptcy Code will find himself, and possibly his lawyer, in prison for
up to five years.
Take for instance U.S. v. Smithson,
where the debtor and his lawyer were convicted under 18 U.S.C. '152 for a
transfer made two days before filing bankruptcy. Pryon (a co-defendant
with his lawyer Smithson) owned purchase options in two buildings. He
transferred these rights to a corporation set up by his lawyer and two
days later filed bankruptcy. Both were sentenced to jail time and
assessed fines.
Finally, a common prosecutorial tool is 18
U.S.C. ' 371. This statute prohibits individuals from committing fraud on
the United States. The government must prove; 1) an agreement between two
people, 2) a scheme to defraud the U.S. and 3) an overt act committed in
furtherance of the agreement.
An attorney was convicted of conspiring to transfer the assets of one
corporation to another in contemplation of bankruptcy under both 18 U.S.C.
' 371 and ' 152.
There, the attorney counseled the client to transfer some of the
corporation's inventory to another company and then auction off the rest
of the company's assets. The attorney, Switzer, set up the transactions
and prepared confessions of judgment for some favored creditors. The
transaction took place prior to the judicial sale for the Trustee in
Bankruptcy's benefit. Switzer's conviction was upheld on appeal because
he was found to have attempted, through his advice and participation in
the transactions, to defeat the bankruptcy statutes, and thereby defraud
the United States of the client's assets in bankruptcy.
PREFERENTIAL TRANSFERS
While most
planners understand state fraudulent transfer rules, which are usually
very similar to the Bankruptcy Code fraudulent transfer statute, many
planners are not conversant with the Preferential Transfer provisions of
the Bankruptcy Code.
Transfers made by a
debtor to an "insider" within one year of filing a bankruptcy may be set
aside, notwithstanding whether the transfer would be considered a
"fraudulent transfer" under fraudulent transfer rules.
Also, Preferential
Transfers made to any party within one year (if an insider) or 90 days of
the filing of a bankruptcy petition can be set aside as well.
Reasonable compensation
paid for services actually rendered will not be considered to be a
Preferential Transfer.
Dividends paid by a
professional practice corporation to its owner or member can be considered
a Preferential Transfer. Many clients are advised by their accountants to
keep wages low and dividends high. This advice often does not take into
consideration fraudulent transfer and Preferential Transfer rules in the
event the client finds themselves in a bankruptcy. In addition, repayment
of shareholder loans may be set aside as a preference.
DISTRIBUTIONS FROM "INSOLVENT" ENTITIES
Another common consideration relates to laws
concerning distributions made from a company under circumstances where
sufficient reserves have not been set aside to pay known or expected
creditors. The board of directors of a company allowing such
distributions can become liable to a creditor.
The liability of the directors would be
based upon the amount of monies or other assets that should have been left
in the company as opposed to being paid out.
According to Florida Statute section
607.06401 (3), no distributions to shareholders may be made, if after such
distribution,
1.
the corporation would not be able to
pay its debts as they become due in the usual course of business; or
2.
the corporation's total assets would
be less than the sum of its total liabilities plus (unless the articles of
incorporation permit otherwise) the amount that would be needed, if the
corporation were to be dissolved at the time of distribution, to satisfy
the preferential rights upon dissolution of shareholders whose
preferential rights are superior to those receiving the distribution.
If the distribution falls within the bounds
of either of the above definitions, then the distribution is characterized
as a wrongful distribution. The director's personal liability is
addressed by section 607.0834 which places personal liability on any
director who votes affirmatively for such a distribution.
The director is personally liable for the
amount of the distribution that exceeds what could have been distributed
without violating section 607.06401 or the articles of
incorporation if it is established that the director did not perform his
or her duties as required by section 607.0830 (good faith; reasonable,
prudent person standard; in the best interest of the corporation).
Additionally, subsection (2) states that a
director held liable under subsection (1) is entitled to contribution from
each shareholder for the amount that such shareholder accepted knowing the
distribution was made in violation of section 670.06401.
Further, the director is entitled to
contribution from every other director who could be liable under
subsection (1) for the unlawful distribution. For example, if there were
two director shareholders who split the initial $150,000 distribution,
then they could each be held to be jointly and severally responsible for
the entire $150,000.
WAGE
STATUTE INTERACTION
Some states allow for exemption of wages and
even deferred compensation from creditor claims. The 2005 Bankruptcy Act
provides that a Trustee may void a transfer of property or an obligation
(including any "transfer to or for the benefit of an insider under an
Employment Agreement") if made within two years before filing, as a
fraudulent conveyance or a preferential transfer for less than adequate
consideration. It is therefore important to be able to document that any
compensation was actually owed when wages are paid to related parties or
"insiders" if a company may become insolvent.
TEN
YEAR RULE FOR ASSET PROTECTION TRUSTS
SIMILAR ARRANGEMENTS
Asset Protection Trusts are arrangements
whereby creditors of a beneficiary may not have access to trust assets
where prevented by the law of the jurisdiction where the trust is formed
and operated. Asset protection trust jurisdictions in the United States
and abroad have therefore proliferated.
The 2005 Bankruptcy Act makes transfers to
self-settled trusts or similar devices subject to being set aside
in bankruptcy when made within 10 years of filing. A self-settled trust
is a trust established by an individual that allows for the trust assets
to be held for the possible benefit of that individual. This 10-year set
aside statute applies if the transfer was made with "actual intent" to
hinder, delay, or defraud present or future creditors. For this rule to
apply, the debtor must be a beneficiary of the trust.
The 10-year rule should not apply; however,
if the debtor forms the offshore trust for the benefit of the debtor's
family, but not for the debtor himself or herself. "Substantial de facto
control" has been found to be sufficient for a court to find that the
trust should be disregarded for creditor protection purposes.
New Bankruptcy Code Section 548(e)(1)
applies to both domestic and offshore asset protection trusts. Time will
tell whether asset protection trusts that have been funded for more than
10 years before the filing of bankruptcy will be better respected than
they have been in the past by bankruptcy courts.
As discussed above, several bankruptcy court
decisions have concluded that offshore asset protection trusts are either
invalid, or that the debtors involved with offshore asset protection
trusts can be jailed on contempt. Nevertheless, informal reports of
favorable settlements reached by debtors whose creditors would apparently
prefer not to "go the distance" to obtain offshore trust assets have been
reported. Further, there is no case known to the authors where the assets
of an offshore asset protection trust have been involuntarily obtained by
a creditor.
Some states only offer unlimited protection
of life insurance and the cash values of annuity contracts. Some states
only protect certain financial products if and to the extent that they are
reasonably necessary for the support and/or retirement of a debtor. The
life insurance, annuity, and offshore financial service industries have
come to market with mutual fund wrapped products that provide income tax
deferral and creditor protection for policyholders and their families.
Does the Ten Year Rule Apply to Annuities and Life Insurance Products?
Is an annuity a "similar device" that would
not be protected in bankruptcy, under the provision applying to ASSET
PROTECTION TRUSTS described above, where within 10 years of filing, a
transfer is made into an annuity or life insurance product with the actual
intent to hinder, delay or defraud present or future creditors?
At one point in the legislative process this
asset protection trust 10-year set aside provision was to specifically
exclude qualified retirement plans. Does this mean that the legislative
intent was to specifically include many financial products that would be
similar to qualified retirement plans, such as annuities?
Is the language "self-settled trust or
similar device" broad enough to include annuity and life insurance
arrangements where money is given to a life insurance company that invests
it and makes cash available at a later time, subject to state or foreign
jurisdiction creditor protection laws and arrangements?
