CONSERVATIVE ASSET PROTECTION PLANNING

Presented By:

TOBY EISENBERG Bisignano & Harrison, L.L.P. 5949 Sherry Lane, Suite 770 Dallas, Texas 75287 (214) 360-9777, ext 26 [email protected]

Co-Authored By Presenter With:

SANDY BISIGNANO, JR. Bisignano & Harrison, L.L.P. 5949 Sherry Lane, Suite 770 Dallas, Texas 75287

ALVIN J. GOLDEN Ikard & Golden, P. C. 400 West15th Street, Suite 975 Austin, Texas 78701

State Bar of Texas 27th ANNUAL ADVANCED TAX LAW COURSE August 27-28, 2009 Houston

CHAPTER 11

TOBY MATTHEW EISENBERG

Bisignano & Harrison, L.L.P. 5949 Sherry Lane, Suite 770 Dallas, Texas 75225 phone: 214-360-9777 ext. 26 email: [email protected]

EDUCATION Southern Methodist University, Dallas, TX Ph.D. Religious Studies – Expected December 2010

The University of Texas School of Law, Austin, TX J.D. – December 1999

Fuller Theological Seminary, Pasadena, CA M.A. Biblical Studies and Theology – August 1997

Rice University, Houston, TX B.A. Philosophy, Music Minor – May 1994

PROFESSIONAL ACTIVITIES AND CREDENTIALS Partner, Bisignano & Harrison, LLP Board Certified in Estate Planning and Probate Law by the Texas Board of Legal Specialization Member of the State Bar of Texas – admitted May 2000

PRACTICE CONCENTRATION Estate Planning. All facets of estate planning, which encompasses the drafting and planning for the disposition of wealth through the use of various planning techniques, including lifetime gifts, and intra-family sales, life insurance and other complex trusts, family limited partnerships, limited liability companies, wills, health care designations, powers of attorney and directives to physicians, and related planning for the protection of assets from creditors.

Business Continuation Planning. Business continuation planning for owners of closely held businesses, including formation of closely held businesses, buy-sell agreements, split dollar life insurance agreements, business recapitalizations, and certain non-qualified deferred compensation agreements.

Charitable Gift Planning. Charitable gift planning, including charitable remainder trusts, charitable lead trusts, and creation of exempt organizations in connection with charitable planning.

Estate and Trust Administration. Administration of trusts and estates, including dependent, independent and ancillary probate procedures, guardianships, income tax planning, preparation of U.S. Estate and Texas Inheritance tax returns, audit negotiations with agents of the Internal Revenue Service and the Comptroller of Public Accounts of Texas, preparation of tax protests, private letter ruling requests and coordinating dissolution of partnerships and closely held corporations.

Fiduciary Representation and Estate and Trust Controversy Matters. Representing fiduciaries and coordinating fiduciary litigation matters, including fiduciary liability issues, will contests, and trust modification and construction issues.

Marital Property Issues. Texas community property system and related marital property matters, including premarital and postmarital partition and/or property agreements between spouses.

Conservative Asset Protection Planning Chapter 11

TABLE OF CONTENTS

I. INTRODUCTION ...... 1

II. BASIC CONSIDERATIONS...... 1 A. Typical Reasons For Estate Planning...... 1 B. Another Important Reason In These Litigious TimesBTo Protect Assets From Contingent, Unknown, And Often Overzealous Juries And Judgement Creditors...... 1 1. Litigious Society ...... 1 2. Economic Decline ...... 1 3. Increased Emphasis on Asset Protection...... 1 C. Scope of Outline ...... 1 1. Debtor and Creditor Rights and Marital Property Liability Rules ...... 1 2. Estate Planning Techniques (including Domestic Asset Protection Trusts) ...... 2 3. Introduction of the Jones Family ...... 2 4. Designing a Plan for the Jones Family ...... 2 D. Definitions and Assumptions ...... 2 1. Preservation Planning ...... 2 2. Assumptions: No Actual or Constructive Fraudulent Intent ...... 2 E. What Clients Will Benefit From the Lessons of This Outline? ...... 2

III. STATE LAW RULES C DEBTOR AND CREDITOR RIGHTS, MARITAL PROPERTY LIABILITY, AND EXEMPTIONS...... 2 A. A Little Context – U.S. v. Townley ...... 2 1. Facts ...... 2 2. Opinion ...... 2 3. Impact of this Case ...... 3 B. UFTA and Fraudulent Transfer/Conveyance Rules of Focus States ...... 3 1. What is a “Transfer”? ...... 3 2. Transfer with Actual Intent to Defraud Is Void...... 3 3. What Is “Actual” Fraudulent Intent? ...... 3 4. Important Badges of Fraud ...... 3 5. Insolvency Crucial Factor...... 4 6. Statute of Limitations for “Actual Intent” Actions...... 4 7. Transfer Fraudulent if Debtor Insolvent...... 4 8. Other Actionable Transfers...... 4 9. Meaning of Insolvency...... 5 C. Marital Property Liability Rules...... 5 1. Relevant Marital Property Concepts...... 5 2. Relevant Rules of Marital Property Liability...... 6 D. Homestead Exemptions...... 7 1. General...... 7 2. Scope of Liability for Owner Occupant’s Debts...... 7 3. Who is Protected? ...... 8 4. How Strong is the Exemption? ...... 8 5. Preservation Planning Potential...... 8 6. Drafting PointerBHomestead Designation...... 8 7. Beware Revocable Management Trusts...... 8 E. Personal Property Exemptions...... 9 1. General...... 9 2. Types of Protected Assets...... 9 3. Designation of Exempt Assets...... 9

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F. Life Insurance Exemption...... 9 1. Are Proceeds (and other benefits) Insulated from the Claims of the Insured’s and/or Beneficiary’s Creditors? ...... 9 2. Liability of Separate Proceeds for Debts Incurred by Insured...... 10 3. Exemption Cumulative...... 11 G. Retirement Plans...... 11 H. Estates by the Entirety...... 11 1. General...... 11 2. Liability for Debts of Spouses...... 11 3. Preservation Planning Potential...... 11 I. 529 Plans...... 11 1. Gifts to Plan Are Complete Even If Donor is the Account Holder...... 11 2. No Estate Tax Inclusion...... 11 3. No Income Tax...... 11 4. Account Holder Can Get Money Back If Needed...... 11 5. May Have Creditor Protection Too...... 11 6. CBAPCPA Provides Added Protection...... 12

IV. RELEVANT FEDERAL BANKRUPTCY RULES...... 12 A. Purpose and Scope of BAPCPA...... 12 B. Effective Dates...... 12 C. Exemptions...... 12 D. Domicile Requirements...... 12 E. The Bankruptcy Estate, Exemptions and Exclusions...... 12 1. The Bankruptcy Estate...... 12 2. Choice of Exemptions...... 13 3. Interplay With State Exemptions...... 13 4. Exclusions...... 14 F. Homestead Exemptions...... 14 1. Effective Date...... 14 2. Limitation on Amount Dependent on Time...... 14 3. Necessity for Occupancy...... 14 4. Definition of “Value”...... 14 5. Increase in Market Value...... 14 6. Payment on Debt Related to Home...... 14 7. Previous Residence...... 15 8. Bad Acts...... 15 9. Adjustment for Inflation...... 15 10. Fraudulent Transfers...... 15 11. The Temporary Opt-Out State Controversy...... 15 12. Tenancy by the Entirety...... 16 G. Retirement Benefits...... 16 1. Governing Law Prior to BAPCPA...... 16 2. Benefits Exempted Under State Exemption Election...... 17 3. New Federal Exemption...... 17 4. Limitation of Exemptions...... 17 5. Plans Affected by Limitation...... 18 6. Applicability to State Law Exemptions...... 18 7. Applicability to Federal Exemptions...... 18 8. Application of Limitation...... 18 9. Discretionary Increase in Amount of Limitation...... 18 10. Rollovers and Trustee to Trustee Transfers...... 18 11. Spousal Rollovers...... 18 12. Inherited IRAs...... 18

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H. Exclusions of Education Account Benefits...... 19 1. Education IRAs...... 19 2. §529 Plans...... 19 3. Interplay with State Exemptions...... 19 I. Fraudulent Transfers in General...... 19 1. Avoidance by Trustee in Bankruptcy – General Rule...... 19 2. Avoidance by Trustee in Bankruptcy – Transfer for Less than “Reasonably Equivalent Value”...... 19 3. Meaning of Insolvency Under Federal Bankruptcy Rules...... 20 4. Trustee’s Power to Void Transfers Under State Law and Denial of Discharge...... 20 J. Transfers to “Self-Settled Trust or Similar Device”...... 21 1. Scope of this Section...... 21 2. Inclusion of Self-Settled Trusts under State Law...... 21 3. Effective Date...... 21 4. Need for this Provision...... 21 5. Conditions of Avoidance...... 21 6. Transfer by Debtor...... 21 7. Debtor as Beneficiary...... 22 8. Actual Intent...... 22 9. Self-Settled Trusts...... 22 10. Similar Device...... 23 11. Transfers by Evil People...... 24 12. Why This Is So Unsettling...... 24 K. Dismissal For Abuse...... 24 L. Involuntary Bankruptcy...... 24 1. Who Are Creditors? ...... 24 2. Constitutional Issue...... 24 3. Can You Even Have An Involuntary Bankruptcy? ...... 24 M. A Closing Thought...... 24

V. PRELIMNARY CONSIDERATIONS FOR PRESERVATION PLANNING...... 24 A. First Satisfy Yourself You Can Represent the Client...... 24 B. Solvency Balance Sheet and Affidavit of Solvency and General Intent...... 25 C. Affidavit Helps Avoid Implications of Fraud...... 25 D. Engagement Letter...... 25

VI. EXAMINATION OF VARIOUS ESTATE PLANNING TECHNIQUES AND TOOLS IN THE CONTEXT OF PRESERVATION PLANNING...... 25 A. Outright Gifts C Advantages...... 25 B. Gifts to Spendthrift Trust C Donor Not a Beneficiary...... 26 1. Advantages...... 26 2. General Rules Re: Spendthrift Trusts...... 26 3. Insulation from Creditor Claims...... 26 4. Extra Care if Donor is Trustee of the Trust...... 26 5. Creditor Protection if Beneficiary is Sole Trustee...... 27 C. Life Insurance...... 29 1. General...... 29 2. Preservation Planning Potential...... 29 D. Irrevocable Life Insurance Trusts...... 29 1. Description of Technique...... 29 2. Effectiveness of Technique As a Preservation Planning Tool: ...... 29 E. Marital Property Partitions (Community Property States)...... 30 1. Traditional Uses for Such Agreements...... 30 2. Background...... 30 3. Marital Property Partition as Preservation Planning Tool...... 31

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4. Post Partition Safeguards...... 31 F. Qualified Personal Residence Trust...... 32 1. Background...... 32 2. Qualified Personal Residence Trust...... 32 3. Advantages of Qualified Personal Residence Trust...... 32 4. Technique as Preservation Planning Tool...... 32 G. Grantor Retained Annuity Trusts (“GRATS”) and Grantor Retained Unitrusts (“GRUTS”)...... 33 1. Description of GRATS and GRUTS...... 33 2. Techniques as Preservation Planning Tools...... 33 H. Qualified Plans...... 34 I. Disclaimers...... 34 1. State Law...... 34 2. Federal Bankruptcy...... 34 J. Family Limited Partnership...... 34 K. Domestic Assets Protection Trusts...... 35 1. Background: From Off Shore to Domestic Asset Protection Trusts...... 35 2. U.S. Response to Off Shore Asset Protection Trusts...... 35 3. Characteristics of an Asset Protection Trust...... 35 4. Other Important Statutory Provisions...... 36 5. Do They Really Work? ...... 36 6. Other Client Concerns...... 37 7. Practice Pointers ...... 39 8. Coordination With Grantor Trust Rules...... 40 9. Conclusion...... 40

VII. INTRODUCING THE JONES FAMILY...... 40 A. Example C The Jones Family...... 40 1. Basic Facts...... 40 2. No Interest in Estate Planning...... 40 3. Eighteen Years Later – Personal Bankruptcy...... 40 B. Could John and Jane Have Averted Financial Disaster? ...... 41 1. As Yogi Berra Might Have Said Regarding Preservation Planning, “You Need to Do It Before You Need to Do It!” ...... 41 2. Less is More...... 41 C. Recommended Preservation Plan For the Jones Family – Sensible and Conservative Steps to Financial ...... Security...... 41 1. Step 1 – Prepare a Detailed Solvency Balance Sheet...... 41 2. Step 2 – Evaluate and Increase Liability Coverage if Necessary...... 41 3. Step 3 – Do New Wills...... 41 4. Step 4 – Buy Cash Value Life Insurance...... 42 5. Step 5 – Buy Annuities...... 42 6. Step 6 – Establish a Pension and/or Profit Sharing Plan...... 42 7. Step 7 – Pay Off Homestead ...... 42 8. Step 8 – Make Gifts in Trust for Children ...... 42 9. Step 9 – Enter Into an Agreement to Partition Community Property...... 42 10. Step 10 – Form a Family Limited Partnership...... 43 11. Step 11 – Spousal Credit Shelter Trust (& Spousal QTIP Trust)...... 43 12. Step 12 – Do Not Sign Loan Guarantees for Friends, Neighbors, Business Partners, Children and/or Other Relatives Unless You Expect to Repay the Loan Yourself...... 43 13. Step 13 – Do Not Agree to Serve on the Board of any Financial Institution or Corporation Unless You are Adequately Insured to Your Lawyer’s Satisfaction...... 43 14. Step 14 – Urge Estate Planning for Parents and Other Relatives From Whom You Expect to Inherit. 43 15. Comparison...... 44

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D. What’s Left After Bankruptcy Under the Recommended Planning For the Jones Family...... 44

VIII. CONCLUSION...... 45

EXHIBIT “A” ...... 47

EXHIBIT “B” ...... 48

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CONSERVATIVE ASSET benefit and enjoyment of their wealth, free from the claims of contingent, unknown, unforeseeable and often PROTECTION PLANNING overzealous creditors. Traditional estate planning (e.g., properly drafted wills, gift trusts, life insurance trusts) I. INTRODUCTION seemed to take a back seat to those techniques and The principal purpose of this outline is to examine arrangements thought to make a client “bulletproof.” the asset protection benefits of traditional and cutting The off shore trust played (and continues to play) a edge estate planning and preservation techniques major role in asset protection planning. Under this available in the United States, with an eye towards arrangement, a wealthy client, with the advice and conservative asset protection planning. consent of a professional advisor, transfers assets to an irrevocable and unamendable “spendthrift trust” with a II. BASIC CONSIDERATIONS. situs in a foreign jurisdiction (e.g., the Cook Islands) A. Typical Reasons for Estate Planning. whose laws will not give full faith and credit to U.S. judgments. An off shore trust thus can pose a virtually 1. To provide for family. insurmountable obstacle for the creditor seeking to 2. To save taxes. recover against the settlor of such trust. But, that obstacle 3. To provide sound asset management for is not insurmountable, because when the stakes are high, children. creditors can be equally creative in their attempts to 4. To assure the continuity of a family recover assets. When unusual or complicated “asset business. protection techniques” are discovered, creditors often 5. To provide for retirement. increase their resolve to recover from the debtor. Bankruptcy Courts can get quite angry at off shore B. Another Important Reason in These Litigious arrangements, prompting those courts to take out their TimesBTo Protect Assets from Contingent, wrath on such debtors. Furthermore, various laws have Unknown, and Often Overzealous Juries and been passed providing certain types of creditors (e.g., the Judgement Creditors. FDIC) with special powers that make life very difficult for debtors. Subjected to these attacks, the client may be 1. Litigious Society. For the past two decades our left asking the question “Was it all worth it?” society has become increasingly litigious. Lawsuits One is left wondering whether the client could have against lawyers, doctors, engineers, architects, and effectively insulated his assets for himself and his family officers and directors of corporations and financial by limiting his estate planning arrangements to institutions have become commonplace C so have large traditional and cutting edge techniques available in the (and often huge) judgments. United States. The answer to this question is “yes” and a careful review of this outline will support such a 2. Economic Decline. In the mid-1980's, our economy conclusion. This outline will also address certain drafting began a steady decline culminating in a recession. This implications of asset protection planning. decline fostered more litigation. As a result several large financial institutions disappeared; the real estate industry C. Scope of Outline. This outline will proceed as suffered greatly; once powerful and wealthy families lost follows: their wealth and influence; and law firm bankruptcy practices flourished. The recession and the steep decline 1. Debtor and Creditor Rights and Marital in consumer and investment confidence will likely foster Property Liability Rules. First, we will examine new and more intense rounds of litigation. relevant debtor and creditor rights and marital property liability rules that may apply if a financially secure estate 3. Increased Emphasis on Asset Protection. Because planning client should experience unexpected and serious of the economic problems of the mid-80's and the financial reversals. However, examining the laws in all economic slump in 2000, clients and their financial and fifty states is beyond the scope of this outline. legal advisors began focusing on techniques and Accordingly, except with respect to the discussion of arrangements designed to insulate a client’s assets from domestic asset protection trusts later in this outline, the unexpected financial reversals. The centerpiece of the authors will generally limit their analysis to the Uniform planning was often the all-encompassing family limited Fraudulent Transfer Act, the Federal Bankruptcy Code, partnership or off shore asset protection trust (and and the laws of California, Colorado, Indiana, New York, sometimes both). Entire estate plans were built around and Texas. For purposes of this outline, those states shall these techniques in the hopes of allowing wealthy clients sometimes be referred to herein as the “Focus States.” to attain the previously unattainable C the full use,

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With regard to Federal bankruptcy, careful attention will more corporations or financial institutions, or (4) wealthy be given to certain “estate planning related” provisions of or successful business persons. the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”). III. STATE LAW RULES C DEBTOR AND CREDITOR RIGHTS, MARITAL PROPERTY 2. Estate Planning Techniques (including Domestic LIABILITY, AND EXEMPTIONS. Asset Protection Trusts). Second, we will (a) briefly An estate planning lawyer should have at least a examine various estate planning techniques used by fundamental knowledge of debtor and creditor rights serious estate planning practitioners, (b) analyze how under state and federal law and must have a thorough utilization of those techniques can protect a client’s knowledge of the marital property liability rules of his assets from unexpected financial reversals, and (c) particular state. Many jurisdictions, including Texas, examine certain drafting considerations of interest to the have adopted a variation of the Uniform Fraudulent estate planner. Transfer Act [hereinafter “UFTA”]. The following is a brief discussion of the debtor and creditor rights under 3. Introduction of the Jones Family. Third, we will the UFTA and the fraudulent transfer/conveyance introduce the Jones family via a hypothetical, but statutes of the Focus States, marital property liability hopefully realistic, case study. rules of the Focus States, and exemptions of the focus states. 4. Designing a Plan for the Jones Family. Finally, we will design and analyze a sophisticated estate plan for A. A Little Context – U.S. v. Townley. This case the Jones family that minimizes transfer taxes, provides involves the foreclosure of an IRS tax lien against asset management, and, as an added benefit, insulates property held in an irrevocable trust created by a tax assets from financial reversals. protester (which may explain, at least in part, the holdings in this case). D. Definitions and Assumptions. The following definitions and assumptions will be used throughout 1. Facts. In 1995, the Townleys transferred their this outline: home and some investment property to the Beaver Trust” in 1995. Although there was an independent third party 1. Preservation Planning. All references in this trustee, Mr. Townley remained the trust manager. He outline to the term “preservation planning” shall mean lived in the home rent free and had virtually no assets estate planning where insulation of a client’s assets from remaining after the transfers to the trust. He further the claims of potential creditors is one of the client’s admitted (evidently numerous times) that the trust was objectives. This outline will focus only on estate created to protect against future creditors even though planning techniques available within the United States. none existed at the time and none were reasonably We will not discuss or analyze off shore trusts. It is foreseeable. (Unless, of course, you count the IRS with noteworthy that over the past two decades, preservation respect to future taxes.) The Townleys filed for planning has received increased attention and acceptance bankruptcy after the IRS asserted its lien, and claimed from the estate planning bar. that the assets in the irrevocable trust were exempt from claims of creditors. 2. Assumptions: No Actual or Constructive Fraudulent Intent. Unless otherwise noted, for all 2. Opinion. The lower court relied primarily on two purposes of this outline, it will be assumed that the client factors in deciding to find a fraudulent transfer and set is solvent immediately before and after any estate aside the trust – the badges of fraud (discussed below) planning technique is implemented, and that no transfer and the admissions that the trust was established to avoid described in this outline was made with an actual or future creditors. constructive intent to hinder, delay or defraud creditors. a. Badges of Fraud. The badges of fraud relied upon E. What Clients Will Benefit From the Lessons of to set aside the trust were (i) retention of control over the This Outline? Many clients should benefit from the trust, (ii) the failure to respect the separate nature of the lessons learned from this outline. These would include a trust, (iii) the use of trust assets for personal use, and (iv) professional concerned about malpractice or negligence the fact that they had virtually no assets left after the exposure, (e.g., doctors, lawyers, dentist, accountants, transfers. Note the similarity to the factors applied by the engineers, architects, life insurance underwriters, etc.), Tax Court in FLP cases because this may become (2) investment advisors and/or securities analysts (3) important in analyzing whether a FLP is a device similar individuals who sit on the board of directors of one or 2

Conservative Asset Protection Planning Chapter 11 to a self settled trust under bankruptcy Code §548(e), 2. Transfer with Actual Intent to Defraud Is Void. discussed in detail in Section IV.J., below. Section 4 of the UFTA provides that a transfer made . . . by a debtor is fraudulent as to a creditor, whether the b. Transfer with Intent to Defraud. Washington creditor’s claim arose within a reasonable time before or adopted the Uniform Fraudulent Transfer Act without after the transfer was made . . . , if the debtor made the changes to the definition of fraudulent transfer as transfer with an actual intent to hinder, delay, or defraud discussed in B.2., below. any creditor of the debtor . . . . The same rule applies in The Townleys’ repeated admissions that they Texas and other Focus States. (TBCC ' 24.005(a)(1); transferred property to the Trust in order to avoid future Cal. Civ. Code ' 3439.04(a); C.R.S. ' 38-8-105(1)(a); potential creditors provide direct evidence of fraud. (9th Ind. Code Ann. ' 32-18-2-14(1); NYD&C Law ' 276). Cir. Slip copy, emphasis added.) 3. What Is “Actual” Fraudulent Intent? Certainly 3. Impact of this Case. From a precedential actual intent to defraud could void a conveyance even if standpoint, this case has relatively little value. Both the the debtor is solvent after the transfer. (see TBCC ' lower court opinion and the appellate opinion are 24.005(a)(1); McWhorter v. Langley, 220 S.W. 364 unpublished and thus, under 9th Circuit rules cannot be (Tex. Civ. App. C San Antonio 1920, no writ); Arnold v. cited. But as a window into possible future judicial Peoples, 34 S.W. 755 (Tex. Civ. App. 1896, no writ); see reasoning, how does it foreshadow a court’s approach to also In re Liquimatic Systems, Inc., 194 F. Supp. 625 admitted asset protection planning or transactions for (S.D. Cal. 1961); Freeman v. La Morte, 307 P.2d 734 which there is really no other plausible explanation? (Cal. Ct. App. 1957); Millard v. Epsteen, 137 P.2d 717 (Cal. Ct. App. 1943)). However, since actual intent is B. UFTA and Fraudulent Transfer/Conveyance difficult to prove, courts recognize that circumstantial Rules of Focus States. evidence or “badges of fraud” can be used to prove 1. What is a “Transfer”? The definition of “transfer” “intent to delay, hinder or defraud” a creditor within the under the fraudulent transfer/conveyance statutes is meaning of the relevant statute. Although no single important since other sections of such statutes (described factor may be sufficient to constitute fraud, if several of below) require a transfer or conveyance of property as a the badges are present in a particular transaction, a court precondition to actionable conduct. In all cases the will likely reach the conclusion that the transaction was definition of “transfer” is very broad. Thus, UFTA undertaken with a fraudulent intent. (See, e.g., §1(12) defines “transfer” as “every mode, direct or Telephone Equipment Network, Inc. v. TA/Westchase indirect, absolute or conditional, voluntary or Place, Ltd., ___ S.W. 3d ___, 2002 Tex. App. LEXIS involuntary, of disposing of or parting with an asset or an 2104 (Tex. App.-- Houston 1st Dist. March 21, 2002, no interest in an asset, and includes payment of money, writ hist.); Blackthorne v. Bellush, 61 S.W. 3d 439 (Tex. release, lease, and creation of a lien or other App.BSan Antonio 2001, no writ); Reynolds v. encumbrance.” Weinman, 40 S.W. 560 (Tex. Civ. App. 1897, writ The same definition is used under the Texas ref’d); Rives v. Stephens, 28 S.W. 707 (Tex. Civ. App. Uniform Fraudulent Transfer Act (TEX. BUS. & COM. 1894, writ ref’d); United States v. Leggett, 292 F.2d 423 CODE ANN. ' 24.002(12) (Vernon 1987) [hereinafter (6th Cir.), cert. denied, 368 U.S. 914 (1961); Jackson v. cited as “TBCC”]) and the Uniform Fraudulent Transfer Farmers State Bank, 481 N.E. 2d 395 (Ind. Ct. App. Acts of California, Colorado, and Indiana. New York 1985)). defines a “conveyance” to include “every payment of money, assignment, release, transfer, lease, mortgage or 4. Important Badges of Fraud. The badges of fraud pledge of tangible or intangible property, and also the most relevant to estate or preservation planning include: creation of any lien or incumbrance”. (N.Y. DEBT. & CRED. LAW ' 270 (Consol. 2002) [hereinafter cited as a. Insolvency. Insolvency of the debtor at the time of “NYC&D Law”]). or immediately after the conveyance. UFTA ' 4(b)(9); The above provisions, and the fraudulent TBCC ' 24.005(b)(9). conveyance statutes of the Focus States, include, expressly or by interpretation, both gratuitous transfers b. Secrecy. Undue secrecy surrounding the and transfers for consideration. (See, e.g., TBCC ' conveyance, such as the failure to record a deed or other 24.005(a); Cal. Civ. Code ' 3439.04; C.R.S. ' 38-8- document of transfer. UFTA ' 4(b)(3); TBCC ' 105(1); Ind. Code Ann. ' 32-18-2-14; and NYD&C Law 24.005(b)(3). ' 276).

