National Association of Estate Planners and Councils

May, 2007 Newsletter
Provided by Leimberg Information Services

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Bankruptcy – What Every Estate Planner Needs to Know

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:

















Timing is darned near everything!


Timing Rules Under the 2005 Bankruptcy Act.












Does the Ten Year Rule Apply to Annuities and Life Insurance Products?




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.


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.[1]

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:


Chapters 11 and 13 contemplate a Repayment plan.

Chapter 7 is essentially a liquidation mechanism.

A Chapter 7 debtor must meet a "means test".


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 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.[2]

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 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.


Significantly different results occur -  depending on which Chapter applies.


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.


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.[3]  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.


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.


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.


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,[4] 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[5].  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[6], therefore, should be applied literally.[7]  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.[8]


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.[9]


In In re Cannon Express Corporation,[10] 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.[11]  The Cannon court combined[12] 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.


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.[13]

          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.


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.


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.[14]


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,[15] 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[16] and Lawrence[17] 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,[18] 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,[19] 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.


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.[20]

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).[21]  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.[22]

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).[23]

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.


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.


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.


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.


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.[24] 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[25] 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[26] 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.[27]

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[28] 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.


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..[29]

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[30], 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.

Fraudulent transfers are not fraudulent.  There is a popular misconception that a "fraudulent transfer" is a transfer that involved defrauding one or more creditors in the bankruptcy court.  Under debtor creditor law, the term "fraudulent transfer" means a transfer made for the purpose of avoiding creditors, or in a situation where the transferor is undercapitalized when business operations and potential risk relating thereto is taken into account.


This is certainly different than "committing fraud", which occurs when one party actively misleads another party.  Committing a "fraudulent transfer" in the debtor creditor law context is generally not a crime, although some states have passed Bar rules which prevent lawyers from being integrally involved in helping or advising clients to effectuate fraudulent transfers,[31] even though it may be unconstitutional, and seems at least distasteful by many to prohibit lawyers from advising their clients to take actions that are in the clients best interests.  At least a client has the right to know all potential actions and potential implications thereof.

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.[32]

Transfers are also illegal if asset protection planners intend to evade the Federal Deposit Insurance Corporation (FDIC), or the National Credit Union Administration Board's Comptroller of the Currency or the Director of the Office of Thrift Supervision[33] under 18 U.S.C. '1032.  In U.S. v. Brown,[34] the appellant's conviction for concealing property from the FDIC and the Trustee in Bankruptcy was affirmed.  There appellant transferred his interests in a home, fitness center and a corporation to family members and friends.  He did not reveal the transfers or his interests to the FDIC, to whom he owed $2.4 million, or to the bankruptcy trustee.

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.[35]  Take for instance U.S. v. Smithson,[36] 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.[37] 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.[38]  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.


          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.[39]

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.[40]

Reasonable compensation paid for services actually rendered will not be considered to be a Preferential Transfer.[41]

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.


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.


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.[42]



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.[43]

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.[44]

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?[45]



The "mansion loophole closing" provisions of The 2005 Bankruptcy Act will reduce the protected homestead equity value to as low as $125,000 if one of the three exception provisions (summarized below) applies:

1.  The entire value of homestead property will not be protected where its value has been increased by a disposition of non-exempt property made by the debtor during the 10 years prior to filing bankruptcy with the intent of hindering, delaying, or defrauding creditors. [46]

The reduction is based upon the value of the homestead resulting from such "fraudulent transfers".  The courts must determine how to apportion appreciation in the value of a homestead that occurs after the "fraudulent conversion" has occurred.

2.  A debtor cannot exempt any amount of homestead property worth in excess of $125,000 that is acquired during the 1,215 days (three years and four months) before the bankruptcy filing.[47]

This is not an intent-based provision, but applies automatically when a person does not have the requisite time period to qualify for protection.

As an exception to this $125,000 cap, money derived from the sale of a prior residence can be applied to facilitate the purchase of a replacement property if certain requirements are met. Where the new homestead costs significantly more than the prior homestead, the amount of homestead protection is limited to $125,000 plus the proceeds from the sale of the prior residence used to purchase the new residence.

Several issues will arise with respect to how to handle appreciation, depreciation, and amortization of mortgage indebtedness in the context of successor homes.

In a post-BAPCPA case decided in October of 2005, In re Charles H Wayrynen, a debtor who had not lived in Florida 1,215 days filed bankruptcy with a homestead and was found not to be subject to the $125,000 cap.[48]


The court found that the statute would only apply where the debtor elects to use state exemptions, and Floridians are required to use the state exemptions, and have no elective choice between the federal and state exemptions.

Whoever drafted the statute must have assumed that all debtors have the opportunity to elect to use the federal exemptions or the state exemptions, not realizing that in Florida the debtors are required to use the state exemptions.


Congress' obvious intent was to limit the Homestead Exemption to $125,000 for debtors who choose to flee to debtor-friendly Homestead Exemption states, the most notable being Florida and Texas, unless the debtor resides in the Homestead protection state for at least 1,215 days before filing.[49]

At least three courts have found that the clear intent of the statue overrides the literal reading, and have enforced the 1,215-day rule in states, such as Florida and Nevada, that allow debtor's to "opt out" of the federal exemptions in favor of using the state exemptions.[50]

3.   The homestead exemption can be limited to an absolute cap of $125,000 where the debtor is convicted of a felony, which evidences that the filing of the bankruptcy was abusive (perhaps the rationale here is that the debtor won't need a house if he is going to jail).[51]


The homestead protection is limited to $125,000 where the debt involved arises from the violation of federal or state securities laws, fiduciary fraud violations of RICO, intentional torts or willful or reckless conduct resulting in serious physical injury or death in the preceding five years.[52] Doubtlessly, there will be more suits filed against doctors alleging willful and reckless conduct in malpractice actions.

The Section 522(q)(1) reduction to $125,000 will not apply to the extent that the homestead property is reasonably necessary for the support of the debtor and any dependant of the debtor.[53]  How much of a home will debtors be found to need?

a.   Do two spouses enjoy the benefit of two caps?   In In re Rasmussen[54] 349 B.R. 747 (M.D. Fla. 2006), the Bankruptcy court in the Middle District of Florida ruled that two spouses could "stack" their state law homestead exemptions together creating $250,000 of coverage for their home.  The court cited 522(m) which applies 522 separately to individuals filing joint bankruptcy cases.  The court went on to analogize the homestead exemption to other exemptions married bankrupt's may file together such as $2,000 total for automobile exemptions and $2,000 total for personal property exemp

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