A former lawyer, Robert Ferrante, owned a beautiful 5,500 square foot home on an exclusive island in the harbor of Newport Beach, California, and which had fifty feet of bay frontage. In 1994, Robert transferred property into a qualified personal resident trust ("QPRT", pronounced as "cue-pert") with a 20-year term, to expire in 2014. The QPRT was named the "518 Trust".
In 2004, William Seay, coincidentally a former trustee of the 518 Trust, sued Robert on a loan which the latter had not repaid, and won a judgment against Robert for about $2.4 million. Seay immediately recorded an abstract of judgment in Orange County, and then filed an action in the California Probate Court (where, effectively, all matters concerning trusts are heard in California) to cause the revocation of the 518 Trust and to declare it a sham to defeat the Robert's creditors.
Robert's ex-wife, Mia Ferrante, challenged Seay's claims on behalf of the Ferrante's children who were remainder beneficiaries of the 518 Trust, and won. The California Probate Court dismissed Seay's case, and the California Court of Appeals affirmed. The Court of Appeals noted that Seay had not sought to seek Robert's life estate or reversionary interest, and overruled Seay's argument that an irrevocable trust can somehow be deemed a revocable trust based on the subsequent conduct of the settlor (Robert).
One very important truism to understand about creditor-debtor law is that in collection proceedings, creditors can fail numerous times, but only need to succeed once. The flip side of this is of course that debtors must always be perfect in their defense. The debtor who believes that creditors will go away after a single failure is setting themselves up to lose the war, even after they won a spectacular battle.
Another truism about creditor-debtor law is that in no place will a debtor be more vulnerable than in bankruptcy. Folks who are trying to use legal forms to protect their assets should also think twice, and then a third and fourth time, before diving under the protections of the bankruptcy court, because it can come with a heavy price.
Remember these two truisms as Robert's story continues, which picks up now with him (gulp!) voluntarily filing a case for Chapter 7 bankruptcy on January 11, 2010. While Robert was eventually to win the discharge that he sought, his bankruptcy strategy did not go completely as planned.
As in all Chapter 7 bankruptcies, a Trustee (Thomas Casey, whom I will refer to as the "BKT" to distinguish him from any trustees of the 518 Trust) was appointed to liquidate Robert's estate for the benefit of his creditors. The BKT brought an Adversary Proceeding against Robert and other interested parties, and sought an order from the Bankruptcy Court to revoke the QPRT and force it to turn over Robert's beautiful harbor-side house for sale. This time, Robert, Richard Shinn (the QPRT's Trustee), and the Ferrante children as remainder beneficiaries, all protested the entry of such an order, and the Bankruptcy Court never got around to hearing it for whatever reason.
Again, creditors only need to win once, and persistent creditors are the debtor's worst nightmare. The BKT amended his Adversary Complaint twice, and on his Second Amended Complaint then moved for summary judgment to revoke the QPRT and force the turnover of the Newport Beach home.
To understand the Trustee's theory, one must understand the basics of how a QPRT operates. Essentially, and as its name suggests, a qualified personal residence trust only works for a personal residence. The settlor of a QPRT will make an irrevocable gift of the home into the QPRT, retaining for himself a right to live in the home for some period of years, referred to as the "QPRT Term". During this term, the settlor has the full use of the home and is responsible for all expenses, and with few exceptions no other property can be conveyed into the trust.
The reason for these machinations is a desire by the settlor (and beneficiaries) to avoid federal estate and gift tax. If the settlor can live past the QPRT Term, then the settlor's right to live in the home lapses, and the home passes completely into the trust (and thus for the benefit of the remainder beneficiaries) without any federal estate or gift taxes being due. However, if the settlor dies before the end of the QPRT Term, then the home reverts back to the settlor's estate, and Uncle Sam collects the federal estate or gift taxes as if the QPRT never existed.
Suffice it to say that our good friends in the U.S. Treasury Department have promulgated substantial regulations which create strict conditions under which a QPRT must operate. One of the most important conditions is that the QPRT must be irrevocable, such that a "completed gift" is made to the trust when the home is transferred into it.
Very importantly, Robert's QPRT was drafted with the following provisions:
The issue before us requires a careful analysis of the IRS regulations for a QPRT and the 518 Trust provisions. The following trust provisions are pertinent:
Paragraph II: Irrevocability. This trust and all interests in it are irrevocable, and the grantor has no power to alter, amend, revoke, or terminate any trust provision or interest whether under this instrument or any statute or rule of law.