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Conservative Asset Protection Planning Chapter 11 c. Transfer of All Property. Transfer of all of a (Tex. 1899) (Burden of proof lies with the donee to show debtor’s property. UFTA ' 4(b)(5); TBCC ' that when gift was made, the donor-spouse had enough 24.005(b)(5). property remaining to pay off the donor’s debts). d. Transfer to Closely Related Party. A transfer of 6. Statute of Limitations for “Actual Intent” property to a transferee who is closely related to the Actions. Statute of limitation provisions vary by state debtor-transferor. UFTA ' 4(b)(1); TBCC ' and the lawyer engaged in preservation planning should 24.001(b)(1). be aware of the relevant limitations period governing in his or her state. The Texas statute is typical. A e. Pending Litigation. Pending or threatened fraudulent transfer action under TBCC ' 24.005(a)(1) litigation against the debtor. UFTA ' 4(b)(4); TBCC (actual intent) must generally be brought within four ' 24.005(b)(4). years after the fraudulent transfer was made, or, if later, within one year after the fraudulent transfer was, or f. Deviation from Normal Formalities. Entering into reasonably could have been, discovered; and a fraudulent a transaction (e.g., gift, creation of trust, partition transfer action under TBCC Section 24.006(a) agreement, etc.) without following usual formalities. R. (constructive fraud) must generally be brought within four G. Blossman & Co. v. Friske, 76 S.W. 73 (Tex. Civ. years after the transfer. TBCC ' 24.010. This same App. 1903, no writ); United States v. Leggett, 292 F.2d limitations period applies in California, Colorado, and 423 (6th Cir.), cert. denied, 368 U.S. 914 (1961). Indiana. (See Cal. Civ. Code ' 3439.09(a) and (b), C.R.S. ' 38-8-110(1)(a) and (b), and Ind. Code Ann. ' 32-18-2- g. Secret Reservation of An Interest. The debtor’s 19(1) and (2)). secret reservation of an interest or enjoyment from the transferred property. UFTA ' 4(b)(2); TBCC ' 7. Transfer Fraudulent if Debtor Insolvent. UFTA 24.005(b)(2). ' 5(a) provides that a transfer by a debtor who is insolvent or will be rendered insolvent by the transfer is h. Continued Enjoyment of Property. Continued fraudulent as to preexisting creditors unless the transfer is possession and use of the property by the debtor- made for fair consideration. The Texas Uniform transferor. UFTA ' 4(b)(2); TBCC 5 24.005(b)(2). Fraudulent Transfer Act and the laws of the Focus States follow the same rule. (See TBCC ' 24.006(a); Cal. Civ. i. Transfer Shortly Before or After Debt Incurred. Code ' 3439.05; C.R.S. ' 38-8-106(1); Ind. Code Ann. The debtor transferred assets shortly before or after a 32-18-2-15; NYD&C Law ' 273). Thus, these substantial debt was incurred. UFTA ' 4(b)(10); TBCC provisions codify what appears to be the longstanding ' 24.005(b)(10). willingness of courts to insulate gifts from the existing creditors of the donor so long as, at the time of the gift 5. Insolvency Crucial Factor. Although there are and immediately after the gift, the donor has sufficient many “badges of fraud”, courts have earmarked the nonexempt assets to pay his or her debts. See, e.g., Pope debtor’s insolvency at and immediately after the Photo Records, Inc. v. Malone, 539 S.W. 2d 224 (Tex. conveyance as a crucial and often determinative badge of Civ. App. C Amarillo 1976, no writ); Terry v. 0' Neal, 9 fraud. Accordingly, a conveyance will not usually be S.W. 673, 71 Tex. 592 (1888) (Husband gave land to his held to be fraudulent as to existing creditors if the debtor- wife and children. At the time of the gift, husband was transferor has retained sufficient assets subject to indebted but owned sufficient nonexempt assets to pay execution to satisfy the claims of those creditors, his debts. Held: conveyance of property to one’s spouse assuming of course that there is no direct evidence of an when one has sufficient property after the conveyance to actual intent to hinder, delay or defraud such creditors. pay existing debts is valid.). (See, e.g., Mitchell v. Porter, 349 S.W. 2d 785 (Tex. Civ. It should also be noted that intent to hinder, defraud App. C Houston 1961, writ ref’d n.r.e.)). Courts have or delay is not a prerequisite to bringing an action under also held that a transfer without adequate consideration UFTA ' 5(a), under TBCC ' 24.006(a) or under the (such as a gift) gives rise to a presumption of fraud if the fraudulent transfer/conveyance statutes of the remaining donor is insolvent at the time of the conveyance or is Focus States. (See Cal. Civ. Code ' 3439.05; C.R.S. rendered insolvent as a result of the conveyance. '38-8 -106(1); Ind. Code Ann. ' 32-18-2-15; NYD&C Therefore, it is incumbent upon the donee to show that at Law ' 273). the time of the gift, the donor had sufficient nonexempt property subject to execution to pay the donor-debtor’s 8. Other Actionable Transfers. State fraudulent debts. See, e.g., Maddox v. Summerlin, 49 S.W. 1033 conveyance statutes may also include other types of transfers that may be considered fraudulent. Section 4

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4(a)(2)(i) of the UFTA treats conveyances made without a manner making the transfer voidable. UFTA ' 2(d). fair consideration by a person engaged or about to The same engage in business as fraudulent if the capital remaining rules apply in Texas and most of the Focus States. after the conveyance is unreasonably small. The intent of TBCC ' 24.003(d); Cal. Civ. Code ' 3439.02(d); C.R.S. the person is not considered. The same rule applies in ' 38-8-103(4); Ind. Code Ann. ' 32-18-2-12(a)(1) and Texas and most of the Focus States. (See TBCC (2). New York follows the same rule by implication ' 24.005(a)(2)(A); Cal. Civ. Code ' 3439.04(b)(1); since assets are valued at the “fair salable value.” C.R.S. ' 38-8-105(1)(b)(I); Ind. Code Ann. ' 32-18-2- NYD&C Law ' 271. The UFTA and the statutes of the 14(2)(A); see also NYD&C Law ' 274. Section Focus States provide that in determining insolvency, 4(a)(2)(ii) of the UFTA provides that every conveyance assets exempt from attachment by applicable made and every obligation incurred without fair nonbankruptcy laws shall not be considered. UFTA ' consideration is fraudulent if the person intends to or 1(2); TBCC ' 24.002(2)(B); Cal. Civ. Code believes he will incur debts beyond his ability to pay as ' 3439.01(a)(2); C.R.S. ' 38-8-102(2)(b); Ind. Code they mature. Texas and most of the Focus States have Ann. ' 32-18-2-2(b)(2); NYD&C Law ' 270. the same rule. TBCC ' 24.005(a)(2)(B); Cal. Civ. Code ' ii. Fair Market Value or Forced Sales Value? 3439.04(b)(2); C.R.S. ' 38-8-105(1)(b)(II); Ind. Code In evaluating a person’s solvency, a key question is Ann. ' 32-18-2-14(2)(B). whether to value the person’s assets at fair market value or liquidation value. The Texas statute values assets at 9. Meaning of Insolvency. The insolvency of the their fair valuation. TBCC ' 24.003(a). The same “fair debtor-transferor at or immediately after the transfer is value” test is used in California, Colorado, and Indiana. often a crucial inquiry in avoiding the reach of fraudulent See Cal. Civ. Code ' 3439.02(a); C.R.S. ' 38-8-103(1); conveyance statutes because it is an important (if not and Ind. Code Ann. ' 32-18-2-12(c). New York follows determinative) badge of fraud. In some circumstances, the “fair salable value” test. NYD&C Law ' 270. the donee of a gift, as a result of a fraudulent conveyance action by the donor’s creditors, may be forced to prove iii. What Debts are Considered. The value of all that the donor was solvent at the time of and immediately “debts” is considered including the value of contingent after the gift. Accordingly, it is important for estate liabilities as discussed infra. planners to understand how local law determines when an individual is insolvent. iv. How to Account for Contingent Liabilities. In determining whether a debtor is solvent, every debt or a. Balance Sheet Test vs. Ability to Pay? UFTA enforceable claim against the debtor must be considered, §2(a) provides that a person is insolvent when, at the including accounting for the debtor’s contingent time of transfer, the sum of the debtor’s debts is greater liabilities. However, valuation of a contingent liability than the fair value of all the debtor’s assets. However, may be difficult and should take into account such under UFTA §2(b), insolvency is presumed if the debtor factors as serious disputes over validity, the likelihood it is generally not paying his debts as they become due. will mature into present debt, set-off or contribution Texas and the laws of the remaining Focus States provide rights, and availability of defenses to the claim. These similar rules. (See, e.g., TBCC ' 24.003 (a) and (b); Cal. (and other) factors could result in discount from stated Civ. Code ' 3439.02 (a) and (c); C.R.S. ' 38-8-103(1) value. and (2); Ind. Code Ann. ' 32-18-2-12(c) and (d); and NYD&C Law ' 271 (“A person is insolvent when the C. Marital Property Liability Rules. present fair salable value of his assets is less than the 1. Relevant Marital Property Concepts. amount that will be required to pay his probable liability a. Separate Property. In Texas and California, both on his existing debts as they become absolute and community property states, a spouse’s separate property matured.”)). includes, in pertinent part, property owned or claimed by that spouse before marriage and property acquired by that b. How Assets Are Valued in Determining spouse during the marriage by gift, devise, or descent. In Insolvency. both Texas and California, property directly traceable to i. What Assets are Considered? In determining separate property is also separate property. whether an individual is insolvent under the UFTA, the Colorado, Indiana, and New York, so-called debtor shall not include property that has been common law states, likewise expressly or by implication transferred, concealed, or removed with intent to hinder, classify a married spouse’s property as his or her separate delay, or defraud creditors or that has been transferred in property if such property was acquired by that spouse before marriage or during marriage (1) by gift, devise, or 5

Conservative Asset Protection Planning Chapter 11 descent, (2) in exchange for separate property, or (3) by 3.102(a). When Texas spouses combine and commingle agreement of the spouses. their In Texas and in most of the Focus States, property respective sole management community property, that received by a spouse during the marriage by virtue of a property becomes joint management community valid partition or exchange with the other spouse is property. Tex. Fam. Code '3.102. likewise separate property. In California, either spouse generally has the management and control of community personal property b. Community Property. Community property with the absolute power of disposition (other than generally includes property acquired during marriage by testamentary dispositions). Cal. Fam. Code ' 1100(a). residents of community property states other than by gift, However, a spouse may not make gifts [or transfers for inheritance or devise. In Texas, community property is less than fair and adequate consideration] to a third party negatively defined as all property acquired by either without the other spouse’s written consent. Cal. Fam. spouse during the marriage that is not separate property. Code ' 1100(b). Furthermore, in California, either Tex. Fam. Code ' 3.002. Separate property is generally spouse may manage and control community real property defined to include all property on hand at the time of the without the consent of the other spouse, but as to that real marriage, and all property acquired thereafter by gift, property, both spouses must agree to any sale, inheritance, devise or by partition between the spouses of conveyance community property. Tex. Fam. Code ' 3.001. In or encumbrance of such property or in any lease for California, community property includes all property longer than one year. Cal. Fam. Code ' 1102. acquired by either spouse during the marriage except as otherwise provided by statute. Cal. Fam. Code ' 760. In 2. Relevant Rules of Marital Property Liability. California, rents and income from separate property are a. General Rules in Noncommunity Property States. also separate property. Cal. Fam. Code ' 770. However, Absent an agreement or contract to the contrary, a Texas treats such rent and income as community property spouse’s separate property is generally not liable for the unless the contrary is provided by agreement. Tex. Fam. debts and obligations of the other spouse. De Votie v. Code ' 3.002 (The statute defines “community property” McGerr, 15 Colo. 467, 24 p. 923 (1890). as property acquired by either spouse during the marriage, other than “separate property.” Further, the b. General Rules in California and Texas. In Texas, term “separate property” is not defined, under Tex. Fam. a spouse’s creditor can reach the separate property of the Code ' 3.001, to include rent and income from separate debtor-spouse, both halves of the sole management property.) community property of the debtor-spouse, and both Presumptions generally play a key role in halves of all joint management community property. determining the characterization of property as Tex. Fam. Code ' 3.202. In Texas, if the liability arises community or separate. In Texas, property possessed by because of the debtor’s tort, all community property will either spouse during or on the dissolution of a marriage is be liable for the debt. Tex. Fam. Code ' 3.202(d). presumed to be community property unless proven to the In California, jointly managed community property contrary by clear and convincing evidence. Tex. Fam. may be seized by creditors to the same extent as Code ' 3.003. The same presumption exists in California community property managed by the debtor-spouse. through the interpretation of Section 760 of the Thus, because both spouses have equal management over California Family Code. community property in California, a creditor of either Notwithstanding the separate characterization of spouse may reach all of the community property and the property, if such separate property becomes so separate property of the spouse who incurred the commingled with the community property of the spouses obligation. Cal. Fam. Code ' 910(a). However, if the so as to defy tracing and proper classification, all such spouse incurs the obligation during a period of separation commingled property will become community property. prior to divorce, the assets of the other spouse (including See, e.g., Tarver v. Tarver, 354 S.W.2d 780 (Tex. 1965); community property) shall not be subject to that debt. Fountain v. Maxim, 210 Cal. 48, 290 P. 576 (1930). Cal. Fam. Code ' 910(b). In Texas, each spouse has the sole management, control, and disposition rights of the community property c. Distinction Between Community Debt and Joint that he or she would have owned if single, including, but Liability. not limited to, that spouse’s personal earnings, revenue i. General C Presumption of Community Debt from separate property, recoveries from personal injuries, C Community Property States. In Texas, debts and any increases and mutations of, and the revenue incurred by either spouse (hereinafter sometimes referred from, all property subject to the spouse’s sole to as the “contracting spouse” ) during marriage are management, control, and disposition. Tex. Fam. Code ' presumed to be community debts, unless evidence can be 6

Conservative Asset Protection Planning Chapter 11 shown of no community benefit or that the creditor a family as a homestead (100 acres for a single, adult agreed to look solely to the separate estate of the person) and if the contracting spouse for satisfaction of the debt. See, e.g., Cockerham land is not part of a city or municipality. Tex. Prop. v. Cockerham, 527 S.W. 2d 162, 171 (Tex. 1975). The Code ' 41.002(b). same rule applies in California. Cal. Fam. Code ' 910. b. Urban Homestead. The urban homestead exempts ii. Community Debt May Not Give Rise to up to ten acres of land, together with all improvements Joint Liability. In Texas and California, the separate thereon, if the land is used or intended to be used as a property of the noncontracting spouse will not be subject homestead by the family or a single, adult person. Texas to a community debt unless the noncontracting spouse is Constitution Art. XVI, ' 51; see also Tex. Prop. Code ' jointly liable on the debt. The fact that a debt is a 41.002(a). community obligation does not, without more, mean that the spouses are jointly liable on the debt. See, e.g., c. Business Homestead. The business homestead Cockerham v. Cockerham, 527 S.W. 2d 162, 171 (Tex. exempts land situated at a single location in the same 1975); Cal. Fam. Code ' 913(b)(1). Whether a urban area as the urban homestead (so long as that land is noncontracting spouse is jointly liable with the used for a family business). Tex. Prop. Code ' contracting spouse on a community debt depends upon 41.002(a). It is clear the same family or single, adult the facts and circumstances of each case, and more individual can have a business homestead and an urban particularly whether the noncontracting spouse expressly homestead so or impliedly agreed to be liable. Cockerham v. long as the total amount of land involved does not exceed Cockerham, 527 S.W. 2d 162 (Tex. 1975). ten acres. Indiana’s homestead exemption is $7,500 in value. iii. Conclusion. In the context of creditor rights, it Ind. Code Ann. ' 34-55-10-2. In California, the is often crucial to determine if a community obligation exemption can be as low as $50,000.00 or as high as gives rise to the joint liability of the spouses. If a $125,000.00 (e.g., if the debtor is 65 or older). CAL. noncontracting spouse is found to be jointly liable on the CIV. PROC. CODE ' 704.730 (Deering 2002) community indebtedness, all of his or her nonexempt [hereinafter cited as “Cal. Civ. Proc.”]; Cal. Civ. Proc. ' property (whether separate or community) is subject to 704.730(a)(3). In Colorado and New York, the execution in repayment of that debt in the event of exemption is $45,000.00 and $10,000.00, respectively. default. On the other hand, if a community obligation C.R.S. ' 38-41-201; N.Y. C.P.L.R. ' 5206(a) (Consol. does not give rise to joint spousal liability, the 2002) [hereinafter cited as “NY CPLR”]. The estate noncontracting spouse may be afforded a degree of planner should consult his or her state’s homestead creditor protection in that his or her separate property exemption statute to determine the size of the exemption. may be exempt from execution. 2. Scope of Liability for Owner Occupant’s Debts. D. Homestead Exemptions. A homestead is not exempted from all types of creditor 1. General. Homestead laws may offer a client claims. The homestead is generally liable for: considerable protection from the claims of creditors. However, this insulation is often obtained at the expense a. Purchase Money Debts. Purchase money debts of lost liquidity. (i.e., one has to pay back the loan used to Although traditional estate planning does not acquire the homestead). See, e.g., Tex. Prop. typically include a lawyer’s recommendation to pay off a Code ' 41.001(b)(1); NY CPLR Law homestead (rural, urban or business), the estate planner ' 5206(a). would be remiss in not pointing out to the client the b. Home Improvements. Improvement liens if scope of the applicable homestead exemption, especially contracted for in writing and acknowledged by in those states where the exemption is substantial. both spouses. See, e.g., Tex. Prop. Code ' Homestead exemptions vary from state to state. For 41.001(b)(3). example, in Texas, there are three types of homesteads, c. Property Taxes. Ad valorem taxes against the the rural homestead, urban homestead and business homestead. See, e.g., Tex. Prop. Code ' homestead, respectively. Tex. Prop. Code ' 41.002. 41.001(b)(2). d. Federal Tax Liabilities. Federal tax liabilities. a. Rural Homestead. The rural homestead exempts See e.g. United States v. Rogers, 461 U.S. 677 from most creditors 200 acres of land (with (1983). improvements thereon) if used or intended to be used by 7

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3. Who is Protected? The owner of the homestead during times of financial difficulties. See, e.g., In Re receives full protection for the homestead in accordance Carey, 938 F. 2d 1073 (10th Cir. 1991); In Re Bowyer, with the foregoing if the residence is occupied as a 932 F.2d 1100 (5th Cir. 1991); but see, In re Reed, 700 homestead. At the homeowner’s death, if he is survived F.2d 986 (5th Cir. 1983) (“eve of bankruptcy” discharge by a spouse, minor children, or an adult unmarried child of homestead debt prevented debtor’s discharge); In re remaining with the decedent’s family, those individuals Sayler, 98 B.R. 536 (U.S. Dist. Kan. 1987) (use of are generally entitled to the homestead exemption. Texas nonexempt assets to, among other things, retire mortgage Constitution Art. XVI, ' 52 (spouse and minor children on homestead is fraudulent conveyance); Michelson v. receive benefit of exemption); C.R.S. ' 38-41-204 Anderson, 31 B.R. 635, 638 (Bankr. D. Minn. 1982) (surviving spouse and minor children are entitled to (conversion of nonexempt assets into cash which was exemption at debtor’s death); NY CPLR Law ' 5206(b) used to pay off mortgage on homestead was fraudulent). (surviving spouse and minor children receive the benefit However, the lawyer should be very careful about of the exemption). However, if none of those individuals recommending such transfers when the client is insolvent survives the decedent, the homestead is subject to all or is close to insolvency. While the client may be creditor claims of the decedent’s estate. See, e.g., Givens protected, the lawyer may not be! v. Hudson, 64 Tex. 471 (1885); C.R.S. ' 38-41-204; NY CPLR Law ' 5206(b). CAVEAT: If the client may need to file bankruptcy, the limitations imposed by BAPCPA (discussed at IV.F., 4. How Strong is the Exemption? Homestead rules infra, must be carefully considered. are liberally and generously construed. Tolman v. Overstreet, 590 S.W. 2d 635 (Tex. Civ. App. C Tyler b. Combining a Homestead with a Qualified 1979, no writ); Haas v. DeLaney, 165 F. Supp. 488 (D. Personal Residence Trust. The client might consider Colo. 1958). This liberal construction has in some transferring the homestead to a 10-15 year qualified instances been applied to tolerate near fraudulent personal residence trust (“QPRT”). By analogy to a life transfers. See, e.g., Bell v. Beazley, 45 S.W. 401 (Tex. estate, an individual who retains a term interest in the Civ. App. 1898, no writ) (The court stated, “The fact that homestead (and occupies same as such) may be entitled one in failing circumstances, or practically insolvent, to the homestead exemption. Shaw v. Head, 55 S.W. 2d disposes of all his available assets in exchange for a 190 (Tex. Civ. App. C Waco 1932, no writ); Chestnut v. homestead, is not, in law, considered a fraud upon Specht, 272 S.W. 830 (Tex. Civ. App. C San Antonio creditors. . . . The insolvent debtor has the right to 1925, no writ). This would combine the exemption devote what property he may own and possess to the benefits of the homestead with the estate planning acquisition of a homestead.”) and Garrard v. Henderson, potential of the QPRT. 209 S.W. 2d 225 (Tex. Civ. App. C Dallas 1948, no writ) (where Chief Justice Bond noted, “The policy of courts is 6. Drafting PointerBHomestead Designation. Some to uphold and enforce the homestead laws states permit and individual to voluntarily designate notwithstanding the fact that in so doing they sometimes certain property as his homestead. This may be directly assist a dishonest debtor in wrongfully defeating particularly important in those states with very generous his creditors.”). homestead exemptions. For example, Section 41.005 of But there are limits as indicated in Matter of Reed, the Texas Property Code, a person can designate certain 700 F. 2d 986 (5th Cir. 1983). In Reed the debtor property as his homestead by a voluntary designation converted in excess of $50,000.00 of cash and property signed by the person and filed of record in the county to a homestead exemption two weeks before filing for where the property is located. However, care must be bankruptcy. Under the egregious facts (which included a taken that the property described on recorded declaration clear manifestation of actual fraudulent intent), the court is the same property claimed as a homestead for ad refused to grant a bankruptcy discharge but nonetheless valorem tax purposes; otherwise, the filed declaration allowed the exemption to stand. will abrogate the hoped for tax break. Tex. Prop. Code ' 41.005(c). An example of a declaration that complies 5. Preservation Planning Potential. with Texas law is attached at Annex D. a. Paying Off Homestead. If a state has a liberal homestead exemption, advising a client to pay off his or 7. Beware Revocable Management Trusts. In many her homestead could insulate a substantial asset from the jurisdictions and many situations, revocable management reach of creditors. Moreover, if a client is circumspect trusts are used as the principal dispositive device, and the about when he pays off the home (i.e., if he avoids “eve homestead is often placed into such trust. However, the of bankruptcy” and outwardly fraudulent behavior), he cost of doing this may be a loss of the homestead may be able to take advantage of this exemption even exemption under state law. The loss of exemption is 8

Conservative Asset Protection Planning Chapter 11 dependent upon state law and will vary from state to ' 13-54-102; Ind. Code Ann. ' 34-55-10-2; NY CPLR ' state. For example, a Connecticut case held that state law 5205(a). required that the residence be “owner-occupied” and that the equitable interest of the trustor was not sufficient to 3. Designation of Exempt Assets. The individual qualify as a homestead. In re Estrellas, 338 B.R. 538 debtor may be permitted to select which assets will be (Bankr. D. Conn. 2006). See also In re Bosonetto, 271 treated as exempt for purposes of the personal property B.R. 403 (Bankr. M.D. Fla. 2001), denying the exemption statutes. See, e.g., Tex. Prop. Code ' 42.003; homestead exemption on a horrible set of facts. The Cal. Civ. Proc. ' 703.520; C.R.S. ' 13-55-101. Bankruptcy Appeals Panel for the 10th Circuit, interpreting Kansas law, found that an equitable interest F. Life Insurance Exemption in the settlor was enough interest to support the 1. Are Proceeds (and other benefits) Insulated from homestead exemption claim in the face of language the Claims of the Insured’s and/or Beneficiary’s similar to that in the Connecticut statute. In re Kester, Creditors? Life insurance proceeds payable to a named 339 B.R. 749 (B.A.P. 10th Cir. 2006). Likewise, Florida beneficiary also may receive some special creditor law would seem to provide that an equitable interest will protection. See, e.g., Tex. Ins. Code Art. 1108.051 support a claim of homestead exemption. In re (unlimited exemption if proceeds paid to a designated Buonopane, 344 B.R. 675 (Bankr. M.D. Fla. 2006); In re beneficiary); C.R.S. ' 13-54-102(l)(I)(B); Ind. Code Alexander, 346 B.R. 546 (Bankr. M.D. Fla. Tampa Div. Ann. ' 27-1-12-14. But see In Re Mueller, 867 F.2d 568 2006). Extending this doctrine to QPRTs goes into (10th Cir. 1989) (life insurance policies not exempt another whole set of issues. when, in contemplation of bankruptcy and while insolvent, debtor used nonexempt assets to repay E. Personal Property Exemptions. insurance policy loans and prepay insurance policy 1. General. In addition to the homestead exemptions premiums) and In re Sayler, 68 B.R. 111 (Bankr. D. discussed above, certain types of personal property may Kansas 1986). The estate planner should be familiar with be exempt from the claims of creditors. Those the scope of this exemption in his or her state. exemptions may be an additional option for consideration by a client interested in preservation planning. a. Restrictions as to Beneficiary. The life insurance exemption may be limited to proceeds payable to the 2. Types of Protected Assets. Personal property spouse or dependent of the insured, or other specific exemption statutes exempt property by type and amount. beneficiary. See, e.g., Ind. Code Ann. ' 12-1-12-14(e) Generally, the types of assets exempt include personal (spouse, children, dependent relative or creditor). If the effects, family bible, family pictures, musical policy does not designate a beneficiary within the instruments, keepsakes or family heirlooms, household protected class, if the insured changes the beneficiary to a goods, clothing, bedding, furniture, tools and books used person not within such class, or if the relationship in a trade or business, a burial plot, a seat or pew, an between the insured and the beneficiary ceases, the automobile, and livestock and other animals (generally exemption may be lost. setting forth the specific number of each type of animal Texas does not limit the exemption either by amount that may be treated as exempt). See, e.g., Tex. Prop. or identity of a beneficiary. Tex. Ins. Code Art. Code ' 42.002; Colo. Rev. Stat. ' 13-54-102 (1987) Ind. 1108.051. Code Ann. ' 34-2-28-1 (Burns 1986). In Texas, each family is allowed a personal property b. Cash Surrender Values. State statutes may also exemption of $60,000 ($30,000 for a single adult not a specifically exempt cash values from the claims of member of a family) and may exempt assets from a list of creditors. Some courts of certain states have judicially eligible types of personal property up to such limit. Tex. interpreted the applicable statutes to exempt cash values Prop. Code '' 42.001, 42.002. In Texas the personal so as to enforce the purpose of the statute (i.e., to provide property exemption includes unpaid personal service for beneficiaries who are dependent upon the insured for commissions (other than wages), home furnishings, their support and maintenance). See, e.g., In re Bertram, provisions for consumption, farm and ranch vehicles, 59 B.R. 186 (Bankr. N.D. Iowa 1986); Westinghouse wearing apparel, jewelry, firearms, athletic and sporting Credit Corp. v. Crotts, 250 Iowa 1273, 98 N.W. 2d 843 equipment, personal motor vehicles, animals and (1959); but see, In re Tveten, 402 N.W. 2d 551 (Minn. livestock, and cash value of life insurance. In Texas, 1987) (holding that Minnesota life insurance exemption current wages for personal services (other than court statute should be interpreted to exempt an unlimited cash ordered child support) are also exempt. Tex. Prop. Code surrender value, but further holding that such a broad ' 42.001(b)(1). Similar types of exemptions are provided exemption provision was unconstitutional). Texas by the laws of some of the Focus States. See, e.g., C.R.S. 9

Conservative Asset Protection Planning Chapter 11 exempts an unlimited amount of cash values. See, e.g., Inc. v. Malone, 539 S.W. 2d 224, 226 (Tex. Civ. App. C Tex. Ins. Code Art. 1108.051. Amarillo 1976, no writ); Parker Square State Bank v. Huttash, 484 S.W. 2d 429, 432 (Tex. Civ. App. C Ft. c. Power to Change Beneficiary. In Texas and Worth 1972, writ ref’d n. re.). Indiana, a power reserved by the insured to change the beneficiary will not affect the exemption. See, e.g., Tex. ii. Fraud in the Formation of the Insurance Ins. Code Art. 1108.051, Sec. 2(1); Ind. Code Ann. ' 27- Contract. The insurance proceeds will generally be 1-12-14. subject to the claims of the insured’s creditors if the insured committed fraud in the formation of the d. Limits on Dollar Amount. Some states may limit insurance contract and the beneficiary and insurance the dollar amount that will be protected from creditors’ company were actually or constructively aware of such claims. See, e.g., C.R.S. ' 13-54-102(l)(A) (exempt up fraud. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 3(1); to $25,000.00). Texas appears to provide an unlimited San Jacinto Bldg. v. Brown, 79 S.W. 2d 164, 166 (Tex. exemption. Tex. Ins. Code ' art. 1108.051; see also, Civ. App. C Beaumont 1934, writ ref’d). This would N.Y. INS. LAW ' 3212 (Consol. 2002) [hereinafter cited seem to be consistent with the anti-avoidance provisions as “N.Y. Ins. Law”). of state fraudulent conveyance statutes. Arguably the transfer of cash to the insurance company by the debtor e. Property Acquired with Proceeds. While it is for the purchase of insurance on the debtor’s life would clear the proceeds themselves are exempt, it is unclear if be a transfer for fair and adequate consideration and the exemption extends to property acquired with such therefore voidable only if the insurance company (a exempt proceeds. direct party to the transaction) and the beneficiary (a third party beneficiary to the insurance contract) has f. Spendthrift Provisions. When the insurance notice of the contract limits the alienability of a beneficiary’s interest debtor’s fraudulent intent. See, e.g., UFTA ' 4, 7; but under the contract and the rights of creditors to reach see Tex. Ins. Code Art. 1108.051, Sec. 3(1) (exemption such interest, some states’ statutes expressly validate will not apply to premium payments made in fraud of such provisions. See, e.g., Tex. Ins. Code Art. creditors); and In Re Mueller, 867 F.2d 568 (10th Cir. 1108.051, Sec. 5; Ind. Code Ann. ' 27-2-5-1 (b); N.Y. 1989). Ins. Law ' 3212(d)(3). iii. Insolvency When Beneficiary is Designated. 2. Liability of Separate Proceeds for Debts Incurred It may be the insurance proceeds will be subject to the by Insured. One crucial inquiry is the extent to which claims of the insured’s creditors if the insured is the proceeds received by the beneficiary would be liable insolvent when he or she designates the beneficiary. for the claims of the insured’s creditors or the creditors of Pope Photo Records, Inc. v. Malone, 539 S.W. 2d at 226 the beneficiary (in particular, the beneficiary-spouse). (Tex. Civ. App. C Amarillo 1976, no writ); Parker Square State Bank v. Huttash, 484 S.W. 2d at 432 (Tex. a. Extent of Exemption. State exemptions for life Civ. App. C Ft. Worth 1972, writ ref’d n.r.e.). The insurance proceeds may vary regarding the effect of the insured’s creditors may be able to reach the proceeds if, exemptions on creditor claims of the insured, the notwithstanding the insured’s solvency, the insured beneficiary, or both. Some states exempt life insurance designated the beneficiary with an actual intent to hinder, proceeds paid to a named beneficiary. See, e.g., Tex. Ins. delay or defraud his or her creditors within the meaning Code Art. 1108.051 (exempting proceeds from the claims of state fraudulent conveyance statutes. of the beneficiary’s creditors in an unlimited amount) and Ind. Code Ann. ' 27-1-12-14. iv. Fraudulent Payment of Premiums. If the formation of the contract and initial beneficiary b. Exceptions to Protection. In some circumstances, designation is not in actual or constructive fraud of life insurance proceeds will not be exempt from the creditors (because of insolvency or otherwise), or is not claims of creditors, even though such proceeds otherwise pledged as security, but subsequent premiums are made fall within the exemption statute. with a fraudulent intent or when the insured is insolvent, creditors of the insured are able, in some states, to i. Validly Assigned to Creditor. It is clear that recover such premiums from the insurance proceeds. the proceeds will be subject to the claims of a creditor of See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 3(1) the insured to the extent the insurance policy was validly (exemption will not apply to premium payments made in assigned to that creditor as collateral for the debt. Tex. fraud of creditors); In Re Mueller, 867 F.2d 568 (10th Ins. Code Art. 1108.051, Sec. 3(2); Pope Photo Records, Cir. 1989). 10

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However, recovery of premiums paid in fraud of subject to a joint liability of both spouses. See, e.g., First creditors may be available under fraudulent conveyances Nat’1 Bank v. Pothuisje, 217 Ind. 1, 25 N.E. 2d 436 statutes or Bankruptcy Code ' 548. See, e.g., Tex. Ins. (1940). Code Art. 1108.051, Sec. 3(1); In Re Mueller, 867 F.2d 568 (10th Cir. 1989). 3. Preservation Planning Potential. In those states that recognize estates by the entirety and protect the 3. Exemption Cumulative. Is the exemption provided spouses’ interest therein from the reach of creditors, under life insurance exemption statutes with respect to a substantial protection could be achieved by taking beneficiary in addition to the personal property property as tenants by the entirety. The practitioner exemptions provided under general exemption statutes? would be well advised to determine the extent of It would appear that the answer to that question is protection afforded such estates in his or her particular generally yes. In Re Roper, 49 B.R. 4 (Bankr. N.D. Tex. jurisdiction. 1984) cf. In Re Thompson, 103 F. Supp. 942 (D.C. Texas 1952) (holding that a federal bankruptcy court has I. 529 Plans. A so-called “529 Plan” is an investment the duty to interpret state exemption statutes liberally in plan offered by a state that enables an individual to invest favor of the debtor). In Roper, the Bankruptcy Court money on a tax effective basis to help pay for “higher specifically held that the exemptions provided by special education expenses.” Basically, there are two types of Texas exemption statutes are supplementary to the 529 Plans: prepaid tuition plans and savings plans. The general exemptions provided by Tex. Prop. Code ' more popular of the two plans is the so called 529 42.001 et seq. The life insurance exemption in Colorado savings program because the full value of the account is under the general exemption provisions. C.R.S. 13-54- can be used at any accredited college, university (or other 102(l). In Indiana and New York, the exemption is education institution) in the United States. Use of the provided by a specific statute relating to insurance. Ind. 529 savings plan offers the following main advantages: Code Ann. ' 27-1-12-14; N.Y. Ins. Law ' 3212. 1. Gifts to Plan Are Complete Even If Donor is the G. Retirement Plans. A discussion of the creditor Account Holder. Gifts to a 529 Savings Plan are protection features of retirement benefits can be found at complete for federal gift tax purposes even though the IV.G infra. donor is the account holder and can decide when the funds shall be used. I.R.C. '529(c)(2)(A)(i). H. Estates by the Entirety 1. General. When property was conveyed or devised 2. No Estate Tax Inclusion. If the donor/account to husband and wife, an estate by the entirety was created holder dies, the account value will not be included in his at common law. Although estates by the entirety are no or her estate for federal estate tax purposes. I.R.C. longer recognized in some states, other states continue to '529(c)(4)(A). give them effect. The practitioner should consult the law of his particular state to determine the legal effect given 3. No Income Tax. Earnings in the account grow free estates by the entirety. from Federal income tax even when distributed, but only Under an estate by the entirety, the husband and if the funds are used for qualified educational expenses. wife take the whole estate as a single person with the I.R.C. ''529(a), 529(c)(1), and 529(c)(3). right of survivorship. The estate by the entirety resembles a joint tenancy in that there is a right of 4. Account Holder Can Get Money Back If Needed. survivorship in both, but is distinguishable in that the Amazingly, despite the above advantages, the account estate by the entirety may only be between husband and holder can distribute the funds to himself or herself. wife and generally may not be partitioned. However, if the account holder does so, he or she will be taxed on the distribution to the extent of attributable 2. Liability for Debts of Spouses. Generally, an earnings and will be subject to a 10% penalty. I.R.C. estate by the entirety cannot be destroyed by the ''529(c)(6), 530(d)(1), and 530(d)(4)(A). voluntary or involuntary act of either spouse. See, e.g., Schram v. Burt, 111 F.2d 557 (6th Cir. 1940). Courts are 5. May Have Creditor Protection Too. An account divided as to whether and to what extent a creditor of one holder’s 529 Plan balance may also be insulated from the spouse can reach an interest of such spouse in an estate claims of the account holder’s creditors if the account by the entirety. Compare Cullon v. Kearns, 8 F.2d 437 holder is a resident domiciliary of Alaska, Colorado, (4th Cir. 1925), cert. denied, 269 U.S. 587 (1926); with Kentucky, Louisiana, Maine, Nebraska, Ohio, Hoffman v. Newell, 249 Ky. 270, 60 S.W. 2d 607 Pennsylvania, Tennessee, Virginia, or Wisconsin and (1932). An estate by the entirety, however, is generally establishes the account in his domiciliary state. See 11

Conservative Asset Protection Planning Chapter 11 generally Jeffrey T. Kwall, J.D., “Can Creditors Invade exemptions, even in opt-out states, are subject to the Qualified College Savings Plans?”, Journal of Financial homestead caps. One commentator states that this is “a Planning, March 2001. significant limitation on the opt-out clause that was a crucial part of the 1978 Code’s exemption provisions.” 6. CBAPCPA Provides Added Protection. BAPCPA See Brown & Ahearn, “2005 Bankruptcy Reform offers additional protection for Education IRAs and 529 Legislation with Analysis”, Thomson-West (2005). Plans. For a thorough discussion of such protection, see IV.H infra. D. Domicile Requirements. In prior law, the state exemptions which could be claimed by a debtor was IV. RELEVANT FEDERAL BANKRUPTCY determined by the place of the debtor’s domicile for 180 RULES. days preceding the date of filing or for a “longer portion A. Purpose and Scope of BAPCPA. Pushed largely of such 180 day period than in any other place.” That by credit card companies, The Bankruptcy Abuse rule has been substantially changed by BAPCPA, and the Prevention And Consumer Protection Act Of 2005 change is likely to produce some bizarre results. The (“BAPCPA”, though denominated by several members of purpose is to prevent a debtor from moving to a the bankruptcy bar simply as “BARF”) concentrates on jurisdiction with liberal state exemptions (e.g., Texas or consumer debt, but has several provisions dealing with Florida) and then filing bankruptcy within a relatively matters that affect estate planning clients in their asset short time thereafter. Parenthetically, the way the new protection planning. The reader must keep in mind rules operate may or may not prevent gaming the system. several key points which are easy to forget about when 730 days has been substituted for 180 days, but “if the trying to analyze the Act. First and foremost, THE debtor’s domicile has not been located in a single State RULES DISCUSSED BELOW APPLY ONLY IN for such 730-day period, the place in which the debtor’s BANKRUPTCY. They have no effect whatsoever in domicile was located for 180 days immediately preceding creditor rights proceeding outside of the bankruptcy the 730-day period or for a longer portion of such 180- context. Thus, state law exemptions as to homestead and day period than any other. For example, a bankrupt lives IRAs are unaffected outside of the jurisdiction of the in Indiana for 18 months prior to filing bankruptcy. bankruptcy courts. Second, certain state law exemptions Before that, the bankrupt lived in Ohio for two months, (as discussed below), may have to be foregone to avail California for six months, and New York for four or oneself of bankruptcy protection. Third, many changes more months before that. The bankrupt must, if she which receive media attention apply only to “consumer chooses state exemptions, claim exemptions under New debts”. Bankruptcy Code §101(8) (“debt incurred by an York law, even though she has had no connection with individual primarily for a personal, family or household New York for over two years. Bankruptcy Code purpose”. Note: References to the Bankruptcy Code, §522(b)((3)(A). Title 11, U.S.C. are sometimes noted as “BC”). These “consumer debt” changes include, for example, the E. The Bankruptcy Estate, Exemptions and means testing provisions in BC §707(b) and the Exclusions. The essence of obtaining Chapter 7 definition of “debt relief agency” which includes an bankruptcy protection (i.e., liquidation bankruptcy, attorney who advises a debtor in a bankruptcy which is the only type of bankruptcy really discussion in proceeding. this article) is that the debtor must turn over all the assets of the debtor except those assets which are excluded or B. Effective Dates. BAPCPA was enacted on April exempted from the bankruptcy estate. The debtor is 20, 2005, and most provisions become effective 180 days allowed to elect whether to use exemptions granted under thereafter on October 17, 2005. However, certain key state law (except in opt-out states where state law provisions became effective upon enactment. Such exemptions must be used) or those granted under federal effective dates are noted in the discussion of those bankruptcy exemptions. Bankruptcy Code §522(d). amendments. The entire Act is now effective. Exclusions are available to every bankrupt, whether the bankrupt chooses state or federal law exemption. C. Exemptions. BC §522 was substantially amended to create some additional exemptions for “retirement 1. The Bankruptcy Estate. Property of the funds” and to limit state law homestead exemptions. It bankruptcy estate is broadly defined under Section basically left intact, however, the ability of a debtor to 541(a) of the Bankruptcy Code. In relevant part, this choose between state law exemptions and listed federal section provides that the bankruptcy estate shall include exemptions in bankruptcy. BC §522(b)(3)(A) is each of the following: specifically made subject to BC §§522(o) and (p), dealing with homesteads, to make it clear that state law 12

Conservative Asset Protection Planning Chapter 11 a. All Interests in Property Except Exempt (or 2. Choice of Exemptions. BAPCPA generally retains Excluded) Assets. All legal or equitable interests of the the choice of the debtor to choose between state and debtor in property as of the date the petition for federal exemptions, and retains the ability of states to bankruptcy was filed (the “filing date”), less exemptions mandate that their residents may claim only the (and most certainly exclusions even though exclusions exemptions granted under state law. Most states have are not mentioned in the statute nor in the Bankruptcy exercised this right and restrict exemptions to those Rules. Other than as noted, there appears to be little allowed under state law. These states are known as “opt- practical difference between exemptions and exclusions. out states.” Fifteen states and the District of Columbia It would seem that the party objecting to an exclusion are not opt-out states, and allow their residents to choose should have the burden of proof. It would also seem that between state or federal exemptions. These states are: the debtor should have the burden of sustaining a claimed Arkansas, Connecticut, Hawaii, Massachusetts, exemption. However, Bankruptcy Rule 4003(c) places Michigan, Minnesota, New Jersey, New Mexico, the burden on the objecting party. See In re Greenfield, Pennsylvania, Rhode Island, South Carolina, Texas, 289 B.R. 146 (Bankr. S.D. Cal. 2003), which challenges Vermont, Washington, and Wisconsin. BAPCPA does the validity of the Rule. add a new class of federal exemptions in the retirement plan area and substantially restricts the availability of b. Debtor’s Interests in Controlled Community state homestead exemptions in certain cases. Property. All interests of the debtor and the debtor’s spouse in community property as of the filing date that 3. Interplay With State Exemptions. It may be either (a) is under the sole, equal, or joint management difficult to understand that the provisions regarding and control of the debtor, or (b) is liable for an allowable certain state law exemptions, e.g., homesteads, no longer claim against the debtor and an allowable claim against apply in bankruptcy even when the state exemptions are the debtor and the debtor’s spouse, to the extent such elected by the debtor or when the debtor has no choice claim is allowable. but to use state exemptions because the state has “opted out” of the federal exemptions. BAPCPA even overrides c. Fraudulent Conveyances. Property that is some existing state exemptions (See, e.g., Bankruptcy recovered by the trustee in bankruptcy (or debtor in Code §§ 522(b)(1) - (3)). The cardinal rule here is the possession) which was the subject of a prior conveyance bankruptcy relief is a matter of legislative grace created which was subsequently avoided. by the Congress to give debtors a “fresh start.” It begins with the general proposition, noted above, that all d. Property Preserved for the Benefit of the Estate. property of the debtor is property of the bankruptcy Any property preserved for the benefit of or transferred estate. In the exemption provisions, the debtor is to the estate under subordination or the subject of an normally allowed (or even required in the opt-out states) avoided transfer. to use state exemptions. While this may strike some as taking away the benefits of state exemption laws (which e. Certain After-Acquired Interests – 180 Day it may), the important factor is that if an individual wants Property. Any interest in property that would have been to avail himself or herself of the fresh start under property of the estate if that interest had belonged to the bankruptcy, the debtor must forego certain rights which debtor on the filing date, and that the debtor acquires or the debtor may have outside of bankruptcy. In other becomes entitled to acquire within 180 days after that words, if a debtor wants the benefit of bankruptcy date (a) by bequest, devise, or inheritance; (b) as a result protection, then the debtor must play by the rules of a property settlement agreement with debtor’s spouse established by Congress. An issue is raised as to the or an interlocutory or final divorce decree; or (c) as a constitutionality of the loss of state exemptions in an beneficiary of a life insurance policy or of a death benefit involuntary bankruptcy, in which the debtor is forced plan. into the clutches of the bankruptcy rules rather than seeking their protection. The issue is a due process issue. f. Income and Revenue from Property. Proceeds, If a debtor elects bankruptcy, then the debtor has product, offspring, rents, or profits of or from property of voluntarily given up the claim to the state exemptions not the estate, except as such as are earnings from the allowed by the Bankruptcy Code. However, if the debtor services performed by an individual debtor after the is forced into bankruptcy, then state law exemptions are commencement of the case. not given up, but rather denied. However, the validity of this argument is best left to the g. Other After-Acquired Interests. An interest in bankruptcy bar. property that the estate acquires after the commencement of the case. 13

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4. Exclusions. BAPCPA also adds new exclusions held that the debtor must occupy the home prior to the concerning IRC section 529 plans, educational IRAs, 1215 day period. In re Buonopane, 344 B.R. 675 employer withholding for and employee contributions to (Bankr. M.D. Fla. 2006). Query: Does it (or should it retirement benefits, and contributions to certain health make a difference if the debtor lived in Florida prior to insurance plans. Bankruptcy Code §§541(b)(5)-(7). the beginning of the 1215 day period?

F. Homestead Exemptions. The current BAPCPA 4. Definition of “Value”. “Value” means fair market rules regarding homestead exemptions are found at value as of the date of filing the petition (or the date Bankruptcy Code §§522(o)-(q). In an earlier House acquired for after-acquired property). Bankruptcy Code version of BAPCPA, homestead exemptions were capped §522(a)(2). This definition raises serious issues and, in at $125,000. However, as the final bill emerged, that some circumstances, arguably could subject a portion of restriction was substantially lessened to allow residents the homestead or residence to claims of creditors. This of states with large or unlimited homestead exemptions, argument was raised in In re Kaplan, in which the such as Texas and Florida, to retain that exemption in bankrupt acquired a home within the 1215 day period. bankruptcy, while still restricting the ability of a debtor 331 B.R. 483 (Bankr. S.D. Fla. 2005). The trustee in to move to those jurisdictions, buy a large homestead and bankruptcy asserted one value which would have brought effectively convert non-exempt assets to exempt assets in the §522(p) cap into play, and the bankrupt asserted a the form of a homestead. Keep in mind that if the different value below $125,000. There were no facts in debtor’s state does not provide for significant homestead the opinion concerning the cost of the home. The court exemptions, this section acts only as a cap and does not deferred resolution of that issue to deal with the opt-out increase the allowed state exemption. issue. See discussion of In re McNabb, infra. The valuation issue was settled by the parties subsequent to 1. Effective Date. The amendments concerning the opinion. homestead became effective at date of enactment. 5. Increase in Market Value. The statute speaks in 2. Limitation on Amount Dependent on Time. The terms of amount of interest acquired that exceeds principal technique chosen by Congress was to provide $125,000 of value. In a booming real estate market with that, if the debtor elected state exemptions (the federal double digit increases in value, would that increase be exemption for homesteads under BC §522(d)(1) is counted as an “interest acquired”? Logic would dictate $18,450.00), a debtor could not exempt “any amount of that the interest should be related only to the debtor’s interest that was acquired by the debtor during the funds expended on the home, since that is all that would 1215- have been available had such funds not been expended, day period preceding the date of the filing of the petition but if the statute is read to impose a market value balance that exceeds in the aggregate $125,000 of value in” sheet test, the debtor’s equity is clearly increased by the (emphasis added) a residence, cooperative, burial plot for increase in value which is arguably acquired during that the debtor or a dependent, or property claimed as a period. And, the bankruptcy courts that have considered homestead. Bankruptcy Code §522(p). This limitation this issue seem to agree. In a Texas case in which the does not apply to family farmers as defined in homestead was acquired almost 5 years before the Bankruptcy Code §101(18). Bankruptcy Code bankruptcy filing, the court, in a somewhat simplistic §522(p)(2)(A). While the goal of this section is analysis, construed the phrase “interest acquired” to relatively clear, the language is open to some interpretive mean the date that title to the homestead was acquired questions. Bankruptcy Code §522(m) directs that §522 without regard to any increase in value during the 1215 applies separately to each debtor. Thus, in a situation in day period. In re Blair, 2005 WL 3108495 (Bankr. N.D. which both spouses file, the exemption may go up to Tex. 2005). See also In Re Sainlar, 344 B.R. 669 $250,000. (Bankr. M.D. Fla, Orlando Division 2006), in which the Florida court agreed with the holding in Blair that 3. Necessity for Occupancy. An open question under “interest acquired” does not include appreciation during the statute is whether the debtor must have occupied the the time the home was owned, but that “acquired” refers residence as his homestead prior to the 1215 period, or to date of acquisition of title. whether he simply must have owned it. For example, debtor buys a home in Florida outside the 1215 day 6. Payment on Debt Related to Home. Principal period, but then moves to Florida and moves into the payments on mortgage debt, home equity loans or home home within the 1215 day period. One Florida court has improvement loans during the 1215-day period should be treated as an “interest acquired”, at least to the extent that

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Conservative Asset Protection Planning Chapter 11 they exceed normally scheduled payments necessary to criminally negligent homicide with a motor vehicle. amortize the debt. The Blair court would seem to Could this section also apply to medical malpractice contradict this when it states, “However, one does not cases where gross negligence was found? actually ‘acquire’ equity in a home. One acquires title to a home.” Following this reasoning, a debtor could make a. Time of Acquisition Irrelevant. The limitation in a minimal down payment, and then pay off the mortgage §522(q)(1) does not appear to be limited to residences with non-exempt assets during the 1215 day period acquired within the 1,215 day period in §522(p)(1). without losing the unlimited homestead exemption under Thus, the issue of “interest acquired” and “value” are state law (assuming that such payment would not be a irrelevant for purposes of the limitation in this section. prohibited transfer). b. Necessary for Debtor or Dependent. Bankruptcy 7. Previous Residence. The amount of such interest Code §522(q)(2) provides that the limitation in (i.e., of an interest acquired during the 1215-day period, §522(q)(1) shall not apply to the amount of an interest if which is subject to BAPCPA limitation ) does not the residence “is reasonably necessary to the support of include any interest transferred within the 1215-day the debtor and any dependent of the debtor.” The fact period from the debtor’s previous residence acquired that there is no time limit on the applicability of this before the 1215-day period, but only if the debtor’s limitation probably accounts for the fact that there is no previous and current residences are located in the same corresponding relief under subsection (p). state. Bankruptcy Code §522(p)(2)(B). Note, ironically, that if a debtor moves from Florida to Texas, there is a 9. Adjustment for Inflation. The amount in new 1215-day period even though both states have §§522(p) and (q) is subject to adjustment beginning April unlimited homestead exemptions. A Florida court has 1, 1998 and every three years thereafter for changes in construed this exemption to allow the rollover in values the Consumer Price Index for All Urban Consumers from one property to another to consider all residences based on the most recent three year period ending before owned while living in Florida. In re Wayrynen, 332 B.R. January 1 of the year of adjustment. Bankruptcy Code 479 (Bankr. S.D. Fla. 2005). In Wayrynen, the debtor §104(b)(1). had acquired two homes within the 1215 day period and a third home outside of that period. The court found that 10. Fraudulent Transfers. While fraudulent transfers the exemption for amounts from earlier homes dated will be discussed in more detail below, it seems back to the first residence. Interestingly enough, the appropriate to note here that the homestead exemption home purchased during the 1,215 day period was less will be reduced for any transfer made by the debtor of expensive than the previous home. It is still an open non-exempt property (determined as if the debtor had question as to whether there is a time limit on the sale of owned the property at date of filing) during a ten-year the previous home if the debtor continued to reside in the period preceding the date of filing with the actual intent same state even if the funds could be traced. to hinder, delay or defraud a creditor. Bankruptcy Code §522(o). 8. Bad Acts. A debtor may not exempt an “amount of an interest” in excess of $125,000 if the debtor has (i) 11. The Temporary Opt-Out State Controversy. In been convicted of a felony (i.e., a crime punishable by the first opinion after the homestead provisions of imprisonment for more than one year – See 18 U.S.C. BAPCPA became effective, an Arizona bankruptcy court §3156(a)(3)) “which, under the circumstances, severely limited the application of the homestead demonstrates that the filing of the case was an abuse of exemption cap. In re McNabb, 326 B.R. 785 (Bankr. D. the provisions of this title”; or (ii) the debtor owes a debt Ariz.2005). Strictly construing the statutory language, arising from (w) a violation of state or federal securities the court held that the cap did not apply in opt-out states. laws; (x) “fraud, deceit or manipulation” in a fiduciary §522(p)(1) states”...[A]s a result of electing under capacity with respect to securities registered under 1933 subsection (b)(3)(A) to exempt property under state or Act or the 1934 Act; (y) any civil remedy under section local law....” The court held that debtors in Arizona, an 1964 of Title 18 (RICO); or (z) “any criminal act, opt-out state (which has a $150,000 homestead intentional tort, or willful or reckless misconduct that exemption), the debtor did not elect under Arizona law, caused serious physical injury or death to another in the since that law required him to use the state’s exemptions preceding 5 years.” Bankruptcy Code §522(q). In a and thus deprived him of any election. To bolster its recent Massachusetts case (In re Larson, 340 B.R. 444, conclusion, the court noted that §522(o) applied to all Bankr. D. Mass. 2006) the court found that “criminal act” states because its language, “For purposes of subsection did not require a felony conviction in a case involving (b)(3)(A)...,” which was not dependent upon an election. The court also concluded that the statutory language was 15

Conservative Asset Protection Planning Chapter 11 unambiguous, and therefore resort to the legislative context of a bankruptcy proceeding, and does not history was not only unnecessary, it was impermissible. affect the rights of creditors in other contexts. And finally, the court invited Congress to fix this “glitch” in a Technical Corrections Bill which is said to 1. Governing Law Prior to BAPCPA. be in the works. Until then, the court felt that it had to a. Patterson v. Shumate (504 U.S. 753 (1992). After apply the statute as written. Of the states with unlimited many years of wrangling over the status of qualified homestead exemptions, only Texas is not an opt-out plans in bankruptcy, the Supreme Court finally settled state. Of the non opt-out states with dollar limits, only the issue as to plans which were subject to the anti- Minnesota’s exemption of $200,000 exceeds the alienation clause of ERISA. 29 U.S.C. §1056(d)(1) $125,000 in BAPCPA. The Court also noted that [ERISA §206(d)(1)]. The Supreme Court decided that California law would apply under BAPCPA, but that the ERISA was “applicable non-bankruptcy law” (under residency provision did not take effect until October 17. Bankruptcy Code §541(c)(2)) and thus retirement plans Subsequent courts have unanimously disagreed with were excluded from the bankruptcy estate. Some lower the decision in McNabb, including another Arizona court. courts have tried to limit the applicability of this case by In re Summers, 344 B.R. 108 (Bankr. D. Ariz.). Florida considering whether the plan in question met the courts found that the language in the statute was not qualifications of ERISA and the Internal Revenue Code. “unambiguous” and thus resort to legislative history was This case does not apply to situations in which the not only permissible, but necessary, and that the business owner and the business owner’s spouse were the legislative history was clear that the section was intended only participants in the plan. to apply to opt-out states as well. In re Kaplan, supra. See also In re Landahl, 338 B. R. 920 (M.D. Fla., Tampa b. Rousey v. Jacoway (544 U.S. 320 (2005. On April Div. 2006) and In re Wayrynen, supra. Two Nevada 4, 2005, the Supreme Court issued its opinion in Rousey courts reached the same result using the same reasoning v. Jacoway, opinion by Mr. Justice Thomas. In that case, as Kaplan. In re Virissimo, 332 B.R. 201 (Bankr. D. Nev the Court resolved a conflict among the circuit courts as 2005). See also In re Kane, 336 B. R. 477 (Bankr. D. to whether the exemption from the bankruptcy estate in Nev. 2006). 11 U.S.C. §522(d)(10)(E) [the “(d)(10)(E) exemption”] applied to IRAs. The (d)(10)(E) exemption provides an 12. Tenancy by the Entirety. The application of exemption for: §522(p) is dependent upon election, or at least application of state law exemptions. As discussed below, a payment under a stock bonus, pension, profit- in addition to state law and federal law exemptions, sharing, annuity, or similar plan or contract §522(b)(3)(B) exempts property held as tenants by the on account of illness, disability, death, age or entirety or joint tenancy with right of survivorship if such length of service, to the extent reasonably property is exempt from process under applicable necessary for the support of the debtor and nonbankruptcy law. Thus, homesteads acquired within any dependent of the debtor.... (emphasis the 1,215 day period may still be exempt if the title is added) held in such a way as to meet the (b)(3)(B) exemption and only one spouse or joint tenant files for bankruptcy. There are several things which should be noted about this However, if the transfer of non-exempt assets into the exemption. First, it is available only if the debtor does homestead is a fraudulent transfer or one to which not claim state law exemptions, which are much more §522(o) applies, then there is no protection under liberal in many cases. Second, the exemption is limited (b)(3)(B). See In re Wagstaff, 2006 WL 1075382 to the amount necessary for the support of the debtor. (Bankr. S.D. Fla 2006), slip opinion. Note that joint Third, although it remains in the Bankruptcy Code, its tenancy property is not exempt to the extent of joint efficacy is somewhat questionable in that it is effectively debts. overridden for all practical purposes by the new exemption in §522(d)(12) added by BAPCPA. G. Retirement Benefits. BAPCPA also contains The Court decided that an IRA (in this case, a provisions relating to retirement benefits, creating several rollover IRA) was similar to the types of plans new exemptions which apparently override state law enumerated in §522(d)(10)(E) in that in each case the exemptions, even if such exemptions are elected, as well plan “provide[s] income that substitutes for wages earned as providing new federal exemptions. It provides a huge as salary or compensation.” Further, the Court liberalization in the protection of qualified plans, IRAs determined that the 10% early withdrawal penalty was and some non-qualified plans by providing exemptions not insubstantial (noting that they need not decide from the bankruptcy estate. As a reminder, it should be whether a lesser penalty would be) and thus distributions noted that this protection is available only in the were made on account of age, unlike those from a simple 16

Conservative Asset Protection Planning Chapter 11 savings account which could be accessed penalty free ii. Subsection (B) provides that, even if there without regard to age. The Court engaged in further is no favorable determination under §7805, those funds analysis to support its conclusion, but in light of are exempt if the debtor demonstrates that (x) no prior BAPCPA, the continuing importance of this opinion is determination to the contrary has been made by a court or questionable. the IRS, and (y) the retirement fund is in substantial compliance with the IRC, or (z) if not in substantial 2. Benefits Exempted Under State Exemption compliance, the debtor is not materially responsible for Election. As discussed earlier, §522(b)(1) allows that failure. Note, curiously enough, that in the case of a debtors to elect between federal exemptions under plan which has not received a favorable determination, §522(b)(2) and state law exemptions under §522(b)(3). such plan will still be exempt if it meets the other There are three exemptions in §522(b)(3), and they are requirements of (B), while a plan that has a received a listed in the conjunctive. If the state exemptions are favorable determination is only entitled to a presumption. elected, §522(b)(3)(A) exempts property that is exempt under federal law other than under §522(d) and state or iii. Subsection (C) provides that direct trustee local law of the debtor’s domicile, §522(b)(3)(B) retains to trustee transfers will not cause a loss of the (b)(3)(C) the existing exemption for joint tenancy and tenancy by or (d)(12) exemption (discussed below). the entirety property, and §522(b)(3)(C) exempts “retirement funds” to the extent those funds are in a fund iv. Subsection (D) states that a qualified or account that is exempt from taxation under sections rollover will not cause a loss of the exemption. 401 [a qualified pension, profit sharing or employee stock bonus plan established by an employer for the 3. New Federal Exemption. Under Bankruptcy Code exclusive benefit of the employees], 403 [qualified §522(d)(12), a new exemption is created under if the annuity plans established by an employer for an federal exemptions are elected. This exemption is employee], 408 [IRA], 408A [Roth IRA], 414 [retirement identical to the §522(b)(3)(C) exemption and applies to plans for controlled groups], 457 [eligible deferred “(12) Retirement funds to the extent that those funds are compensation plans maintained by an eligible employer exempt from taxation under sections 401, 403, 408, for an eligible employee], or 501(a) [retirement plans by 408A, 414, 457, or 501(a) of the Internal Revenue Code qualified charities] of the Internal Revenue Code.” of 1986.” With the addition of this paragraph (d)(12), it is a. Apparently Additional Exemption. It would seem difficult to understand the need for the §522(d)(10)(E) that because §522(b)(3) is written in the conjunctive, that exemption, which was the subject of Rousey v. Jacoway, a debtor claiming state law exemptions would have supra. Even with the $1,000,000 limitation on the available to the debtor the greater of the (3)(C) exemption for non-rollover IRAs and Roth IRAs exemption or the exemption of qualified plans and IRAs (discussed below), the relief under (d)(12) would seem to under state law. There does not appear to be any sort of be so much more liberal than the “need of the debtor” preemption of state law, which could easily have been requirement in the (d)(10)(E) exemption that the latter done. Thus, if a debtor elects state exemptions, and the section is unnecessary. state law provides little or no shelter for retirement benefits, the federal exemption would protect the plans. 4. Limitation of Exemptions. The blanket exemptions which (3)(C) and (d)(12) would appear to b. Based on Tax Qualification. While the exclusion grant, are subject to a limitation under Bankruptcy Code provided under Patterson v. Shumate was based on the §522(n), which reads: application of ERISA, Title I, the (3)(C) exemption is (n) For assets in individual retirement based only on tax qualification under the enumerated accounts described in section 408 or sections of the Internal Revenue Code. BAPCPA also 408A...other than a simplified employee provides a method for determining whether the plans pension under 408(k)...or a simple retirement meet the qualifications of those sections. Bankruptcy plan under 408(p)..., the aggregate value of Code §522(b)(4). such assets exempted under this section, without regard to amounts attributable to i. Subsection (A) creates a presumption that rollover contributions under section 402(c), plans which have received a favorable determination 402(e)(6), 303(a)(4), 403(a)(5) and under IRC §7805, which determination is still in effect at 403(b)(8)...and earnings thereon, shall not the date of filing the bankruptcy petition, are exempt exceed $1,000,000 in a case filed by a debtor under §§522(b)(3)(C) and 522(d)(12). who is an individual, except that such amount

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may be increased if the interests of justice so a. Adjusted for Inflation. The amount of the require. (Emphasis added). limitation is adjusted for inflation under Bankruptcy Code §104. Given the limitations on contributions to 5. Plans Affected by Limitation. The $1,000,000 IRAs and Roth IRAs, it is very difficult to accumulate limitation is apparently designed to apply to other than more than $1,000,000 in an individually established IRA, employer plans and rollovers from employer plans to particularly given the increase in the limitation due to IRAs; i.e., to individually established IRAs and Roth inflation. A person who began making maximum IRAs. A rollover consists of a distribution to the contributions 30 years ago would have contributed less participant followed by a contribution within 60 days to than $70,000 to the IRA. It would have taken greater another tax exempt plan. Without the rollover than a 15% compound annual return to reach $1 million. provisions, the initial distribution would be taxable to the participant irrespective of what the participant did with b. IRAs are Commingled. If the IRA is a the money. The exemption for a rollover is defined by commingled IRA, is tracing available to segregate the reference to specific Internal Revenue Code sections, rollover portion (and its earnings) from the non-rollover which sections do not include rollovers from one IRA to portion so that the limitation does not somehow get another under IRC §408(d)(3). The apparent result of exceeded by the rollover portion? There is no answer to this is that an IRA rolled over to another IRA will be this in the Act, but certainly it would be worth a try. subject to the $1,000,0000 limitation, while a rollover from an employer plan to an IRA would not. This should 9. Discretionary Increase in Amount of Limitation. not be the case if the funds in the original IRA were It is most mystifying under what circumstances the rolled over from an employer plan and thus were exempt “interests of justice” would require an increase in that from the limitation in the original IRA. Note that amount. Perhaps this could refer to a situation in which a limitation applies only to rollovers, and the issue of an rollover IRA also has contributions, therefore taking it IRA to IRA rollover can be avoided by the use of a out of the safe harbor. If it could be shown that the trustee to trustee transfer, which, unlike a rollover, is not contributory portions (including earnings on that portion) treated as a distribution. Rev. Rul. 78-406, 1978-2 C.B. were less than $1,000,000, then arguably there would be However, this technique cannot exempt an IRA a reason to raise the limitation. Obviously, to the extent originally subject to the limitation. possible, rollover IRAs and contributory IRAs should be kept separate. 6. Applicability to State Law Exemptions. If state law exemptions are elected and provide unlimited 10. Rollovers and Trustee to Trustee Transfers. As a exemptions for IRAs, a question arises whether the general rule, neither the transfer from one exempt plan to highlighted language in §522(n), supra, applies only to another nor a qualified rollover distribution will cause a the (3)(C) exemption or whether it also applies to limit loss of the (3)(C) or (d)(12) exemption. Bankruptcy the state law exemptions under (3)(A). Certainly there is Code §§522(b)(4)(C) and (D). an argument that the (3)(C) exemptions are the assets “exempted under this section” and that the state law 11. Spousal Rollovers. There are still (surprise!) some exemptions are not limited since the exemptions, as important questions left. Is a spousal rollover under pointed out earlier, are in the conjunctive. On the other Treas. Regs. §1.408-8, A-5 subject to the §522(n) hand, the phrase may be interpreted as applying to all of limitation? The better argument is that it should not be if §522. However, given the effect of the limitation, this the account from which it is rolled over was protected as question would appear more academic than real, unless a rollover or a plan for which there is an unlimited the IRA contains an “explosive” asset. exemption. If the spousal rollover is from an IRA which is not a rollover, it should be subject to the same 7. Applicability to Federal Exemptions. The $1,000,000 limitation. It seems this would be consistent limitation clearly applies to the (d)(12) exemption (and with the treatment as an inherited IRA which should presumably, [but who cares?] to the (d)(10(E) exemption retain its exemption from the §522(n) limitation because also.) there has been no change other than the distributee.

8. Application of Limitation. In the real world, this 12. Inherited IRAs. Suppose the beneficiary of the limitation would appear to have little effect, except in the IRA is not the spouse or the spouse does not elect to treat event that a rollover IRA is commingled with a non- the IRA as his or her own? In that case, does this asset rollover IRA. still enjoy the (3)(C) and (d)(12) exemption if the beneficiary is adjudicated a bankrupt? The statute makes no distinction with respect to the beneficiary, but at least 18

Conservative Asset Protection Planning Chapter 11 one commentator has raised the issue as to whether such I. Fraudulent Transfers in General. Bankruptcy funds are “retirement funds” (the asset which is described law has long allowed trustees to set aside what are as exempt) in the hands of the beneficiary. The better commonly denominated as fraudulent transfers or reading of the statute would be that it exempts any funds conveyances if made within one year of the filing of the in the described accounts, and that “retirement funds” is petition in bankruptcy. The Bankruptcy Code provisions simply a convenient rubric. After all, what other than are comparable to the Uniform Fraudulent Transfer Act “retirement funds” ever went into accounts under the (“UFTA”) rules, and provide for two classes of enumerated IRC sections? fraudulent transfers. Bankruptcy Code §548.

H. Exclusions of Education Account Benefits. In 1. Avoidance by Trustee in Bankruptcy – General addition to the new exemptions detailed above, BAPCPA Rule. A trustee may avoid certain transfers made by the also added exclusions with relation to educational bankrupt with “actual intent to hinder, delay or defraud” individual retirement accounts and IRC §529 plans. any creditor. Bankruptcy Code §548(a)(1)(A). Bankruptcy Code §541(b)(5) and (6). a. Actual Intent and Badges of Fraud. Bankruptcy 1. Education IRAs. Contributions to education Code §548(a) (1)(A) provides that a transfer within one individual retirement accounts are excluded from the year of the bankruptcy filing is voidable by the trustee in bankruptcy estate if made more than 1 year prior to filing bankruptcy if it can be shown to have been made with an and (A) the designated beneficiary was a child, actual intent to hinder, delay or defraud creditors. (As grandchild, stepchild or step grandchild of the debtor in noted below, that will increase to two years for cases the year of the contributions; (B) only to the extent that filed after one year of the date of enactment.) Since the such funds are not pledged or promised to any entity in Bankruptcy Code does not define “actual intent”, and connection with any extension of credit and are not since actual intent is so difficult to prove without excess contributions under IRC §4973(e); and (C) in the resorting to circumstantial evidence, the court exercising case of funds placed in all accounts having the same jurisdiction over the bankruptcy matter will inquire as to designated beneficiary not earlier than 720 (sic) days nor whether “badges of fraud” exist which can be used to later than 365 days, only so much of such funds as does prove actual intent. See Collier, 15th Ed. Para. 548.02(5) not exceed $5,000. Thus, contributions within one year at pp. 548-37 – 548-43 and cases cited therein; see also of bankruptcy are included in the estate and any McWilliams v. Edmonson, 162 F.2d 454 (5th Cir. 1947), contribution cert denied, 332 U.S. 835 (1947) and In re Roco Corp., in the second year preceding bankruptcy filing is 701 F. 2d 978, 984 (1st Cir, 1983). excluded only to the extent of $5,000 per beneficiary. All of the “badges of fraud” which can be used to find an actual intent to hinder, defraud or delay a creditor 2. §529 Plans. The exclusion for §529 plans includes under state fraudulent conveyance statutes would be the purchase of a tuition credit or certificate or amounts badges of fraud under BC §548. A presumption of contributed to an account in accordance with IRC fraudulent intent may be found to exist if the trustee in §529(b)(1)(A) under a qualified State tuition program. bankruptcy can prove the existence of several badges of The exclusion contains similar limitations as to the one- fraud. Kelly v. Armstrong, 206 F.3d 794 (8th Cir. 2000); year and two-year time limits and the $5,000 limitation Max Sugarman Funeral Home, Inc. v. A.D.B. Investors, as the preceding section. Additionally, “with respect to 926 F. 2d 1248 (1st Cir. 1991). the aggregate amount paid or contributed,” the exclusion is limited to “the total contributions permitted under b. Effective Date. The changes made by TITLE XIV [IRC] 529(b)(7) [sic]...as adjusted beginning on the date of BAPCPA, Preventing Corporate Bankruptcy Abuse of the filing of the petition...by the annual increase or (which includes the amendments to §548), were effective decrease...in the education expenditure category...” of the with respect to cases commenced after the date of CPI. enactment. The change extending the one-year period for avoidance to two-years took effect with respect to 3. Interplay with State Exemptions. If the debtor cases commenced more than one-year after date of elects state law exemptions, and the state law exemptions enactment of the Act; i.e., April 20, 2006. BAPCPA exempt education IRAs and/or §529 plans and do not §1406(b)(1) and (2). contain similar limitations, then it would seem that the excess of the excluded amount would be included in the 2. Avoidance by Trustee in Bankruptcy – Transfer bankruptcy estate and then exempted under state law. for Less than “Reasonably Equivalent Value”. Additionally, a trustee may avoid a transfer if the debtor

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“received less than reasonably equivalent value in a. The Balance Sheet Test. Section 101(32)(A) of the exchange for such transfer” and (i) the debtor was Bankruptcy Code generally defines the term “insolvent” insolvent at the time of such transfer or became insolvent as a financial condition such that the sum of an entity’s as a result of such transfer, (ii) “was engaged in business debts is greater than all of that entity’s property, at fair or a transaction, or was about to engage in business or a valuation, exclusive of (a) property transferred, transaction, for which any property remaining with the concealed, or removed with intent to hinder, delay or debtor was an unreasonably small capital,” or (iii) if the defraud such entity’s creditors and (b) property that may debtor “intended to incur, or believed that the debtor be exempted from property of the estate under Section would incur, debts that would be beyond the debtor’s 522 of the Bankruptcy Code. Thus, the test of ability to pay as such debts matured.” Bankruptcy Code insolvency for individual debtors under the Bankruptcy §548(a)(1)(B). Code is a balance sheet test. However, this test measures only property includible in the bankruptcy estate; i.e., a. Insolvency the Key Factor. Note in this section property that is neither excludible nor exempt. that insolvency alone is sufficient to allow the trustee to Bankruptcy Code §101(32); see also Bankruptcy Code set aside the transfer if the bankrupt did not receive §101(15) (which defines “entity” to include a “person,” adequate consideration. which in turn is defined in Bankruptcy Code §101(41) to include an individual, partnership and corporation). b. Protection of Good Faith Purchaser. This section also generally protects good faith purchasers for value. b. Valuation of Assets and Liabilities. As noted Accordingly, if a purchaser buys an asset from the earlier, property of the bankruptcy estate is quite debtor-transferor and pays fair and adequate inclusive and extends to virtually any interest in property consideration and has no actual or constructive notice of owned by a debtor. For purposes of determining the debtor-transferor’s fraudulent intent, then the insolvency, then, one must look to what is a “fair purchaser may retain the property. Bankruptcy Code valuation.” One noted commentator has described that §548(c). value as “an estimate of what can be realized out of the assets within a reasonable time, either through collection c. What is a “Transfer”? For purposes of the or sale at the regular market value, conceiving [market fraudulent transfer rules, a “transfer” of property to a value] as the amount which could be obtained for the transferee will be deemed to have occurred when a bona property in question within such period by a ‘capable and fide purchaser of the same property from the debtor diligent business man’ from an interested buyer ‘who is cannot acquire an interest in the property that is superior willing to purchase under the ordinary selling to that of the transferee. Bankruptcy Code §548(d)(1). conditions.’” See Collier 15th Ed., para. 101.29 at pp. 101-57 and 58, and cases cited under note 64. Thus, d. Charitable Gift Exception. Certain qualified under the Bankruptcy Code a forced sale valuation of charitable gifts are excepted from the constructive fraud assets is inappropriate in determining insolvency. provisions of §548(a)(1)(B) of the Bankruptcy Code. Bankruptcy Code §548(a)(2), added in 1998. In re c. Inclusion of Contingent Liabilities. Under Zohdi, 234 B.R. 371 (Bankr. N. D. La. 1999); In re Witt, Bankruptcy Code §101(12), “debt” is defined as liability 231 B.R. 92 (Bankr. N.D. Okla. 1999). An individual on a claim. Under Bankruptcy Code § 101(5)(A), debtor’s gift to a qualified religious or charitable “claim” includes those that are contingent, liquidated, organization, as that term is defined under I.R.C. unliquidated, fixed, contingent, matured, unmatured, §170(c)(1) and (2), is not a constructively fraudulent disputed, undisputed, legal, equitable, secured, or transfer provided the gift does not exceed 15% of the unsecured. Therefore, contingent liabilities, including debtor’s gross income for the year within which the potential liabilities arising as a surety, guarantor or transfer was made. Further, even if the gift does exceed endorser, must be included in the computation of the 15% threshold, the contribution will not be insolvency or solvency. However, the value of those considered constructively fraudulent if the transfer was contingent liabilities may be adjusted for possible rights consistent with the debtor’s prior practice of charitable of subrogation or reimbursement and the likelihood that giving. Note this charitable gift exception does not apply the debtor will be required to repay the debt. See Collier to charitable transfers where the debtor made the transfer 15th Ed. para. 101.29 and cases cited at notes 97 and 98. with an actual intent to hinder, defraud, and delay creditors. 4. Trustee’s Power to Void Transfers Under State Law and Denial of Discharge. The trustee in 3. Meaning of Insolvency Under Federal bankruptcy has the rights of an unsecured creditor of the Bankruptcy Rules. 20

Conservative Asset Protection Planning Chapter 11 bankrupt-debtor to void transfers that could have been b. General Rule. Shurley is nothing more than a voided by the creditor under state law. Bankruptcy Code restatement of the general rule that the amount included §544(b). This provision is particularly important since, in the bankruptcy estate – i.e., the amount not excluded as to alleged fraudulent transfers under state law, the under §541(c)(2) as exempt under applicable trustee may rely on these statutes and the accompanying nonbankruptcy law – is the debtor’s interest in the trust, statute of limitations (which would have been available including any benefit which might accrue as a result of to a creditor under state law) rather than the two-year trustee discretion. Stated another way, to the extent that statute described in Bankruptcy Code §548. the settlor has irrevocably parted with any beneficial interest (such as the remainder interest in a charitable J. Transfers to “Self-Settled Trust or Similar remainder trust or a grantor retained annuity trust), such Device”. A new provision was added to BC §548 interest is not part of the bankruptcy estate unless the allowing the trustee in bankruptcy to look back ten years transfer was a fraudulent transfer. to avoid certain transfers. Bankruptcy Code §548(e). 3. Effective Date. This section became effective 1. Scope of this Section. While the section was upon enactment. aimed specifically at DAPTs, its reach is actually much longer and much broader. The effect of the section is to 4. Need for this Provision. It is important to note, at extend the usual four year statute of limitations on the outset, that, absent a provision of state law creating fraudulent transfers to 10 years in the case of any transfer an exemption for self-settled trusts, those trusts are “self settled trust or similar device”. included in the bankruptcy estate to the extent of the debtor’s interest because they do not fit within the 2. Inclusion of Self-Settled Trusts under State Law. applicable non-bankruptcy law exclusion of §541(c)(2). The trustee in bankruptcy could, under pre-BAPCPA Thus, if state law provides an exemption, then §548(e) is law, bring into the bankruptcy estate only the debtor’s necessary to trump that exemption. interest in self-settled trusts which were not protected as DAPTs under state law and which were not fraudulent 5. Conditions of Avoidance. A transfer may be transfers. avoided if “(A)... made to a self-settled trust or similar device; (B) such transfer was by the debtor; (C) the a. The Shurley Analysis. In 1997, the 5th Circuit debtor is a beneficiary of such trust or similar device, issued a landmark opinion regarding spendthrift trusts. and (D) the debtor made the transfer with actual intent to Shurley v. Texas Commerce Bank, 115 F.3d 333 (5th Cir. hinder, delay or defraud any entity to which the debtor 1997). In that case, one daughter (who later filed for was or became, on or after the date that such transfer was bankruptcy) contributed her ranch, which was still in the made, indebted.” Bankruptcy Code §548(e)(1). An trust at date of filing. The other daughter and the parents analysis of each of those provisions follows, with the contributed their ranch properties. Both parents later analysis of “self-settled trust or similar device” being died and their substantial estates poured over into the discussed last. trust. The trust provided for distributions of income to the two sisters and invasion of principal for support. The 6. Transfer by Debtor. While this may seem fairly bankrupt had a special testamentary power of obvious and easy to determine, clever debtors may use appointment. The bankruptcy court found that the whole subterfuges to try to avail themselves of the exclusion trust was self settled, and that creditors could reach the under BC §541(c)(2) concerning spendthrift trusts. In a entire trust. The 5th Circuit, in a carefully reasoned case tried in the Bankruptcy Court of the Western opinion, found that the trust was self-settled only as to District of Texas, Austin Division and affirmed by the the ranch that the debtor contributed, and earnings federal district court of the Western District of Texas, thereon. The bankrupt argued that the only thing that a which case is presently on appeal to the 5th Circuit, the creditor could reach was her income interest, but the debtor argued that transfers to third persons who later court rejected that argument. Citing Bank of Dallas v. transferred the same assets to a trust established by the Republic National Bank (540 S.W.2d 499 (Tex. Civ. debtor’s sister of which the debtor was the sole App. - Waco 1976, writ ref’d n.r.e.), and Restatement 2d beneficiary during his life, were not transfers by the of Trusts, §156, the court held that the discretion in the debtor for purposes of determining if the trust was self- trustee for support payments gave the debtor access to settled. In re Bradley, Case No.02-12741-FRM, Bankr. the entire self-settled portion of the trust, and thus the W. D. Texas-Austin (2005). The trial court and district ranch and not merely her income interest was subject to court vigorously rejected this argument, but, nonetheless claims of creditors. the issue was raised.

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7. Debtor as Beneficiary. If the debtor retained any device” subject to avoidance by the trustee in interest at all or is a beneficiary, does this make the entire bankruptcy. transfer voidable by the trustee? The answer is yes, since the statute simply requires that the debtor be “a a. Domestic Asset Protection Trust. The DAPT is a beneficiary.” There is an open question as to whether self-settled trust that is exempt under state law, so that if this applies if the debtor is a contingent beneficiary. state law exemptions are chosen, this provision is designed to override the state law exemption. Note that 8. Actual Intent. The concept of actual intent (as all DAPT laws exclude transfers that are fraudulent under discussed above) is prevalent in the Bankruptcy Code, state law from the protection of a DAPT, so that even if and indeed this section can be thought of as merely an the debtor elects state law exemptions, the trustee can exception to the general two-year rule under BAPCPA. proceed under §544(b) if state law is more exacting than federal law or if the trustee is within the usual four year a. Are DAPTs Always Made with the Proscribed statute of limitations. If federal exemptions are elected, Intent? With respect to DAPTs, and despite the the DAPT would offer no protection because the DAPT arguments of their advocates, in a bankruptcy context, it would not be (i) exempt under the federal exemptions may be difficult to argue that the transfer does not meet and (ii) excluded under the “applicable nonbankruptcy this test with creditors vigorously complaining. Many law” rubric of BC §541(c)(2). have argued that DAPT’s, particularly when the trust situs is outside of the settlor’s state of residency, serve no b. Self-Settled Estate Planning Trusts. Arguably, viable purpose other than removing assets from the reach split interests trusts which are specifically sanctioned by of the settlor’s creditors. the Internal Revenue Code or Regulations should be presumed to have been created for purposes other than b. Pattern of Distributions. It would seem that a the actual intent to delay, hinder or avoid creditors, pattern of distributions either for support or based upon except in egregious circumstances. Whether the requests from the settlor/beneficiary might reinforce the provision will be so interpreted remains to be seen. To argument that the sole purpose of the DAPT was to the extent the trustee is successful in avoiding the hinder creditors. (This would be the same argument in a conveyance, the trustee should be able to reach the entire non-bankruptcy setting, but with a shorter limitations trust and not just the debtor’s retained interest therein. period.) i. Grantor Retained Annuity Trust. Because c. Badges of Fraud. As with the other provisions in GRATs are clearly self-settled trusts which are not the Bankruptcy Code dealing with actual intent, such exempt under most state laws, the annuity interest would intent may be proven by a finding of the presence of be includible in the bankruptcy estate and would not sufficient badges of fraud. qualify as a spendthrift trust under other nonbankruptcy law of §541(c)(2). If the GRAT (or GRUT) is d. Is There a Presumption? Does §548(e) create a conventionally designed for maximum gift tax leverage presumption that a DAPT created under state law, that is (e.g., a Walton GRAT), then establishing actual intent exempt under state law, was not a fraudulent would be extremely difficult in view of the fact the conveyance? Definitely not since state law does not grantor retained an annuity equal to the contribution plus create such presumption. After all, all state statutes deny some return thereon. Another issue with GRATs is that creditor most of them are very short term so that the transfer to protection if the trust’s creation was itself a fraudulent the remainder person will probably be complete before transfer. filing for bankruptcy. In that event, the settlor would no longer be a beneficiary, and §548(e) should not apply e. Proving Fraudulent Intent. One practical issue and conventional fraudulent transfer analysis and statute with the ten year time frame is that the farther away the of limitation rules would apply. transfer the more difficult the proof of actual intent. Four year statutes of limitation are in place not only to allow ii. Qualified Personal Residence Trust. The people to get on with their life after a certain period, but trustee in bankruptcy is entitled to set aside the entire also because memories tend to fade and proof disappears transfer under §548(e) and not just to acquire the right of after a certain period. occupancy which is the debtor’s sole interest.

9. Self-Settled Trusts. For estate planning lawyers, iii. Charitable Remainder Trust. The trustee in the most troublesome language in the section is that bankruptcy can reach the entire transfer. It will be which makes a transfer to a “self-settled trust or similar interesting to see how many trustees would try to take 22

Conservative Asset Protection Planning Chapter 11 assets away from a charity? And there really is no d. Partition of Community Property. While it would statutory authority to set aside a portion of the transfer. seem that this technique would fall outside the scope of Again, fraudulent intent in this kind of transfer may be §548(e)(1) because the spouse who files bankruptcy is difficult to prove. not a beneficiary of the property partitioned to her spouse, under the law of certain states, income from 10. Similar Device. As pointed out above, there are separate property is still community property, and thus issues even with the direct object of this provision. Still the bankrupt spouse could arguably be a beneficiary, more frightening is what the bankruptcy trustee and the even though the income may be subject to the sole bankruptcy court might determine to be a similar device. management of the owner-spouse. (Note that Texas has Estate planners use many techniques for discounting or a presumption that income from a gift of community wealth transfer that may contain an element of creditor property is the separate property of the donee-spouse. protection, but such estate planners would not consider However, by statute, the income from partitioned many of them to be “similar devices” to a DAPT. And, property is community property unless the partition even if such technique is a similar device, §548(e) does agreement provides to the contrary). In many ways, not apply unless actual intent can be shown. Because however, the partition is simply another way of most of these techniques (a term vastly preferable to the rearranging ownership and should not be subject to the more pejorative term “device”) are used in connection similar device analysis. Even if the partition is unequal, with traditional tax favored wealth transfer planning, the analysis should be a “fraudulent transfer” analysis there ought to be almost a presumption that the rather than a “similar device” analysis. This should be technique, even if considered a “similar device” usually true even if the partition puts exempt assets in the hands is not entered into with the “actual intent” required by the of the potential debtor and non-exempt assets in the statute. While advocates of DAPTs would argue that hands of the spouse. they are also wealth transfer devices, the author does not believe that their primary function is wealth transfer e. Inter-Vivos QTIP. This technique is frequently and/or estate tax avoidance. used in common law jurisdictions to assure the ability of each spouse to take advantage of the full unified credit. a. Retirement Plans. Some commentators have While it has the effect of putting assets out of the reach suggested that an IRA or retirement plan by a controlling of the donor spouse’s creditors, its use would seem not to shareholder (or perhaps even one by an employer where be a similar device since the donor spouse is not a current participation is elective) is a similar device. That beneficiary. However, note the question raised above proposition would seem difficult to sustain in view of the about contingent interests. Suppose the donee spouse has elaborate provisions in §522(b)(3)(C) and 522(d)(12), not a special power of appointment which includes the donor to mention the exclusion of ERISA qualified employer among the class of potential appointees. The better plans under §541(c)(2). argument would seem to be that this transfer is not a similar device, but how many bankruptcy judges (or b. Life Insurance and Annuities. Many states have lawyers for that matter) are going to understand the statutes that are extremely favorable to life insurance and workings of an inter-vivos QTIP. annuity policies, exempting both the policies and their proceeds from claims of creditors of the owner of the f. Family Limited Partnerships. The most difficult policy and the beneficiary unless the transfer to acquire technique to analyze is the FLP, which typically or maintain the policies constituted a fraudulent transfer. combines wealth transfer planning with asset protection. Absent egregious facts, it would seem difficult to attach And with a long series of FLP cases requiring substantial badges of fraud to such policies. It may be slightly easier purposes other than estate tax avoidance, there may be a to attack anuities if the debtor was wealthy at the time the danger (for asset protection purposes) in expressly policy was acquired because of the apparent lack of need arguing before the IRS or in tax court that one such non- of an income stream in later years. However, there are tax purpose FLP’s serve is asset protection. However, the arguments concerning tax deferred growth and even the analysis used in many tax cases may be instructive in creditor protection if there were no reasonably the bankruptcy context. One of the elements relied upon foreseeable creditors on the horizon. in Strangi v. Commissioner, 429 F.3d 1154 (5th Cir. 2005) as well as other similar cases was the amount of c. Life Insurance Trusts. In life insurance trusts, the assets the settlor is not a beneficiary and thus this would not meet transferor placed in the partnership in relation to total the definition of a self-settled trust. A “similar device” wealth. This is very similar to the badges of fraud and must also meet the requirement that the person insolvency test. And, if asset protection is only one establishing the device be a beneficiary. 23

Conservative Asset Protection Planning Chapter 11 benefit, does that, in itself, rise to the level of actual 2. Constitutional Issue. It is clear that if a debtor intent? voluntary elects to avail himself or herself of the protections of bankruptcy law, the debtor cannot 11. Transfers by Evil People. Bankruptcy Code complain about the loss of certain state law exemptions. §548(e)(2) includes in the definition of a “transfer” But there appears to be a serious constitutional question, certain transfers involving judgments and criminal fines, raised by bankruptcy judges and academics, as to “incurred or which the debtor believed would be whether such rights may be taken away involuntarily. incurred” for certain securities laws violations and This could be one of the more interesting issues to watch. “fraud, deceit or manipulation in a fiduciary capacity.” Some have argued that this is a limitation on (e)(1), but 3. Can You Even Have An Involuntary the better view is that it is in addition to the general self- Bankruptcy? One commentator has argued that the settled trust rule. It is believed that this section provides credit counseling requirement under Bankruptcy Code the “actual intent” as a matter of law. §109(h) applies to every individual bankrupt, and thus, if the debtor simply fails to take the credit counseling, the 12. Why This Is So Unsettling. Uncertainty in the law bankruptcy action, even an involuntary bankruptcy, brings an inability to properly advise clients in the must be dismissed. This argument seems to go a bit too planning and structuring of their affairs. As with the rest far to be credible, and will meet the same fate as the opt- of BAPCPA, this provision is so poorly drafted that it is out state controversy on homesteads.. inevitable that it will create uncertainty. Compound this with the fact that it will be argued by bankruptcy lawyers M. A Closing Thought. Despite the fact that Congress who have no knowledge of estate planning techniques, had more than ample time to refine the language of the and will be decided by bankruptcy judges, who probably Act, BAPCPA is a very poorly drafted statute which will have even less knowledge, and you have a recipe for create problems for estate planners (and bankruptcy disaster reminiscent of the early days of arguments as to lawyers) for many years to come. In discussing the the effect of bankruptcy on qualified retirement plans. homestead exemption, the Kaplan court (331 B.R. 483, Bankr. S.D. Fla. 2005) stated in a microcosm what is true K. Dismissal For Abuse. As to a non-consumer of the entire act: debtor, the standards under which a bankruptcy case may be dismissed have not changed. Bankruptcy Code Over the coming months, or years, §707(a). As for consumer debtors, a multitude of new courts will need to wrestle with some requirements must be met. The case can be dismissed if interpretation issues in calculating the the consumer debtor meets the means test but does not available exemptions under the cap in voluntarily convert to a Chapter 11 or Chapter 13. §§522(p) and (q), including, for example, how to handle appreciation in L. Involuntary Bankruptcy. The rules on involuntary the property. Courts should focus on bankruptcy are not materially changed by BAPCPA. these issues and the scores of other Bankruptcy Code §303. If the bankrupt has 12 or more issues arising under the Reform Act that unsecured creditors it takes three creditors to force the will engender bona fide debate.” debtor into involuntary bankruptcy; with less than 12, it takes only one. In either case, the debts among the three If anything, that observation is an understatement. or one debtor must aggregate $12,300.00. V. PRELIMNARY CONSIDERATIONS FOR 1. Who Are Creditors? While almost everyone has PRESERVATION PLANNING. twelve creditors when recurring monthly bills are In designing a preservation plan for a client, care counted, some bankruptcy courts have held that such “de must be taken to document the that all estate planning minims” debts do not count toward the twelve creditors. techniques which include the transfer of assets were not See Denham v. Shelman, 444 F.2d 1376 (5th Cir. 1971) undertaken in actual or constructive fraud of preexisting (“It is a well settled proposition that insignificant debts or anticipated creditors and that the client was “solvent” which are customarily paid on a regular basis should not immediately before and immediately after the transfer. be counted to defeat an involuntary petition.”) Cited in In re Smith, 123 B.R. 423 (M.D. Fla. 1990). For a A. First Satisfy Yourself You Can Represent the professional then, it might be difficult to find 12 Client. Before the practitioner accepts the creditors, and thus one malpractice claim could result in representation, he must first satisfy himself that the an involuntary bankruptcy. client’s motives are clean, i.e., the client is not undertaking the plan with an actual or constructive intent 24

Conservative Asset Protection Planning Chapter 11 to hinder, defraud, or delay creditors. This will require a solvency balance sheet attached) and general intent. As careful examination of the client’s motives and a careful mentioned above, the insolvency of a client before or review of the client’s current financial condition. In immediately after a transfer, is an important [and often many instances, the client’s clean motives and obvious conclusive] badge of fraud, however evidence of other solvency (as described below) can be determined during badges of fraud can also tip the scale against the client the initial interview (e.g., if the client is a long-time and against the practitioner’s representation of the client. client). A few comments about the affidavit of solvency are appropriate: B. Solvency Balance Sheet and Affidavit of Solvency and General Intent. It is very important for the C. Affidavit Helps Avoid Implications of Fraud. practitioner to satisfy himself that the client is [and will] The affidavit is admittedly self serving but does offer remain “solvent” both before and immediately after the some protection for the practitioner if a judgment creditor plan is implemented. However, as noted above, in the makes a claim against the practitioner for participating in context of asset protection planning, a person is a fraud: considered “solvent” if the fair market value of his nonexempt assets exceeds the fair value of his liabilities i. The affidavit attempts to address the including contingent liabilities. Consideration should nonexistence of the following nonfinancial therefore be given to requiring the client to prepare a badges of fraud: pending litigation, threatened solvency balance sheet both before and immediately after litigation, secret reservation of an interest in the plan is implemented. An example of such a balance any transferred property, transfer shortly sheet with regard to our hypothetical family is attached before or after substantial debt is likely to be as Annex A. A few comments regarding the “solvency incurred, transfer shortly before the client balance sheet” are in order: intends to enter into a risky business that could give rise to liabilities beyond the client’s i. The balance sheet should be signed by the ability to pay. client(s). ii. The client should consider signing another ii. If practicable, the balance sheet should be affidavit (and providing another “solvency certified as accurate by the client’s CPA, to the balance sheet”) shortly after the preservation best of the CPA’s knowledge and belief. plan is fully implemented. The latter affidavit iii. Rule of Thumb: If the fair market value of the would allow the client to affirm that he did not liquid assets is not 200% of the client’s retain a secret reservation of an interest in the liabilities (including contingent liabilities), transferred property or continued to enjoy the consideration should be given to obtaining transferred property. formal valuations of hard-to-value assets (e.g., real estate, limited partnership interests, closely D. Engagement Letter. After the practitioner has held stock) and such valuations must reflect satisfied himself that he can ethically represent the client, lack of control and lack of marketability he should require the client to sign an engagement letter discounts. that sets forth the scope of the representation and the fee iv. Valuing contingent liabilities may be arrangements. particularly problematic. If the client is defendant in an actual or threatened lawsuit, an VI. EXAMINATION OF VARIOUS ESTATE attempt should be made to have defense PLANNING TECHNIQUES AND TOOLS IN counsel assess a value to the claim including THE CONTEXT OF PRESERVATION the client’s out- of-pocket defense costs. In PLANNING. some instances, a client can easily obtain such A. Outright Gifts C Advantages. Outright gifts of a letter. In other cases, defense counsel may property have long been an important and effective estate refuse to provide any information regarding the planning tool. Those gifts (1) are easy and inexpensive value of the claim. In those instances, the to make; (2) can permanently remove property (and practitioner may have no choice but to include appreciation) from the donor’s estate for federal estate the entire value of the claim as a debt. tax purposes even if the donor dies within three years of a gift (thereby saving tax dollars); (3) can achieve some After the practitioner has been provided with a “solvency limited income shifting benefits for donees who are balance sheet” demonstrating that the client is solvent, fourteen and the Client should be asked to provide the practitioner with an affidavit regarding his solvency (with the 25

Conservative Asset Protection Planning Chapter 11 older; and (4) enable the donor to observe how the donee 3. Insulation from Creditor Claims. handles money, which provides insight into testamentary a. Of Donor. Whether gifts under a spendthrift trust, planning. under which the donor is not a beneficiary, will be useful Assuming no actual or constructive fraud, the as a “preservation planning” tool will generally require effectiveness of outright gifts as a “preservation examination of the same factors as are examined with planning” respect to the preservation planning potential of outright tool will in large part depend on whether the parties can gifts. Accordingly, absent a clearly manifested actual establish that the gifts were not fraudulent as against intent to hinder, delay or defraud creditors, the main preexisting creditors especially if the donee is a family inquiry will be on whether the gift to the trust rendered member. If the gift is attacked as a fraudulent the donor insolvent or was made at a time when the conveyance, it is critical the donee be able to prove that donor was insolvent. If at or after the gift in trust, the the gift did not render the donor insolvent (exclusive of donor does not have sufficient nonexempt assets to pay the gift and property not available for execution) and was his debts, it is unlikely that the gift in trust will afford not made when the donor was insolvent (exclusive of the any real protection. gift and property not available for execution). See, e.g., Maddox v. Summerlin, 49 S.W. 1033 (Tex. 1899) b. Of Beneficiary. In those states which recognize (burden of proof lies with the donee to show that when spendthrift trusts, it is clear that if the spendthrift trust is gift was made, the donor-spouse had enough property validly created, the creditors of a beneficiary will have no remaining to pay off his debts). If the donee cannot greater claim to the assets of the trust than the beneficiary sustain such proof, the gift may be voidable under state could have. Accordingly, if the trust is a purely law and under federal bankruptcy law. Bankruptcy Code discretionary trust and the beneficiary has no right of ' 548. withdrawal, the beneficiary’s interest should be insulated from the claims of his creditors and any attempt at B. Gifts to Spendthrift Trust C Donor Not a alienating, pledging, or otherwise charging his beneficial Beneficiary. interest in the trust should be void. First Bank & Trust v. 1. Advantages. Gifts in trust offer all of the same Goss, 533 S.W. 2d 93 (Tex. Civ. App. C Houston [1st advantages of outright gifts, with the added advantage of Dist.] 1976, no writ); Baker v. The Vermont Bank & ongoing management for trust beneficiaries. If the trust Trust Co., 342 F.2d 12 (2d Cir. 1965) (applying Vermont does not permit voluntary assignment or alienation by the law); Johnson v. Morawitz, 292 F.2d 341 (10th Cir. beneficiary of his or her beneficial interest in trust, or 1961) (applying Kansas law); Patton v. Patrick, 123 Wis. involuntary attachment of such interest by the 218, 101 N.W. 408 (1904). This rule is subject, of beneficiary’s creditors, the so-called “spendthrift trust” course, to the special rule regarding indebtedness may also offer the added advantage of insulation of trust incurred by a beneficiary relating to the support of assets from the claims of a beneficiary’s creditors. dependents. Thus, the preservation planning usefulness of a spendthrift trust from the focus of a beneficiary is 2. General Rules Re: Spendthrift Trusts. Although quite good assuming that the fraudulent conveyance the differences of the various state laws are wide, most obstacles can be avoided. states have long recognized that an individual is free to establish a trust for the support and maintenance of a 4. Extra Care if Donor is Trustee of the Trust. The beneficiary which prevents the beneficiary from donor should not be a trustee of the trust. This voluntarily or involuntarily assigning or alienating his prohibition makes sense from an estate and income tax interest. See, e.g., Tex. Prop. Code ' 112.035. Some standpoint since a trust under which the settlor is a common exceptions to this rule are that spendthrift trust trustee could, if not properly drafted, be included in the protection will not generally be available if the settlor is donor-settlor’s estate for federal estate tax purposes, or also a beneficiary of the trust or if a creditor seeks be a complete failure as an income shifting tool. Cf. Rev. reimbursement from the trust for expenses incurred for Rul. 79-353, 1979-2 C.B. 325; United States v. the legal support and maintenance of a beneficiary’s O’Malley, 383 U.S. 627 (1966); Cf. I.R.C. ' 674. dependents. See e.g. Tex. Prop. Code ' 112.035(d). However, if the donor insists on being the trustee, extra However, the legislatures of a handful of states (most care should be taken (1) to insure the gift is complete for Notably Alaska and Delaware) have reformed their trust federal gift tax purposes, (2) to avoid inclusion of the laws specifically to allow for self-settled spendthrift trust in the donor’s estate, and (3) to avoid violating the trusts, as discussed below. Practitioners should grantor trust rules (unless a defective grantor trust is determine the status of spendthrift trusts in their desired). particular jurisdiction as well as the exceptions and/or limitations that may apply. 26

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5. Creditor Protection if Beneficiary is Sole Trustee. the trust assets as part of Husband’s bankruptcy estate. Section 541(a) of the Bankruptcy Code provides that if Held: trust was not a valid spendthrift trust under Illinois the debtor is a beneficiary of a spendthrift trust valid law because Husband had “unregulated dominion and under applicable state law, then the assets of the trust are control over the corpus of the trust.” not considered property of the bankruptcy estate. However, does this rule apply if the beneficiary is the ii. In Re Pugh, 274 B.R. 883 (AZ 2002). In this sole trustee of the trust under which the beneficiary is not case, Mother died and created a discretionary the settlor? Answer: It depends on the state law testamentary trust for Son and named Son as trustee. The applicable to the trust and/or how the trust is actually trust had an anti-alienation (i.e., spendthrift) clause. The administered. trust provided that no distributions can be made to Son unless Son appointed a “person of suitable age and a. Individual is Sole Trustee and Sole Beneficiary. If discretion to serve as co-trustee.” Son appointed Sister as the beneficiary is the sole trustee and also has the entire a co-trustee but never told her of the appointment and beneficial interest, then the legal title and beneficial title continued to use the trust assets without any oversight will merge and the spendthrift provision will no longer from Sister or anyone else. Son filed for Chapter 7 apply because the trust will terminate as a matter of law. bankruptcy and the bankruptcy trustee sought to include 2 A. Scott & Fratcher, The Law of Trusts ' 99. As a assets of the trust as part of the bankruptcy estate. Held: practical matter, in a well drafted trust, legal title and Court found that Son was in fact the sole trustee. beneficial title will not merge because of the existence of Accordingly, because Son was the sole trustee, Arizona remainder beneficiaries. In such instances, the spendthrift statutory and case law invalidated the spendthrift provision may be valid even if the sole current provisions. beneficiary is also the sole trustee. iii. Restatement (Third) of the Law of Trusts. b. Texas Saves Sole Trustee Spendthrift Trusts. Section 60, Comment g of the Restatement (Third) of the Texas law avoids application of the merger doctrine in a Law of Trusts states that sole trustee of a trust under sole trustee/sole beneficiary trust if the trust is designated which the trustee is a beneficiary does not receive a spendthrift trust and if the settlor is not the trustee. In spendthrift trust protection even though subject to a such instances, Texas courts will appoint a new trustee or distribution standard such as HEMS. The theory is that co-trustee thereby avoiding the merger of interests and the trustee has effective control over the trust assets and termination of the trust. ' 112.034(c).Tex. Prop. Code. their distribution. The Restatement (Third) thus applies Furthermore, Texas law specifically provides that the same rule that Restatement (Second) applied to self spendthrift trust protection is not lost if the beneficiary is settled trusts, i.e., that a creditor of a trustee-beneficiary the sole trustee so long as distributions to that beneficiary can reach as much of the trust assets as could have been are limited to an ascertainable standard such as health, distributed to the trustee-beneficiary. education, maintenance and support. ' 112.035(f).Tex. Prop. Code. d. Drafting Pointers. In those states, such as Texas, that give effect to spendthrift trust language even if the c. But Certain Bankruptcy Decisions and beneficiary is the sole trustee, drafting trusts to permit the Restatement Put Sole Beneficiary/Sole Trustee beneficiary to be the sole trustee of his “spendthrift” trust “Spendthrift Trusts” At Risk B at Least in Certain would appear to be effective to insulate the trust’s assets States. Practitioners must look to local law to determine from the claims of the beneficiary’s creditors. if sole trustee/sole beneficiary trusts will be accorded Nonetheless, if asset protection is an important spendthrift trust protection. consideration, consider the following:

i. In Re McCoy, 2002 U.S. Dist. LEXIS 13239 i. First and foremost, make sure the trust has an (ND, Ill. 2002). In this case, Wife died and created a anti-alienation (i.e., spendthrift) provision. A testamentary trust naming Husband as trustee. Under the form of spendthrift clause is as follows: trust, Husband was to receive all income at least quarter- annually for Husband’s lifetime. Husband/trustee was Spendthrift Trust Provision. Each trust created also empowered, under the trust instrument, to distribute hereunder is a spendthrift trust. Accordingly, corpus to himself as he required or desired for Husband’s prior to the actual receipt of property by any health, support, and maintenance without regard to the beneficiary under the terms of any trust created interests of any other beneficiary. The trust had a typical by this instrument, no property (income or anti-alienation (i.e., spendthrift) clause. Husband filed for principal) distributable under that trust shall be bankruptcy and the Chapter 7 trustee sought to include subject to anticipation or assignment by any 27

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beneficiary, or to attachment by, or Trust Committee. interference or control of, any creditor or assignee of any beneficiary, or be taken or A. Appointment of Trust Committee. I reached by any legal or equitable process in hereby appoint a Trust Committee (herein so- satisfaction of any debt or liability of any called) for each trust created hereunder and that beneficiary. Any attempted transfer or committee shall be composed of [MEMBERS]. encumbrance of any interest in that property by If membership in a committee is reduced to less any beneficiary hereunder prior to distribution than three (3) individuals, the remaining member shall be void. or members of that committee shall appoint a sufficient number of individuals to bring the ii. Appoint an independent corporate fiduciary as total membership of the committee to a total of the sole trustee of the trust. three (3) individuals. If at any time there are no iii. Provide for a very strong facility of payment members serving under a Trust Committee, then clause so that the trustee may make the adult beneficiaries of the applicable trust distributions for the benefit of the beneficiary who are entitled to have income distributed to or directly to third parties without making actual accumulated for their benefit, if any, and if none, distributions to the beneficiary. any beneficiary of any trust created hereunder, iv. Or appoint one or more independent individual may appoint three (3) individuals to serve on trustees as the only trustee(s) of the trust. In that committee. Such an appointment shall be this context, an independent trustee would be a by an acknowledged instrument delivered to all individual who is not related or subordinate to individuals so appointed. Under no the beneficiary. circumstances shall any Trustee who is removed v. Or appoint the beneficiary as a co-trustee with by a Trust Committee serve on any Trust a corporate fiduciary or individual independent Committee hereunder. No beneficiary of any trustee but give investment powers to the trust created hereunder or Trustee of that trust beneficiary/trustee and distribution powers to shall serve as a member of the Trust Committee the corporate of individual independent co- for that trust. It is my intention that there shall trustee. always be three (3) members serving on each vi. If the beneficiary is a sole or co-trustee and the Trust Committee hereunder. trust is a discretionary trust, the trustee(s) should be limited to making distributions to the B. Powers of Trust Committee. The Trust beneficiary for his health, education, Committee for each trust created hereunder shall maintenance and support, after taking into have the discretionary power, by majority vote, account other financial resources available to to remove at any time a Trustee of that trust the beneficiary. (other than my Spouse but including, if vii. If the beneficiary is a sole or co-trustee of a applicable, a Co-Trustee appointed by any trust which may be used for his support, do not individual Trustee) and, in its discretion, appoint include a provision that says that the trustee’s a successor Trustee. The powers granted under shall act in his sole and absolute discretion or this subsection must be exercised by that the exercise of his discretion shall be acknowledged instrument, signed by those binding and conclusive on all parties. members of the committee intending to exercise viii. Do not give the beneficiary a withdrawal right those powers, and delivered to the Trustee being over the trust. removed and, if applicable, to the successor ix. Include a provision in the governing Trustee being appointed. No Trustee or member instrument empowering one or more of the Trust Committee for that trust shall be independent individuals to remove and replace liable for the exercise of or failure to exercise a trustee. This power can even be given to the that committee’s discretionary powers granted beneficiary, but in that case the power should hereunder. No member of any Trust Committee be limited to the appointment of a corporate hereunder shall have any duty to monitor the trustee or an individual who is not related or performance of a Trustee or to take any action subordinate to the beneficiary, and, of course, with respect to that trust. Further, each member should include a prohibition against the trustee of each Trust Committee hereunder shall be held appointing himself. If it is desired to use a harmless and indemnified from the assets of the committee, the following language could be applicable trust for any claim or cause of action included in the trust to achieve this result: filed against that committee member for 28

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exercising or failing to exercise that committee’s specifically protect benefits under an annuity contract discretionary powers hereunder. Any Trustee from the reach of creditors. Tex. Ins. Code Art. appointed by a Trust Committee must be an 1108.051; Ind. Code Ann. ' 27-2-5-1. Independent Trustee. D. Irrevocable Life Insurance Trusts. C. Life Insurance. 1. Description of Technique. 1. General. Life insurance has long been a favored a. General. The irrevocable life insurance trust has estate planning (and estate creation) tool. Furthermore, long been a useful and popular estate planning tool. despite the seven-pay test of I.R.C. ' 7702A, it has also Under this arrangement, the settlor generally establishes been “tax favored.” For example, the so-called “inside an irrevocable trust for certain designated beneficiaries build-up” on participating (i.e., dividend paying) and (e.g., his children). The trustee of the trust then becomes nonparticipating cash value policies can occur on a “tax the owner and beneficiary of a life insurance policy on deferred” basis, and with few exceptions, the insurance the settlor’s life or on the lives of the settlor and the proceeds will be received by the beneficiary(ies) free settlor’s spouse (either through an original purchase by from any income tax. Theodore H. Cohen, 39 T.C. 1055 the trustee or through a gift of the policy to the trustee). (1963) (cash values); I.R.C. ' 72(e)(1)(b) (dividends); Since the trust does not generally have sufficient cash I.R.C. ' 101(a). with which to make premium payments that cash is generally provided by the settlor or other individuals 2. Preservation Planning Potential. Assuming the through cash gifts to the trust. client has not violated state or federal fraudulent A distinguishing characteristic of an irrevocable life conveyance statutes through the purchase of insurance or insurance trust is that each beneficiary is generally given a plan or program of annuities, state life insurance a 30- to 60-day right to withdraw his or her pro rata exemption provisions seem to offer some interesting portion of each gift to the trust. If the withdrawal right is preservation planning as follows: not exercised, it lapses as to that year. The purpose of the withdrawal right is to cause such gifts to be a. Purchase of Interest Sensitive Life Insurance considered gifts of a “present interest” thereby qualifying Policies including Whole Life, Universal Life and for the annual per donee gift tax exclusion under I.R.C. Variable Life. A client who seeks to achieve certain ' 2503(b). See Crummey v. C.I.R., 397 F.2d 82 (9th Cir. preservation planning objectives, should consider 1968); Rev. Rul. 73-405, 1973-2 C.B. 321; Mary Hull purchasing an interest sensitive life insurance policy, Naumoff, 46 T.C.M. 852 (1983). including whole life, universal life, or variable life (which provides the potential for market appreciation) b. Primary Reasons for Use. The primary estate rather than term insurance. This would appear to offer planning advantages in using these trusts are: (1) substantial protection to a designated beneficiary complete exclusion of the insurance proceeds from the assuming that the client has not purchased such policy gross estates of the settlor and the settlor’s spouse, (2) with an intent to hinder, defraud or delay creditors. avoidance of the onerous generation-skipping transfer Notwithstanding the rules for modified endowment tax, and (3) availability of the insurance proceeds to the contracts as provided under I.R.C. ' 7702A, single estate of the settlor and the settlor’s spouse by premium whole life may also be a useful preservation empowering the trustee, on a discretionary and planning tool. The adverse income tax consequences can nonbinding basis, to purchase assets from or loan money be minimized if the taxpayer/insured waits until he or she to an estate. attains age 59-1/2 before borrowing from or otherwise receiving distributions from the policy. 2. Effectiveness of Technique As a Preservation Although some states limit the protection afforded Planning Tool: life insurance cash surrender values, other states appear a. Insulation from Claims of Settlor’s Creditors. to grant an unlimited exemption. For example, Texas Since the settlor-insured should never be a beneficiary of appears to offer unlimited protection. See, e.g., Tex. Ins. this trust, the effectiveness of the irrevocable trust to Code Art. 1108.051. insulate life insurance trust assets (including proceeds paid to the trust upon the death of the settlor) from the b. Nonqualified Deferred Annuity. Consideration claims of settlor’s creditors will largely depend upon could also be given to implementing a deferred annuity whether any transfers to the trust are considered program either independently or through the client’s fraudulent conveyances or ineffective gifts within the employer if the client is an owner of a closely held meaning of state fraudulent conveyance provisions or business or is in a position to influence the employer’s Bankruptcy Code ' 548. If any portion of the trust is decisions in this regard. The statutes of several states attributable to prior fraudulent conveyances, that portion 29

Conservative Asset Protection Planning Chapter 11 may be reachable by the creditors of the settlor or the 1976-1 C.B. 293, and Ltr. Rul. 8350004 (August 17, settlor’s estate. 1983). However, state exemption statutes may prevent creditors of the beneficiary from reaching those proceeds b. Insulation from Trust’s (or Trust Beneficiaries’) so long as the lapse of a withdrawal right itself is not Creditors. considered a transfer subject to the fraudulent i. Invariably Designated a Spendthrift Trust. conveyance statutes. See, e.g., Tex. Prop. Code ' Irrevocable life insurance trusts are invariably designated 112.035(e). as spendthrift trusts by the practitioner. This is done to protect the proceeds from the claims of the trust E. Marital Property Partitions (Community beneficiaries’ creditors. As indicated earlier, spendthrift Property States). trusts are generally upheld under the laws of most 1. Traditional Uses for Such Agreements. Marital jurisdictions. Accordingly, prior to distribution, trust property partition and exchange agreements between assets should be insulated from the beneficiaries’ spouses domiciled in community property states creditors because of the “spendthrift trust provisions.” (hereinafter called “marital property agreements”) have But see discussion below regarding the lapse of a been used by estate planning lawyers for a variety of withdrawal right. reasons. Some of the more common uses are as follows:

ii. Applicability of Exemption Provisions. Even a. In Funding Irrevocable Life Insurance Trusts. It if the spendthrift provision is found to be invalid, state may be advisable to create separate property out of life insurance exemption statutes may insulate trust assets community property to enable the noninsured spouse to from the trust beneficiaries’ creditors. Because many of fund, with her separate property, an irrevocable life such statutes offer protection from the beneficiary’s insurance trust that purchases and maintains a life creditors, a literal reading of such statutes would offer insurance policy on the life of the insured-spouse. If the protection to the trust itself since it is literally the insured dies within three years after the trust purchases beneficiary of the life insurance proceeds. However, if the insurance, the proceeds would arguably be removed such provisions are interpreted to include, within the from the insured’s estate. See I.R.C. ' 2035(d)(2) (which definition of beneficiary, “beneficiaries of the trust”, appears to apply only if the transferor (or deemed additional creditor protection may be available. transferor) of the life insurance policy was the insured; Headrick v. Commissioner, 918 F.2d 1263 (6th Cir. iii. Does Beneficiary Become a Grantor When 1990); Estate of Joseph Leder, 893 F.2d 237 (10th Cir. Withdrawal Right Lapses? As discussed earlier, when 1989); Ltr. Rul. 8906003 (September 16, 1988). gifts are made to an irrevocable life insurance trust, each Alternatively, the insured-spouse may need separate beneficiary is usually given a right to withdraw his or her property to fund the irrevocable life insurance trust so pro rata portion of the gift for a specified period. When a that the noninsured spouse can be a beneficiary of the beneficiary allows his or her withdrawal right to lapse, trust without running afoul of I.R.C. '' 2036 and 2038. for gift tax purposes, the beneficiary is deemed to have If the noninsured spouse is a beneficiary and is deemed made a gift of the property subject to the power, subject to have made one-half of the gifts (e.g., because of to the so-called “$5,000 or 5%” exclusion. I.R.C. community property laws), one-half of the trust proceeds '' 2514(b) and (e); I.R.C. ' 2041(b)(2). Although no would arguably be includable in her estate at her case addressing the issue was found, it may also be true subsequent death. that under state property law, a beneficiary is deemed to have made a transfer of property when he or she allows b. To Create an Estate in the Nonwage Earning his or her withdrawal right to lapse. If so, that Spouse. The spouses may wish to partition community beneficiary has then become both a settlor and property (e.g., cash, marketable securities or other liquid beneficiary of the trust possibly invalidating the assets) to create an estate in the spouse who works inside spendthrift feature of the trust. The argument would be the home raising the children and managing the that the spendthrift trust provision is invalid with respect household. to any portion of the trust attributable to the beneficiary- debtor’s lapsed withdrawal rights. For examples in 2. Background. which gifts to a trust by a settlor under which he was a a. General. Marital property agreements are permissible beneficiary were held to be incomplete gifts specifically authorized by statute in Texas and California. because of the invalidity of underlying spendthrift For example, Section 4.102 of the Texas Family Code clauses, see Outwin v. Commissioner, 76 T.C. 153 provides that spouses, at any time, may enter into a (1981), Rev. Rul. 76-103, partition or exchange agreement between themselves with respect to any part of their community property then 30

Conservative Asset Protection Planning Chapter 11 existing, or to be acquired, and that the property d. Consider Recording Marital Property transferred to a spouse as a result of such agreement shall Agreements. If practical, record the marital property become that spouse’s sole and separate property. The partition agreement to take advantage of statutes Texas Family Code also provides that spouses may agree providing for constructive notice when such an that income or property arising from the separate agreement is properly recorded. For example, Texas property then owned by either of them, or which may Family Code '4.106(b) provides that a marital property thereafter be acquired, shall also be the separate property agreement between spouses may be recorded in the deed of the owner. Tex. Fam. Code ' 4.103. In Texas, such records where the spouses reside and in each county an agreement must be in writing and must be signed by where real property affected by the agreement is located. both spouses. Tex. Fam. Code ' 4.104. The statute goes on to provide that with respect to real property, if the partition or exchange agreement is b. Effect of Marital Property Agreements on recorded in the county where the real property is located, Creditors. Generally, if a conveyance between spouses such recordation shall serve as constructive notice to a is supported by adequate consideration and does not good faith purchaser for value or a creditor without involve fraud or undue influence, the transaction will be actual notice. Tex. Fam. Code '4.106(b). enforced by courts. If such a transaction is in fraud of creditors, the conveyance may be set aside under state Practice Pointer. Some clients are timid about fraudulent conveyance statutes. See e.g. Tex. Fam. Code recording a partition agreement that lists the ' 4.106. values of the assets to be partitioned. If so, consider having the spouses execute several 3. Marital Property Partition as Preservation copies of the partition agreement and make Planning Tool. Assuming that the partition agreement is sure that one of the copies has omitted the entered into without an actual or constructive intent to values of the assets. Use that executed original commit fraud against a preexisting creditor and the for purposes of recordation. If the document is transferor-spouse is not insolvent at the time of the to be recorded in several counties, consider partition or rendered insolvent because of the partition, execution of multiple copies. the marital property agreement can be a useful preservation planning tool. This is because the property Recordation also eliminates the element of secrecy in the set aside to a nondebtor spouse would become the sole transaction. As discussed earlier, undue secrecy is a and separate property of that spouse and may not be common badge of fraud. TBCC ' 24.005(b)(3); United subject to the liabilities of the other spouse unless both States v. Leggett, 292 F.2d 423 (6th Cir.), cert. denied, spouses become liable by other principles of law. 368 U.S. 914 (1961).

4. Post Partition Safeguards. If a marital property e. Revise Financial Statements. Remove the partition agreement is entered into between the spouses property set aside to the nondebtor spouse from the for the purpose of creating separate property in a debtor spouse’s balance sheet. nondebtor spouse, it is essential that the integrity of the agreement be preserved by following certain post f. Separate Books. Have the nondebtor spouse partition safeguards. Consider the following checklist: maintain a separate set of books with respect to his or her separate property. a. Retitle Property. Take all necessary steps to retitle (in the sole name of the wife) separate property set aside g. Document Nondebtor Spouse Loans to the to the wife as her sole and separate property; and retitle Debtor Spouse. If it is necessary for the nondebtor (in the sole name of the husband) separate property set spouse to advance funds to the debtor spouse, document aside to the husband as his sole and separate property. all such advancements as loans and consider securing such loans. b. Proper Tax ID Number. Make sure bank accounts, brokerage accounts, and similar accounts bear h. Sign No Agreements Creating a Charge Against the social security number of the spouse in whose name Nondebtor Spouse’s Estate. If one of the purposes of the account is styled. the marital property partition agreement is to insulate the separate property set aside to the nondebtor spouse from c. Sign and Record Deeds. Make sure deeds the business risks thereafter assumed by the debtor conveying real and personal property are properly signed spouse, caution the nondebtor spouse against signing and recorded. loan guarantees, promissory notes, partnership

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Conservative Asset Protection Planning Chapter 11 agreements, or any other agreements which could create interest (i.e., the gift) would be valued at a charge against the nondebtor spouse’s assets. $352,210.00. If the home appreciates at 6% per year, at the end of fifteen years the home would i. Avoid Commingling of Assets. Avoid be worth approximately $2.4 million. If Jane commingling any jointly owned or community property has outlived the trust term, substantial value has with the separate property set aside to the nondebtor been transferred at a very low gift tax cost. spouse. Moreover, since the home has a use value rather than an income stream, Jane had no j. Periodically Reaffirm the Agreement. Reexecute accumulation of income as in the case of a the marital property partition agreement every few years. GRAT or GRUT. This could serve as a useful cleanup of problems if commingling has occurred. 3. Advantages of Qualified Personal Residence Trust. The main estate planning advantages to this F. Qualified Personal Residence Trust. technique are as follows: 1. Background. Chapter 14 of the Code contains valuation rules applicable to certain gifts under which the a. Value Shifting With Minimum Gift Tax transferor retains an interest. These rules are designed to Consequences. If properly structured and implemented, prevent the overvaluation of the retained interest (and if the term holder outlives the term of the QPRT, none of therefore the undervaluation of the residual or remainder the residence should be included in the term holder’s interest passing to the donee) by requiring that the estate for federal estate tax purposes. Thus, any retained interest meet certain conditions. If those appreciation in value occurring after the gift will be conditions are not met, the retained interest is required to shifted to the remainderman. have a zero value. Since the thrust of Chapter 14 is that the valuation of the gift is equal to the valuation of the b. Retained Use and Enjoyment. The term holder is entire interest minus the retained interest, a zero entitled to the use, possession, benefit, management and valuation for the retained interest can result in a much control of the residence during the term of his or her larger gift. Under Chapter 14, the retained interest must estate. Authority for this proposition should be the life be in the form of an annuity interest (that is, a fixed estate cases. Blackwell v. Blackwell, 24 S.W. 389 (Tex. payment payable at least annually) or a unitrust interest 1893); Gonzales v. Gonzalez, 457 S.W. 2d 440 (Tex. (that is, annual payments equal to a fixed percentage of Civ. App. C Corpus Christi 1970, writ ref’d n.r.e.). the fair market value of the trust as determined annually). Despite these benefits, the term holder, by analogy to the If the retained interest is not in the form of an annuity or duty of a remainderman who succeeds to the interest of a unitrust interest, the value of the retained interest is zero life tenant, should also have a duty not to commit waste and therefore the value of the gift to the trust is equal to on the property and, by agreement, would generally be the value of the entire interest in the property. I.R.C. required to act prudently toward the property. Gonzalez, ' 2702(a)(2). 457 S.W. 2d at 447; Bryson v. Connecticut General Life Ins. Co., 196 S.W. 2d 532 (Tex. Civ. App. C Austin 2. Qualified Personal Residence Trust. An 1946, writ ref’d) (in general, a life tenant owes a duty to exception to the required annuity or unitrust payments is the remainderman to protect the remainderman’s interest found in the rules relating to qualified personal residence from forfeiture by reason of any act or omission on the trusts, or “QPRT.” Under this arrangement, the taxpayer part of the life tenant). transfers his homestead and/or a vacation home to his children while retaining the exclusive use, possession and 4. Technique as Preservation Planning Tool. enjoyment of the house for a fixed term. The gift is a. Transfer of Remainder Valid if Not in Fraud of equal to the fair market value of the residence less the Creditors. A QPRT should be upheld as valid as long as value of the retained interest the transfer is not in actual or constructive fraud of The QPRT may be a very effective wealth shifting creditors. However, if transfer is made with actual intent technique. to defraud, BAPCPA brings back the entire interest for a period of ten years. Example: Assume Jane, age 50, transfers a personal residence worth $1 million to a fifteen b. Limitation on Sale Without Consent of year QPRT. Assume the applicable rate under Remainderman. This technique could be attractive as a I.R.C. ' 7520 is 6%. At this interest rate, the preservation planning tool. This is because, unless retained (i.e., “use value”) of the house would otherwise provided by the instrument creating the QPRT be $640,750.00. Accordingly, the transferred or by agreement between the term holder and 32

Conservative Asset Protection Planning Chapter 11 remainderman, the term holder would not likely have a context of preservation planning because of the trustee’s power of sale over the entire fee interest in the property apparent inability under Bankruptcy Code ' 363(h) to without the consent of the remainderman. Again, sell the remainder interest (without permission from the authority for this proposition would likely rest with life remainderman) in an asset in which the bankrupt debtor estate/remaindermen cases. Although the term interest held a life estate at the time of filing. Thus, so long as would certainly be subject to execution and sale in the creation of the life estate and remainder arrangement payment of the term holder’s debts, the term interest is was not in fraud of creditors, the remainderman’s interest likely to be an unattractive asset to a creditor because should remain intact. This same logic should apply to a upon expiration of the term, the property would term holder’s interest in the QPRT. But the expanded automatically pass to the remainderman. If anyone is powers of a trustee in bankruptcy to set aside a transfer in willing to purchase the term interest, it would likely be fraud of creditors under Bankruptcy Code §548(e) will the bankrupt and then at a substantial discount. apply to QPRTs. c. Bankruptcy Trustee’s Inability to Sell G. Grantor Retained Annuity Trusts (“GRATS”) Remainder Upon Term Holder’s Bankruptcy. and Grantor Retained Unitrusts (“GRUTS”). i. Bankruptcy Code ' 363(h). Subsection 1. Description of GRATS and GRUTS. A grantor 363(b) generally empowers a trustee in bankruptcy to sell retained annuity trust (“GRAT”) or a grantor retained property of the bankruptcy estate after proper notice and unitrust (“GRUT”) could also be very useful estate hearing. In addition, if certain conditions are met, planning techniques if the trust can outperform the Subsection 363(h) empowers the trustee to sell an asset required payment (either by earning more income than is of the bankruptcy estate free and clear of an interest any required to be paid or by appreciating at a rate higher other individual (or individuals) may have had in that than the required payment). In this instance, value may asset as joint tenants, tenants in common or tenants by be able to be shifted to the remaindermen at a relatively the entirety with the debtor-bankrupt. Such sale can only low gift tax cost. occur if (a) a partition of the estate’s interest is impracticable, (b) a sale of the estate’s undivided interest Example: Assume Dad, age 55, transfers $1 would realize significantly less than if the whole property million of X Corporation, publicly-traded is sold (and parcels allocated), (c) the benefit of sale to common stock, to a fifteen year GRAT retaining the estate outweighs the detriment, if any, to co-owners, a level annuity equal to 6% of the initial fair and (d) such property is not used in the production, market value of the GRAT. If IRC Sec. 7520 transmission, or distribution, for sale, of electrical energy rate is 6%, the annuity interest would be equal or of gas for heat, light or power. to $541,410.00 and the remainder interest would be equal to $458,590.00. One year after the ii. In Re Livingston. An important limitation on transfer, X Corporation begins marketing a the scope of Bankruptcy Code ' 363 was announced by microchip that revolutionizes portable personal the United States Court of Appeals for the Eleventh computers. Despite the annual payment, the Circuit in In Re Livingston. 804 F.2d 1219 (11th Cir. value of the trust at the end of fifteen years is 1986) [hereinafter cited as Livingston]. In Livingston, a worth $5 million. Accordingly, $5 million of married couple purchased a home and because of the value has been transferred at a relatively low gift peculiarities of local (Alabama) law, the couple’s joint tax cost (i.e., $458,590.00). ownership interest was found to be a tenancy in common for life with a cross contingent remainder in fee. Thus, 2. Techniques as Preservation Planning Tools. The upon the death of a spouse, the surviving spouse would same considerations discussed above with regard to a take the entire interest by operation of law. The husband QPRT apply as well to a GRAT or GRUT. In the became a bankrupt. The trustee in bankruptcy attempted absence of any intent to hinder, defraud or delay the to sell the entire interest in the home under the authority grantor’s creditors, the transfer to the GRAT or GRUT of Section 363(h). The Eleventh Circuit upheld the should be upheld. In such a case, neither the grantor’s decision of the federal district court and held that the creditors nor a trustee in bankruptcy should be able to trustee was not empowered (under Section 363(h)) to sell sell the remainder interest without the consent of the the Debtor’s wife’s contingent remainder interest without remainder man. In Re Livingston, 804 F.2d 1219 (11th her permission. See also In re Spain, 831 F.2d 236 (11th Cir. 1986). Cir. 1987). But see discussion at IV.J9 supra suggesting that assets iii. Significance of Livingston in Preservation of the entire GRAT could be reachable by the Grantor’s Planning Context. Livingston is significant in the creditors if transfer made in fraud of creditors. 33

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H. Qualified Plans. It appears that BAPCPA’s is arguable that a literal reading of Section 541(a)(5)(A) amendment to BC §522(b)(3) provides significant asset of the Bankruptcy Code would treat such a disclaimer as protection to qualified plans and IRAs. See discussion at a voidable transfer. See, e.g., In Re Cornell, 95 Bankr. IV.G supra. Pension and profit sharing plans will 219 (Bankr. W.D. Okla., 1989). continue to be useful and popular asset accumulation arrangements so long as they retain their tax favored J. Family Limited Partnership. status. Furthermore, they enjoy the added benefit of The family limited partnership can also be a useful being exempt from the claims of the participant’s preservation planning tool depending upon the rights creditors. Shumate v. Patterson, 504 U.S. 753 (1992). accorded under local law to a judgment creditor of a partner and the applicable transfer restrictions imposed I. Disclaimers. Assume that within a few months on a partner under the partnership agreement. Under the prior to filing for bankruptcy, during a period when a typical family limited partnership, a husband and wife debtor is clearly insolvent, the debtor’s great aunt dies would each contribute assets to the partnership in leaving him $1,000,000 under her will and further exchange for large limited partnership interests (99%) providing that if the debtor had predeceased his aunt, the and general partnership interests (1%). One of the $1,000,000 would pass in trust for the debtor’s children. spouses typically serves as managing general partner Alternatively, what if the debtor’s great aunt died after he either individually or through a corporate entity that he or filed his petition in bankruptcy but before the expiration she controls. The partnership agreement requires the of 180 days after the filing? If the debtor validly consent of a large majority in interest (e.g., 80%) of the disclaims this $1,000,000 gift thereby causing it to pass partners as a condition precedent to distributions, in trust for the debtor’s children, will this disclaimer be dissolution or partition. Husband and wife would then deemed to be a fraudulent transfer under federal make gifts of limited partnership interests to their bankruptcy law? What if no bankruptcy proceeding is children, grandchildren, and/or trusts for their benefit. ever filed? If husband has financial reversals and loses his interest in the partnership to a judgment creditor, many 1. State Law. Some states have addressed the issue states’ local partnership law could relegate the judgment and held that a valid disclaimer is not a fraudulent creditor’s rights to that of an assignee of a partnership transfer because the disclaimer causes the property to interest. For example, under Section 7.03 of the Texas pass from the decedent to the alternate beneficiaries, not Revised Limited Partnership Act, the rights of a from the disclaimant to the alternate beneficiaries. See, judgment creditor of a partner are limited to a charging e.g., Dyer v. Eckols, 808 S.W. 2d 531 (Tex. App. C order against the income produced from the partnership Houston 14th Dist. 1991, writ dism’d) (court held interest of a partner. As one author puts it, “Does this judgment debtor had a right to disclaim a bequest to her mean that a limited partner’s interest cannot be lost to a without being found to have made a conveyance); judgment creditor? If the general partner has the right to Colacci v. United Bank of Boulder, 549 P.2d 1096 (Ct. withhold a distribution of income under the limited App. 1976) and Estate of Hansen, 248 N.E. 2d 709 (Ct. partnership agreement, does this mean that a creditor App. 1969). Other courts have found a disclaimer to be a having a charging order must pay income tax on income fraudulent transfer. In re Estate of Kalt, 108 P.2d 401 he, she or it never receives?” Gibbs, Faerie, Gold: How (1940). to Protect and Conserve Family Resources, Article presented to 1989 Texas Bar Convention. Furthermore, 2. Federal Bankruptcy. The result in a federal restrictions in the partnership agreement may make it bankruptcy context is less certain. The success or failure virtually impossible for the creditor to effect a dissolution of the disclaimer may depend on when the disclaimer is of the partnership without the consent of a substantial effected. Thus, if the disclaimer is executed before filing percentage in interest of the limited partners. Thus, the of the petition in bankruptcy, the disclaimer may be creditor can find himself as an assignee of a partnership upheld so long as applicable state law does not interest in a closely-held family enterprise. characterize the disclaimer as a transfer of the disclaimed Commentators have begun to speculate whether the assets from the disclaimant. See, e.g., Blackwell v. ten year recovery period afforded trustees in bankruptcy Lurie, 223 F.3d 764 (8th Cir. 2000); Simpson v. Penner, with regard to transfers to a “self settled trust” or “similar 36 F.3d 450 (5th Cir. 1994) (disclaimer one-day before device” would apply to transfers to family limited bankruptcy petition filed is not a fraudulent transfer); see partnerships if these transfers are considered fraudulent. also Leggett v. United States, 120 F.3d 592 (5th Cir. 1997); Hocker v. United Bank of Boulder. 476 F.2d See discussion at IV.J.10 supra. Only time (and an 838 (10th Cir. 1973). However, if the disclaimer is of a active judiciary) will tell. gift occurring within 180 days after the petition is filed, it 34

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K. Domestic Assets Protection Trusts. respect to trusts settled within their own jurisdictions. 1. Background: From Off Shore to Domestic Asset Many such Protection Trusts. jurisdictions did away with the rule against perpetuities a. Traditional Rule. Until the late 1990's, nearly in order to make their trust laws even more appealing. every state prohibited a settlor from creating an All of this was done in an attempt to attract investment irrevocable “spendthrift trust” that protected trust assets capital. from the claims of the settlor’s past, present, and future creditors if the settlor was a beneficiary of the trust. This d. Alaska and Delaware Fight Back. In 1997 both rule against insulating assets from the claims of a Alaska and Delaware adopted new trust statutes making settlor’s creditors with respect to self-settled, spendthrift self-settled, spendthrift trusts possible within United trusts (a/k/a domestic asset protection trusts) dates back States, at least theoretically, for the first time. By to the Statute of Elizabeth which was passed in 1570. effectively repealing the Statute of Elizabeth (as The statute voided any transfer made with the intent to articulated under the Restatement (Second) of Trusts), defraud one’s creditors and abolished the statute of Alaska and Delaware thus launched a new era in asset limitations on claims to set aside such transfers. The protection planning motivated by the competition for Restatement (Second) of Trusts adopted the Statute of investment capital. A total of nine have all adopted Elizabeth, which had been part of the common law ever similar domestic asset protection trust statutes, and more since its enactment. Virtually every state in the United states are likely to follow. However, for various States adopted these rules, making it impossible to create technical and practical reasons, Delaware and Alaska a valid self-settled, spendthrift trust in the United States. have remained the more attractive jurisdictions and are All past, present, and future creditors were entitled to constantly in competition to expand protection under disregard spendthrift language as to the settlor who was a their statutes, and for these reasons, they alone will be beneficiary of that trust. As a result, creditors of the discussed below. settlor/beneficiary had access to the trust assets even if the settlor had no such access himself. 2. U.S. Response to Off Shore Asset Protection Trusts. Generally, domestic asset protection trust laws b. Permissible Spendthrift Protection. Many work by providing a statute of limitations on fraudulent jurisdictions have allowed spendthrift protection for transfer actions or claims and by allowing spendthrift beneficiaries other than the settlor upon the theory that protection for the settlor. Specifically, all of the settlor’s the settlor ought to be able to protect younger creditors, including those existing at the time of the beneficiaries from wasting the trust assets by means of transfer, will have only four years from the date of the incompetence, imprudence, or misfortune. Furthermore, transfer to initiate an action to set aside the transfer as creditors can easily determine that such trust assets are fraudulent. However, claims for torts occurring prior to not available for repayment. Even though the same the transfer or for child support or alimony are generally arguments could at least in part be applied to justify not subject to the spendthrift restrictions. spendthrift protection for the settlor of a trust, no such protection was traditionally allowed in any common law 3. Characteristics of an Asset Protection Trust. jurisdiction for equitable (if not moral) reasons. Should a What follows are the major provisions that must be debtor be able to escape liability for his debts and still included in any Delaware or Alaska domestic asset have something available to support himself? Surely the protection trust. debtor should have something left to live on, but aren’t bankruptcy laws and homestead or personal property a. Irrevocability. The trust must be irrevocable. AS exemptions sufficient? Why should a debtor be able to, 34.40.110(b)(2). 12 Del C. '3570(10)b. in effect, set aside his own amount of exempt assets by simply establishing a trust? So the prevailing arguments b. Identity of Trustee. The trust must have a qualified went, at least until the 1980's when off shore jurisdictions trustee, defined in Delaware as a natural person who began to rethink the issue. resides in the state or a corporation subject to supervision by certain regulatory agencies with the state. 12 Del C. c. Off Shore Competition. In the 1980's, foreign '3570(9). In Alaska, at least one trustee must be an jurisdictions modified their trust laws to remove the rule Alaska resident or a trust company or bank possessing against self-settled, spendthrift trusts and provided for trust powers and having its principal place of business in very short statutes of limitations regarding fraudulent Alaska. AS 13.36.035(c). conveyance claims. They began to require their courts to disregard the judgments of other jurisdictions with c. Situs Requirements. The qualified trustee must materially participate in the administration of the trust 35

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(e.g., maintain trust records). At least a portion of the counseling, drafting, preparation, execution, or funding trust assets must be located within the state. 12 Del C. of such trusts is protected. 12 Del C. '3572(d)-(e). '3570(9); AS 13.36.035(c). e. Actual vs. Constructive Fraud. An advantage to d. Choice of Law. The trust instrument should state Alaska law is that it requires proof of actual fraud and that the law of the situs jurisdiction governs the validity, does not permit claims for constructive fraud as in other construction, and administration of the trust. In jurisdictions. AS 34.40.010. Delaware on the other hand Delaware, such provision is mandatory. 12 Del C. follows the common law rule allowing proof of '3570(10)a. constructive fraud. 6 Del C. ''1304-1305. e. Spendthrift Clause. The trust must have a f. What is Barred. Delaware bars all actions with spendthrift clause. 12 Del C. '3570(10)c. respect to the transfer including actions to enforce judgments of any jurisdiction. 12 Del C. S3572(a). f. Distributions to Settlor. The trustee may have the Alaska bars only actions with respect to claims under its power to make distributions of principal or income in its own fraudulent conveyances statute. AS 34.40.110(d). sole discretion, and the settlor may retain a right to certain income interests, including certain annuity or 5. Do They Really Work? Whether domestic asset unitrust payments, without losing spendthrift protection. protection trusts will work as intended remains uncertain AS 34.40.110(b)(3); 12 Del C. '3570(10)(b). since there have not yet been any reportable cases regarding their validity. What follows is a brief 4. Other Important Statutory Provisions. Delaware discussion highlighting the major legal hurdles that could and Alaska provide other rules that warrant mentioning. threaten the viability of domestic asset protection trusts. a. No Rule Against Perpetuities. Alaska has adopted a. Judgment Against the Settlor. A creditor could a 1,000 year rule against perpetuities, essentially seek a judgment against the settlor in the settlor’s or the abolishing the rule for all practical purposes. AS creditor’s own state. The creditor would have little or no 34.27.010, AS 34.27.050-100. Delaware has adopted a problem with asserting jurisdiction for the matter. A 110 year rule against perpetuities for real property and court hostile to domestic asset protection trusts could abolished the rule against perpetuities entirely for refuse to apply the law of the trust situs on public policy personal property. 25 Del C. '503(a)-(b). However, any grounds and deny the purported spendthrift protection. If interest in a corporation, limited liability company, the trust is drafted properly, the settlor would not have partnership, business trust or other entity which holds any legal right or control over the trust assets and thus real property is expressly excepted from the scope of the could not use them to satisfy the creditor’s claims. The 110 year rule against perpetuities for real property. 25 creditor would then have to seek enforcement of his Del C. '503(e). judgment in the situs state, which could prove to be problematic (as discussed below). It should be noted that b. Partial Avoidance of Transfer. In Delaware, the if the court believes the settlor does have the practical transfer may be held void only to the extent necessary to ability (even if not the legal ability) to receive satisfy the judgment debt. 12 Del C. '3574(a). distributions from the trust but does not produce such result, the court may hold the settlor in contempt of court c. Trust Advisor/Trust Protector. Non-residents and impose civil or criminal penalties if the settlor does may act as trust advisors or trust protectors. In Delaware, not comply with an order to turn over the assets. See a Federal Trade Commission v. Affordable Media, L.L.C., trust advisor may have the authority to remove and appoint qualified trustees and/or direct, consent, or 179 F.3d 1228 (9th Cir. 1999); Goldberg v. Lawrence (In disapprove distributions from the trust. 12 Del C. re Lawrence), 227 B.R. 907 (Bankr. S.D. Fla. 1998); '3570(9)(c). In Alaska, the trustee advisor serves only as In re Portnoy, 201 B.R. 685 (Bankr. S.D.N.Y. 1996). an advisor (with no legal powers), though the trust protector may be given broad powers to modify the trust b. Judgment Against the Trustee. A creditor could and/or remove or appoint a trustee. AS 13.36.370 and seek a judgment against the trustee in a non-situs state. AS 13.36.375. Jurisdiction over the trustee could be a significant problem if the trust assets are not located in the non-situs d. Extensive Liability Protection. In Delaware, the state and the trustee has not solicited or conducted trustee, trust advisor, and any person involved in the business in the non-situs state. However, if jurisdiction over the trustee is valid and the creditor prevails, the 36

Conservative Asset Protection Planning Chapter 11 trustee would face a serious dilemma. The trustee could requirement of actual fraud; the creditor might only need ignore the order and face possible contempt charges in to prove facts equivalent to those necessary for proving a the non-situs state. Alternatively, the trustee could constructive fraud claim. comply with the order and face a lawsuit by the settlor or other beneficiaries for violating its fiduciary duties under e. Full Faith and Credit Clause. The Full Faith and the laws of the trust situs. Credit Clause of the U.S. Constitution requires each state to enforce the judgments of other states. Under this c. Choice of Law Provision. Very likely, a suit in the clause, a creditor would argue that a judgment in favor of situs state would pose no choice of law issues. However, the creditor in a non-situs jurisdiction must be enforced if suit is brought in a non-situs jurisdiction (e.g., settlor’s by any court in the situs jurisdiction. However, if a domicile), the creditor would likely argue that the choice statute seeking to limit the enforcement of such claims is of law clause in the trust instrument is invalid based on found to be a procedural rule, such argument will likely policy concerns. Specifically, a debtor should not be fail. Specifically, at least one court has held that statutes able to secure the benefits of a more debtor-friendly limiting the time in which an action to enforce a fraudulent conveyance statute or obtain spendthrift judgment may be brought are procedural and thus do not protection for himself simply by choosing another state’s violate the Full Faith and Credit Clause. Matanuska laws when the legislature in his own domicile has clearly Valley Lines, Inc. v. Molitor, (365 F.2d 358). The theory promulgated a strong policy on the issue. The law is is that a state is not required to operate under multiple sparse in this area, and modern courts tend to enforce procedural systems, and thus a four-year statute of forum law unless there is a strong reason for departing limitations on any actions (whether to enforce a judgment from it. Thus, it is highly likely that a creditor would or bring an initial claim) provides merely a uniform prevail in any choice of law issue for a suit brought in a procedural rule. Delaware law operates to bar any and non-situs state. However, a creditor’s victory in a non- all actions (procedural) and is thus arguably stronger on situs state may prove meaningless depending the this issue than Alaska law which operates to bar outcome of other legal issues. fraudulent transfer claims brought under Alaska law (substantive). d. Contract Clause. Some commentators have The Full Faith and Credit Clause could also operate expressed concern over the Contract Clause contained in to enhance creditor protection since each state must also Article I, Section 10 of the U.S. Constitution. While the respect the acts of other states (including their issue is unsettled, state legislatures enacting self-settled legislatures). Thus, a judgment in a non-situs state spendthrift trusts are drafting their statutes in way that arguably would not necessarily trump the acts of the most likely presents no Contracts Clause issue. The legislature in the situs state since they both should have Contract Clause applies only to prevent modifications of equal sovereignty under the Full Faith and Credit Clause. existing contracts and not also to prevent prospective Furthermore, the settlor or trustee could seek a judgment modifications to contracts. The Alaska and Delaware in the situs state, which should be considered equally statutes do not purport to be effective for trusts created valid with the non-situs judgment. If the issue is before enactment of such statutes and would only bar ultimately settled by a “which judgment was obtained claims of existing creditors if they received notice of the first” analysis, the trustee or settlor could seek a transfer to such trusts. Accordingly, the only issue is declaratory judgment in the situs state prior to any whether the statutory baring of an existing creditor’s litigation in a non-situs state. action or claim would be considered a modification of an existing contract between the settlor and the creditor. f. Bankruptcy Issues. Because of the addition of BC But, unless the contract between the settlor and the §548(e) by BAPCPA, it now appears clear that transfers creditor stated that the creditor had a security interest in to domestic asset protection trusts can be reached within the settlor’s assets that were subsequently contributed to ten (10) years after the transfer. On the one hand, the the trust, how could the statute providing spendthrift provisions significantly expand the “look back and protection to such transfer be held to be a modification of recover” power of bankruptcy trustees. On the other an existing contract? Presumably, then, the Contract hand, it gives at least tacit approval to domestic asset Clause analysis would greatly resemble the analysis of protection trusts as asset protection tools. See discussion whether the transfer was fraudulent as to the creditor, at IV.J, supra. since the statutory spendthrift protection would only be applicable if invoked by the settlor in such a way as to 6. Other Client Concerns. Clients will not only be “modify” settlor’s existing contract with the creditor. concerned about whether domestic asset protection trusts Perhaps, the only utility of a Contract Clause argument actually work but will also want to know what kind of would be to use it is as an end-around Alaska’s distributions they can receive if and when such trusts 37

Conservative Asset Protection Planning Chapter 11 have withstood the attacks of their creditors. In other powers. In other words, the settlor can incur debts and in words, can the client get distributions at a time when he effect relegate his creditors to the trust assets for truly needs them (i.e. after all other assets are gone)? repayment, thereby retaining the ability to fully enjoy the Additionally, the client will want to know whether he can economic benefit of the assets for himself. Under I.R.C. combine domestic asset protection trust planning with the '2036, the trust assets would thus be includable in the goal of excluding the trust assets from his estate. settlor’s estate because he has not given up sufficient dominion and control over the beneficial enjoyment of a. Distributions After Attack. If the spendthrift the assets. On the other hand, if self-settled spendthrift protection sought by the trust instrument is ultimately trusts prevent the settlor’s creditors from recovering upheld, none of the trust assets will be accessible by against the trust, the trust assets should not be includable settlor’s creditors, even after a judgment in the settlor’s in the settlor’s estate (unless, of course, they are own domicile, unless distributed to the settlor. Any includable under another theory). distributions to the settlor become the property of the Since 1999, it has been informally reported the IRS settlor and are thus subject to attachment by settlor’s will not issue private letter rulings with respect to creditors. AS 34.40.110(a) typifies the general rule with whether a transfer of assets to a self-settled spendthrift regard to any form of spendthrift protection. If the settlor trust in such jurisdictions as Alaska and Delaware will be has no right to distributions, the trustee will not make a completed gift, even though it has issued a few distributions to the settlor if such distributions would favorable PLR’s in the past. For example, PLR 9837007 only end up going to the settlor’s creditors since the held that a transfer to an Alaska self-settled spendthrift trustee could be liable for breaching its fiduciary duty trust was a completed gift. Furthermore, the IRS has under situs law to uphold the spendthrift protection never issued a ruling on the issue of whether such assets clause as to the settlor. Because creditors know that the are includable in the settlor’s estate and continues to settlor will probably never get any distributions from the decline to do so. The IRS is operating on the theory that trust in such situation, the theory is they will likely be the facts and circumstances necessary to make such a willing to settle their claims for a fraction of their stated determination do not exist until the settlor’s death (or value (“a bird in the hand is worth two in the bush”). after substantial administration of the trust) because there Upon settling the claim, the settlor will be discharged by could be an implied arrangement between the settlor and the creditor, and the trustee will be free under the trust the trustee to make distributions to the settlor. instrument to make distributions to the settlor as he sees Even assuming that the Delaware and Alaska fit. Until the creditor settles the claim (or if the creditor statutes work as intended, the settlor may still have an is more concerned with principle than with business and impermissible ability to “borrow” from the trust assets thus decides to leave the judgment in tact rather than for purposes of IRC '2036. Because children (child settle), then the trustee could make distributions to the support), spouses (spousal support) and certain tort settlor’s spouse or descendants (if a sprinkling power is claimants are creditors who can attach the trust assets to given to the trustee in the trust instrument) who in turn satisfy claims against the settlor, the IRS could take the could provide for the settlor’s support. In addition to a position that the settlor has not relinquished sufficient spray or sprinkle power, the more effective approach dominion and control of the trust assets to make the would be to include a strong facility of payment clause, transfer a complete gift or to avoid estate tax inclusion. allowing distributions for the beneficiary’s benefit Whether such “access” to the trust assets ultimately without distributions actually being made to the proves to be fatal under IRC '2036 remains an open beneficiary. question, though it probably is not. It would be a far stretch of the English language to assert that the ability of b. Combining Tax Planning with Asset Protection: the settlor to cause trust assets to go to his children or Pipe Dream or Reality? Some clients may be more spouse for child or spousal support or to tort claimants is inclined to make large lifetime gifts if they know the retention of an ability to enjoy the assets. assets will be available for distribution to themselves if Thus, while it appears that self-settled trusts can be ever needed. If they can be assured that the assets will be effectively combined with estate planning, at least some excluded from their estates at death, however, most doubt remains. clients would have no doubt about such lifetime planning. Unfortunately, the there is some amount of c. Special Power of Appointment With Asset uncertainty associated with whether such assets will be Protection Trusts. With off shore Asset Protection includable in the settlor’s estate. Trusts, the settlor usually retains a testamentary special If creditors can reach the assets in the trust, the power of appointment because he does not wish to make settlor has indirect dominion and control over the the transfer subject to gift tax. Such power of economic benefit of the trust assets by means of his own appointment is a retained power over beneficial 38

Conservative Asset Protection Planning Chapter 11 enjoyment of the trust, and thus the assets will be jurisdiction over trust assets held in another state (and includable in the settlor’s estate. Do the new rules get this is uncertain), Article 8 creates an enforcement around this issue? If the settlor is only interested in asset problem for such court since attachment can only be by protection (and not also with combining tax planning), legal process within the situs jurisdiction. Even if opting will a special power of appointment jeopardize asset into Article 8 would not ultimately prevent a creditor protection? from being able to attach the trust assets, it will serve as a deterrent to litigation because of the enhanced legal 7. Practice Pointers. hurdles creditors will face. a. Use Trust Advisors. Using direction and consent advisors rather than non-situs Co-Trustees will help d. Give Trustee a Sprinkling Power. Consider prevent the application of non-situs law and weaken empowering the trustee to sprinkle income and/or creditor attempts to obtain jurisdiction over the trust (i.e., principal over the settlor’s spouse and/or descendants. over such Co-Trustee). Any attempt by the settlor’s creditors to attach the trust assets will affect the rights of all the beneficiaries and not b. Notify Creditors. Consider notifying existing just those of the settlor, thereby diminishing the equitable creditors at the time of the transfer in order to ensure that argument that would otherwise exist if the settlor was the the statute of limitations will begin running. If the sole beneficiary. Additionally, if the settlor’s creditors transfer is not fraudulent and the settlor is in good would be entitled to attach any distributions actually standing with the creditor, the creditor will not have made to the settlor, the settlor could still be supported by much incentive to spend its resources in an attempt to set distributions made to the settlor’s spouse or descendants aside the transfer, and the statute of limitations will begin if they chose to support him. to run. Furthermore, giving creditors notice of the unavailability of such assets diffuses any equitable e. Give Trustee a Facility of Payment Clause. argument that the creditor was misled by a secret trust Allow the trustee to pay third parties directly so that the arrangement. distributions are not made to the beneficiaries but to those person who provide necessaries to the c. Wrap Assets in a Limited Partnership. Consider beneficiaries. forming a limited partnership to hold the assets intended for transfer to the trust. In addition to providing an f. Limit Trustee’s Discretion. Limiting the trustee’s additional layer of creditor protection under the laws of discretion over distributions might convince a court not the debtor’s own jurisdiction, the partnership could opt to compel distributions on behalf of settlor’s creditors. into Article 8 of the Uniform Commercial Code (which The trustee’s discretion could be limited to the health, deals with investment securities) and obtain additional support, and maintenance of the settlor, thereby creditor protection. See U.C.C. '8-103(c), stating that a excluding distributions in satisfaction of a creditor’s partnership interest is a “security” for purposes of Article claims. 8 if, inter alia, the terms of the partnership agreement expressly provide that the partnership interests are g. Maintain Sufficient Liquidity. Consider securities governed by Article 8. All corporate securities maintaining liability insurance or assets on hand that will (regardless of the terms of the corporate bylaws) fall be considered adequate for the settlor’s profession or within the scope of Article 8 of the Uniform Commercial business activities. As with corporations, a court is much Code, and thus a corporation could also be used to obtain less likely to uphold a claim for piercing the liability veil the benefits of Article 8. if the debtor has sufficient assets or is adequately insured. Although, Article 8 is not a jurisdictional statute, it does provide some degree of practical protection by h. Charitable Planning. Delaware allows a settlor to limiting a creditor’s ability to attach the partnership retain the lead interest (i.e., annuity or unitrust) in a interest to those procedures provided in Article 8. charitable remainder trust and still obtain spendthrift U.C.C. '8-112 describes the process by which a creditor protection. As long as the transfer does not appear may attach a security, providing for different fraudulent, an attack by a creditor to attach the trust mechanisms depending on whether the security is assets would force a court to consider the impact that certificated, uncertificated, or issued under a “securities granting the requested relief would have on charity. entitlement” system. The result is that a creditor will not Even if the legal arguments are not strengthened in such be able to attach those assets under order of a court a case, the court may be driven by a different equitable within a non-situs jurisdiction, thereby limiting the analysis and find it harder to compromise the interests of ability of such court enforce a judgment on behalf of the charity in favor of a creditor in such circumstances. creditor. Hence, even if a non-situs court may have 39

Conservative Asset Protection Planning Chapter 11 i. Consider a Pre-emptive Strike by Trustee. least discussing them with virtually all of his wealthy Consider obtaining a trustee who will seek a declaratory clients. judgment in the situs jurisdiction to the effect that the trustee is not obligated to make payments from the trust VII. INTRODUCING THE JONES FAMILY. to any of settlor’s creditors. The court would be Having discussed the legal rules, available obligated to grant the judgment under local law, and the techniques, and preliminary planning considerations, it is Full Faith and Credit Clause of the U.S. Constitution now time to see how they apply to a realistic factual would require other states to uphold the judgment as to scenario. property held within the situs. Of course, the settlor’s creditors (who would have to be given notice) could A. Example C The Jones Family. foreclose any such litigation by initiating an involuntary 1. Basic Facts. John Jones, age 40, is a bankruptcy proceeding against the debtor; but the same prominent corporate securities lawyer in Dallas, Texas. facts and circumstances justifying such an action would He is married to Jane Jones, age 38. John and Jane have also likely render the transfer to the trust void under situs three children, James (age 12), Jared (age 10) and law. Jennifer (age 1). John is a partner in Money, Money & 8. Coordination With Grantor Trust Rules. The Moremoney, L.L.P. (“MM&M”). John’s projected grantor trust rules do not impose any unique issues with partnership draw for the current year is $500,000.00 with respect to domestic asset protection trusts. The use of an expected special distribution of $250,000.00 (to be certain trust powers granted to a non-adverse trust paid next January). After taxes and living expenses, John advisor (e.g., a power exercisable in a non-fiduciary and Jane have a surplus of $300,000 per year. John is capacity to reacquire assets by substituting assets of an confident that he can expect the same compensation and equivalent value under I.R.C. ' 675(4)(C)) are perhaps surplus for the next 20 years (and we will assume the the best way to achieve grantor trust status without same for purposes of this example). running afoul of either the asset protection rules John’s and Jane’s financial statement, as of the discussed above or the gift and estate tax rules for date of this speech, is described in Column 1 of removing the trust assets from the settlor’s estate. Exhibit A (attached). Likewise, if non-grantor status is desired for the trust, both the Alaska and Delaware statutes provide ample 2. No Interest in Estate Planning. Despite drafting room to secure that result concurrently with the repeated suggestions from friends and professional achievement of self-settled spendthrift protection. advisors, John has no interest in estate planning. He and Jane currently have simple “all to spouse” wills which 9. Conclusion. Domestic asset protection trusts provide contingent testamentary trusts for their children. appear to work, although some doubt still remains. As John is content with this arrangement especially since the with any attempt to radically alter the law, the movement unlimited marital deduction will result in no federal of certain state legislatures to validate domestic asset estate tax upon the death of the first spouse to die. John protection trusts will be tested in the courts since so has also read about the so-called “Kiddie Tax” and high much is at stake and certain aspects of existing law tax rates imposed on trust income so he sees no point in remain uncertain. The most conservative clients will establishing any trusts for his children since the income likely wait a few years to see if the movement picks up tax savings seem to be minimal. momentum or begins to flag and whether their own jurisdictions will adopt similar asset protection laws. 3. Eighteen Years Later – Personal The client only stands to lose the transaction costs of Bankruptcy. Eighteen years after achieving establishing such a trust (including considerable prominence in his profession, and after whatever litigation costs the client later decides to pursue accumulating substantial wealth, John and Jane file for in defense of the trust, if any); although if estate planning personal bankruptcy under Chapter 7 of the Bankruptcy is combined with asset protection planning, the client Code. The Jones’ financial statement fifteen years later may also be giving up other opportunities for estate and three years before the bankruptcy filing is described planning. Thus, while a clear path is not laid out before at Column 2 of Exhibit A. Note that it is assumed John the client, the prudent estate planning practitioner will at and Jane’s cash reserve stayed at $1.0 million, their least become familiar with domestic asset protection securities (including surplus cash, which they invested in trusts and be prepared to discuss them with his clients. If securities) grew at 8%, and their real estate grew at 3%. domestic asset protection trusts work, and if they can be This financial catastrophe is the result of a combined with gift, estate, and GST tax planning, the malpractice lawsuit brought nearly three years before the estate planning practitioner would be remiss for not at bankruptcy. Despite serious and major flaws in the 40

Conservative Asset Protection Planning Chapter 11 plaintiff’s case, a jury returned a verdict against John in for those unforeseen creditors. In the long run, you will the amount of $25.0 million, only $1.0 million of which likely preserve more. was covered by malpractice insurance. Despite optimism by John’s attorney, the Texas Court of Appeals and C. Recommended Preservation Plan For the Jones Texas Supreme Court affirmed the trial court’s judgment. Family – Sensible and Conservative Steps to Financial As a result of the bankruptcy, nearly all of John’s Security. After a detailed analysis of John’s and Jane’s and Jane’s nonexempt assets were seized to satisfy the situation, Mr. Planner makes the following plaintiff’s judgment. This includes the Jones Family recommendations: Farm which has been in John’s family since before the Civil War. The assets left for the Joneses after the 1. Step 1 – Prepare a Detailed Solvency Balance bankruptcy are shown at Column 3 of Exhibit A. Sheet. Many of the techniques described below involve Because of this financial downturn, Jennifer, a the transfer of assets. In order for these techniques to sophomore at Stanford University, must transfer to a successfully protect assets, it is important for John and state school. Jared, after a three-year hiatus, may not be Jane to demonstrate they are “solvent” both before and able to start at Harvard Law School in the fall. The after the transfers described below. This will go a long Jones’ have also decided to sell their house since the way in overcoming allegations of actual or constructive monthly mortgage payment of $3,500 is unrealistic in fraud. Accordingly, Mr. Planner insists that John and light of John’s current income level, which has declined Jane develop a detailed current balance sheet substantially because of the publicity surrounding the demonstrating their solvency at all relevant times. trial. If things are not bad enough, John’s father, Jacob, a. What is “Solvency” in the Asset Protection dies of a heart attack three months after John files for Context? In order to be considered “solvent”, John and bankruptcy. The $500,000 John inherits from his father Jane must prove the aggregate value of their non-exempt is also seized by the trustee in bankruptcy to pay John’s assets exceeds the aggregate value of their debts debts. immediately before and immediately after implementation of the techniques described below. This B. Could John and Jane Have Averted Financial means value of their home equity, $60,000 of certain Disaster? What could John and Jane have done personal effects, life insurance cash values, and other differently to avoid this financial disaster? Should they exempt assets cannot be considered. have sent their liquid assets “off shore” to an exotic South Pacific island? Should they have formed a “mega” b. The Term “Debts” Includes the Value of family limited partnership? Or should they have “Contingent” Claims. Further, the term “debts” is consulted with an estate planning advisor with much more broad than used in the traditional sense. It experience in “Preservation Planning” for a thoughtful includes not only contractual debts and debts that have analysis of their estate and preservation planning been reduced to judgment but also the value of options? Let’s assume John and Jane have consulted contingent claims and liabilities. For example, if at the with I.M. Planner, Esq., a well respected estate planning time of the planning, John had already received a demand lawyer. During the initial meeting, Mr. Planner reviews letter from a potential claimant, John would need to John’s and Jane’s family and financial situation and estimate the possibility of recovery and assign a value to explores their objectives. He then shares with John and the claim. The value of this claim would therefore be Jane two guiding principals to a successful preservation considered a “debt” in determining whether John and plan. These principles are as follows: Jane are solvent.

1. As Yogi Berra Might Have Said Regarding 2. Step 2 – Evaluate and Increase Liability Preservation Planning, “You Need to Do It Before Coverage if Necessary. If possible, John should You Need to Do It!” Designing and implementing a increase [or convince his firm to increase] his malpractice comprehensive preservation plan on the eve of insurance. Further, John and Jane should consider adding bankruptcy or other financial disaster is likely to be too an umbrella “all risks” liability coverage to his existing much too late. Waiting for the “ax to fall” is too late. homeowner’s insurance coverage. The incremental cost Planning must be done before you know or should have of increasing liability coverage from $1 million to $5 known the ax exits. million is surprisingly inexpensive.

2. Less is More. As they say in Texas, “Pigs get fat 3. Step 3 – Do New Wills. John makes a new will. and hogs get slaughtered.” The same principle applies to John makes a gift of his “applicable exclusion amount” preservation planning. Leave some money on the table to a credit shelter trust for Jane and the children with the 41

Conservative Asset Protection Planning Chapter 11 residue of John’s estate passing into a qualified with $34,000.00 of salary reduction and profit sharing terminable interest marital deduction trust for Jane. contribution each year. Distributions of income and principal to Jane and the children from the credit shelter trust will be limited to b. Accumulations in Plan. The plan earns 8% each distributions for health, education, maintenance and year. Fifteen years later, John’s vested account balance is support. Distributions of principal to Jane from the $997,026. marital deduction trust will likewise be limited to distributions for Jane’s health, support, and maintenance. 7. Step 7 – Pay Off Homestead. John and Jane After Jane’s death, the assets will be held in three trusts, decide to pay off their mortgage balance using some of one for each child. Each child’s trust shall provide as their cash. At the end of the fifteen year period, the follows: homestead residence has no mortgage and is worth nearly $1.2 million. i. The Trustee(s) may distribute income and principal to the child and the child’s 8. Step 8 – Make Gifts in Trust for Children. descendants for health, education, a. Description of Program. John and Jane establish maintenance, and support. three irrevocable gift trusts, one for the benefit of each of ii. The trust will last for the child’s lifetime. their children. The principal purpose of each trust is to iii. The child will be given a testamentary limited provide for each child’s college education. Each of the power of appointment in favor of John’s and trusts provides for Crummey withdrawal rights, so John Jane’s descendants, the child’s spouse (in trust and Jane can make an annual gift of $26,000 of their only), and/or charities. The child will also be community property to each trust ($78,000 total gifts). A given a contingent general power of trust company affiliated with a large brokerage company appointment over the trust to avoid the is the trustee of each trust. The trust assets consist of a generation-skipping tax at the child’s death if low expense “total market” index fund. the estate tax rate is lower than the GST rate. If John and Jane limit their gifts to the annual exclusion amount, no gift tax returns are required to be Jane’s will is a mirror of John’s will. The same plan filed and the gifted assets should forever be removed could also be accomplished through the use of pour over from John’s and Jane’s gross estates for federal estate tax wills and a revocable living trust. purposes. Similarly, net income of the trusts will likewise be removed from John’s and Jane’s estates for 4. Step 4 – Buy Cash Value Life Insurance. federal estate tax purposes. a. Purchase. John and Jane purchase a $2.0 million whole life policy on each spouse’s life ($4.0 million total b. Accumulations in Trusts. John and Jane continue insurance). The premium on John’s policy is $29,680. these annual gifts for fifteen years. The assets in the The premium on Jane’s policy is $21,780. trusts grow at a net rate of return of 8%, compounded annually. Fifteen years later, the trusts have a collective b. Accumulations. Fifteen years later, the net cash value of $2,287,294. surrender value of John’s policy is $568,960, and the net cash value of Jane’s policy is $415,800. The total cash 9. Step 9 – Enter Into an Agreement to Partition value for both policies is $984,760. Community Property. a. Description of Partition. John and Jane own $3.6 5. Step 5 – Buy Annuities. million of community property cash and publicly-traded a. Purchase. In January of each of the next fifteen common stocks. In recognition of Jane’s support, John years, John uses $100,000 of his year end bonus to pay wants Jane to have some of her own separate property, in the premiums on a variable annuity with a track record of addition to the $200,000 of publicly traded bonds she earning at least 8% each year. inherited from her father (as indicated on Exhibit A). Accordingly, John and Jane enter into a written b. Accumulations. Fifteen years later, the annuity is agreement to partition the $3.6 million of jointly owned worth $2,932,428. cash and securities into two $1.8 million shares, one for John, as his sole and separate property, and one for Jane, 6. Step 6 – Establish a Pension and/or Profit as her sole and separate property. Sharing Plan. The partition agreement also provides that the a. Description of Plan. At John’s urging, MM&M income earned on each spouse’s separate property adopts a 401(k) and profit sharing plan for all eligible (including income from the $200,000 of publicly traded full-time employees. Under the plan, John is credited 42

Conservative Asset Protection Planning Chapter 11 bonds Jane inherited) will be that spouse’s separate ii. The Trustee(s) may also distribute income and property. principal to the Children (more remote After the partition, $1,800,000 of cash and publicly descendants) for health, education, traded stocks are transferred solely into John’s name as maintenance, and support. his separate property and $1,800,000 of cash and iii. Jane is granted a testamentary special power publicly of appointment to distribute the assets traded stocks are transferred solely into Jane’s name as remaining at her death outright or in trust to or her sole and separate property. for the benefit of any one (1) or more of John, the Children (and more remote descendants), b. Jane’s Accumulations. Jane does a good job and charities. investing her $1,800,000 share of the partitioned assets iv. If Jane does not exercise the testamentary and the $200,000 of bonds she inherited. Fifteen years special power of appointment, the assets later, Jane’s $2,000,000 has grown to $6,344,338. remaining at her death pass into separate trusts for the Children identical to those described at 10. Step 10 – Form a Family Limited Partnership. Step 3 above. a. Description. Shortly after this speech, John transfers the Jones Family Farm to a family limited Note: John and Jane could also form a second family partnership called Jones Farm, Ltd. (“JFL”). The 1% limited partnership (“JFL II”) with $1.0 million of John’s general partner is a limited liability company called J&J, and $1.0 million of Jane’s separate property. The 1% LLC. (“J&J”). Each of John and Jane owns a 50% general partner could be J&J, LLC (described above), membership interest of J&J. Initially the sole limited and each of John and Jane would own a 49.5% limited partner is John (99%). Shortly after forming JFL, John partnership interest. Sometime after forming JFL II, gives a 49.5% limited partnership interest to Jane. That John could give his entire 49.5% limited partnership gift is intended to include the income generated from the interest to the credit shelter trust. In addition to an gifted partnership interest. additional layer of likely creditor protection and an Over the next several years John and Jane begin ability to pool investment assets together (i.e., Jane’s making gifts of the LLC membership interests and $1.0 million with John’s $1.0 million), the transfer of the limited partnership interests to the children’s trusts limited partnership interest may be entitled to lack of described earlier. control and lack of marketability discounts. However, it is assumed that John and Jane do not form this second b. 15 Years Later. Fifteen years later, JFL is worth partnership. approximately $778,984 and ownership is as follows: 12. Step 12 – Do Not Sign Loan Guarantees for J&J = 1% GP interest Friends, Neighbors, Business Partners, Children (LLC membership interests owned equally by John, and/or Other Relatives Unless You Expect to Repay Jane and each of the children’s trusts) the Loan Yourself.

John = 27% LP interest 13. Step 13 – Do Not Agree to Serve on the Board of Jane = 27% LP interest any Financial Institution or Corporation Unless You James’ Trust = 15% LP interest are Adequately Insured to Your Lawyer’s Jared’s Trust = 15% LP interest Satisfaction. Jennifer’s Trust = 15% LP interest 14. Step 14 – Urge Estate Planning for Parents and 11. Step 11 – Spousal Credit Shelter Trust (& Other Relatives From Whom You Expect to Inherit. Spousal QTIP Trust). After the partition agreement One month before John files his bankruptcy petition, described at Step 9 above, John creates a “credit shelter John convinces his father to establish a testamentary trust trust” for the benefit of Jane and the children with $1.0 under his will properly designated as a spendthrift trust. million of his newly created separate property (i.e., using Under that trust, John’s brother, Jerry, is trustee with up his $1.0 million applicable gift tax exclusion amount). absolute discretion to distribute income and/or principal The terms of the credit shelter trust will generally be as to John, Jane and their children for any reason. Jerry is follows: also empowered to terminate the trust at any time if he believes to do so would be in the best interest of the i. The Trustee(s) may distribute income and beneficiaries. Upon termination, the trustee is required to principal to Jane for her health, support, and distribute the property to John. John has no right to force maintenance. Jane is the primary beneficiary. a termination. 43

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15. Comparison. For purposes of comparing the “no 4. Homestead. Since John elected his state law planning” scenario with the “preservation planning” exemptions in lieu of the federal list of exemptions, and scenario, it is important to note that $263,460 of John since the Federal Bankruptcy law limiting the homestead and Jane’s $300,000 surplus was used to purchase and/or exemption will clearly not apply, it is clear that his nearly fund certain exempt assets (see immediately below) and $1.2 million homestead will be exempt from the claims that it is assumed such purchases and funding were not in of creditors. Therefore, the only debts for which John’s defraud of creditors and not otherwise reachable in homestead would be liable would include purchase bankruptcy. money debts (i.e., one has to pay back the loan used to acquire the homestead), valid liens on the homestead for Annual Amount home improvements, ad valorem taxes, and federal tax John’s Insurance Premiums $ 29,680 liabilities. Jane’s Insurance Premiums $ 21,780 Purchase of Annuities $ 100,000 5. Gifts to Children’s Trusts. In order to recover the 401k and Profit Sharing $ 34,000 gifts, the trustee in bankruptcy would need to prove that Annual Exclusion Gifts to they were fraudulent conveyances. To do so, it would be Children’s Trusts $ 78,000 necessary to prove that John was insolvent immediately Total $ 263,460 before or after the gifts or that the gifts were made with an actual intent to hinder, delay, or defraud John’s D. What’s Left After Bankruptcy Under the creditors. Recommended Planning For the Jones Family. Under Texas and federal bankruptcy law, an 1. Selection of State Exemptions. In the early stages individual is considered “insolvent” when the sum of that of the federal bankruptcy proceeding, John is given a person’s debts exceeds the sum of that person’s choice regarding the exemption of property from nonexempt assets, at fair value. Thus, at the time of each unsecured creditor claims. He may either claim federal gift John appears to have met the test of solvency. exemptions under the Bankruptcy Code or he may claim Furthermore, although the gifts are for the benefit of the exemptions given to him under Texas law. Texas is a family members (generally a badge of fraud), the gifts community property state. were clearly motivated by valid estate planning John wisely elects to claim his state law exemptions objectives and none of the other so-called badges of thereby protecting $60,000 of eligible personal property, fraud seem to exist. all of his homestead, most (if not all) of his vested Nearly all of the assets of the children’s trusts interest in the profit sharing plan, most (if not all) of his should be beyond the reach of the trustee in bankruptcy and Jane’s life insurance cash values, and most (if not and therefore insulated from John’s judgment creditor. all) of his annuity. These exemptions and other protected assets will be described more fully below. 6. Jane’s Separate Property (Acquired by Inheritance and Partition). The bonds Jane inherited 2. Life Insurance and Annuities. from her father are clearly her sole and separate property. a. Life Insurance Cash Values. Article 1108.051 of In addition, Jane’s $1.8 million share of the partition of the Texas Insurance Code will insulate the life insurance community property, cash and stocks, the income earned cash values and death benefits to the extent those cash from those assets, Jane’s inheritance, and the income values and benefits are not attributable to premiums paid from that inheritance, are, by agreement, her sole and in fraud of creditors. separate property. Under Texas law, Jane’s separate property is not b. Value of Annuities. Article 1108.051 of the Texas generally subject to John’s liabilities unless she has Insurance Code will likewise insulate the value of the agreed to be liable (which she has not). annuities to the extent those values are not attributable to All of Jane’s separate property should therefore be premiums paid in fraud of creditors. insulated from John’s judgment creditor. The only chance that the trustee in bankruptcy would have to reach 3. Profit Sharing Plan. It is clear John’s vested profit some of Jane’s property would be to show that the sharing account balance will be insulated from John’s partition agreement was void as a fraudulent conveyance. judgment creditor (and therefore available to John upon Even if such a fraudulent conveyance could be proven, retirement). Any doubt about this result was settled by an arguable two-year statute of limitations with respect to the United States Supreme Court in Shumate v. interspousal transfers would appear to preclude recovery Patterson. 504 U.S. 753 (1992). by the trustee.

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7. Family Limited Partnership. John’s interest in and protect a client’s assets from judgment creditors. J&J and JFL are certainly reachable by creditors. Hopefully this outline has demonstrated that a However, they are not very attractive assets C both are comprehensive estate plan can not only achieve minority interests in a family business. The trustee in traditional estate planning objectives but can also provide bankruptcy is likely to sell at pennies on the dollar to substantial asset protection benefits B and all this can be other family members. achieved without a passport.

8. Spousal Credit Shelter Trust. The credit shelter trust established by John for the benefit of Jane and the Children should be insulated from John’s judgment creditor, unless the trustee in bankruptcy can shoe the gift to the trust is void as a fraudulent conveyance. Even if it can be shown, an arguable two-year statue of limitations would appear to preclude recovery by the trustee. The credit shelter trust is a valid spendthrift trust and is therefore not considered the property of the bankruptcy estate within the meaning of Bankruptcy Code § 541. Therefore, the full $3,172,169 should be available to Jane and the Children. Distributions to Jane could also be used to pay some of John’s living expenses, such as mortgage payments, food, clothing, etc.

9. John’s Inheritance From His Father. The testamentary spendthrift trust established by John’s father or John’s benefit is a valid spendthrift trust and is therefore not considered to be property of the bankruptcy estate within the meaning of Bankruptcy Code ' 541.

10. Summary of Asset Protection Benefits of Estate Planning. Column 3 of Exhibit A (No Planning) and Exhibit B (Planning) provide a clear comparison of the asset protection benefits to John and Jane of ignoring preservation planning versus implementing a comprehensive preservation plan. It is unquestionably clear that the preservation planning alternative will preserve more assets for John’s and Jane’s family if financial catastrophe occurs. All of the preservation planning was with conservative estate planning techniques well within the scope of the average Texas estate planner’s repertoire — no offshore trusts or even DAPT’s were used!

VIII. CONCLUSION. Many practitioners shy away from discussing asset protection as an important benefit of estate planning. This is a mistake. Often the practitioner confuses “hiding assets” with the legitimate aim of assisting a client in protecting his or her assets from the claims of contingent, unknown, unforeseeable, and often overzealous creditors. Further, some practitioners mistakenly believe that true asset protection can only be achieved through the use of off shore trust planning. The reality is the estate planner has at his or her disposable an arsenal of traditional and cutting edge techniques that, if properly implemented, will preserve 45

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EXHIBIT “A”

JOHN & JANE JONES C FINANCIAL CONDITION

1 2 3

Assets Left for Family After Bankruptcy Discharge/ Description Today 15 Years Later No Planning

Cash (community property (“C.P.”)) $ 1,000,000 $ 1,000,000 $-0-

Marketable Sec. Bonds (Jane’s separate property 200,000 634,434 634,434 (“S.P.”)) Stocks (Public) (C.P.) 3,000,000 18,313,792 -0-

Real Estate Homestead (: acre lot) (C.P.) 750,000 1,168,476 1,168,476 Jones Family Farm (John’s S.P.) 500,000 778,984 -0-

Tangible Personal Prop. (C.P.) 100,000 100,000 60,000

Total Assets $5,550,000 $21,995,686 $1,862,910

Debt on Homestead (500,000) $ -0- -0- ($3,500/mo./30 year loan)

Net Worth $5,050,000 $21,995,686 $1,862,910

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EXHIBIT “B”

TOTAL ASSETS FOR JONES FAMILY WITH PRIOR PLANNING

Assets Available to Directly Benefit John and/or Jane

John’s Vested Profit Sharing Plan $ 997,026 (no exposure)

Homestead 1,168,476 (no exposure)

Jane’s Separate Property 6,344,338 (very little or no exposure)

Trust for John Created by Father 500,000 (no exposure)

Cash Value of Life Insurance 984,760 (very little or no exposure)

Jane’s 27% limited partnership interest in Jones Family Partnership (undiscounted) 210,326 (no exposure)

Value of Deferred Annuities 2,932,428 (very little or no exposure)

Total for John and/or Jane with Preservation Planning $ 13,137,354

Total for Jane and the Children (Credit Shelter Trust) $ 3,172,169

Assets Available to Directly Benefit the Children

Securities in Children’s Trusts $ 2,287,294 (very little or no exposure)

45% limited partnership interest in Jones Family Partnership (undiscounted) in Children’s Trusts 350,543 (very little or no exposure)

Total Assets for Children $ 2,637,837

Total for Jones Family with Preservation Planning $ 18,947,359

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