Paragraph III A.4.: Option to Purchase Residence. The Grantor shall have the option to acquire all or part of the Residence from the trust immediately prior to the expiration of the trust. The option price will be the then fair market value of the Residence then held by this Trust.
Paragraph III B. When the Trust Terminates. The Trust terminates only as provided in this paragraph:
3. Cessation of Personal Residence Trust Status. Unless the Trustee makes a timely election under subparagraph III[C.], this trust shall terminate when it ceases to be a Qualified Personal Residence Trust ("QPRT"), and on such termination the Trustee shall distribute all of the trust assets to the Grantor....
4. The date on which the Residence ... ceases to be used or held for use as a personal residence shall be known as the "Cessation Date."
Paragraph III C. Conversion to a Grantor Retained Annuity Trust. Within thirty (30) days from the date on which this trust would otherwise terminate under subparagraph III [B.3.], the Trustee may elect to convert the trust to a Grantor Retained Annuity Trust ("GRAT")....
Paragraph III A.4. is referred to by the parties as the "buy-back" provision.
Looking at this language, the BKT came up with the theory that, because Robert could terminate the QPRT by ceasing to use it as his own personal residence, the QPRT was thus de facto revocable (no matter what it said about being irrevocable), and thus it did not qualify as a QPRT for federal estate and gift tax purposes. The QRPT therefore failed, and the beautiful Newport Beach home reverted to Robert, and therefore to Robert's bankruptcy estate.
In other words, the BKT claimed, Robert had the ability to effectively "toggle" into the off-position the QPRT at any time, simply by choosing to no longer live in the home, and this destroyed the QPRT's protections as to his creditors and made the home available for liquidation.
Moreover, as an alternative argument, the BKT claimed that beginning on March 1, 2009, Robert quit using the Newport Beach property as his home, and instead for two years it was occupied on a leased basis by Shinn who was the Trustee of the QPRT. On that date, argued the Trustee, Robert's QPRT failed and the Newport Beach reverted back to Robert individually and thus into his bankruptcy estate.
Finally, the BKT argued that the existence of the "buy-back" provision violated the Treasury Regulations which state in part that:
the term holder may not re-acquire the personal residence (i.e., the trust is prohibited from selling or transferring the residence, directly or indirectly, to the grantor (and certain others) during the QPRT Term or at any time after the QPRT Term.
According to the Trustee, these provisions meant that the 518 Trust failed to qualify as a QPRT when Robert subsequently moved back into the home, and thus the 518 Trust was required under its own terms to convert to a grantor retained annuity trust ("GRAT"), which should have required the 518 Trust to distribute the Newport Beach home back to Robert, and thus into his bankruptcy estate.
Robert, Shinn, and the kids fervently objected to the BKT's motion on the grounds that none of the "terminating events" had actually occurred. They argued that Robert was not required to actually occupy the Newport Beach property, but only that he have a right to occupy it for a minimum of 14 days each year. As to the Shinn lease in 2009, they claimed that the lease never went into effect, and so the QPRT never terminated and Robert never "bought back" his interest.
As to the Treasury requirements that a QPRT not contain a buy-back provision, Robert et al., argued that those requirements were not promulgated until 1997, and did not apply to this QPRT which was settled in 1994. Finally, they argued that whatever Robert did or could do post-creation of the QPRT in 1994 could not under California law turn an irrevocable trust into a revocable one -- only the remainder beneficiaries (Robert's kids), they claimed, had that ability.
Before the Bankruptcy Court, the BKT won on two grounds.
The Bankruptcy Court first reasoned that the QPRT was revocable because Robert could terminate the QPRT status simply by ceasing to reside in the Newport Beach property. Thus, if Robert could exercise this power to terminate the QPRT, then the Bankruptcy Trustee had the same power.
Second, the Bankruptcy Court found that the "buy-back" provision violated the QPRT requirements, and thus either revoked or terminated the QPRT, to the benefit of Robert's bankruptcy estate.
So what about the earlier ruling of the California Probate Court that the QPRT was not revocable? The Bankruptcy Court ruled that because the BKT was not a party to that case, the decision reached by that Court was not binding upon the BKT, and so he could proceed in his adversary action unfettered by the Probate Court's ruling.
Robert et al. moved for rehearing, urging the circular argument that the 518 Trust could not be a QPRT unless it was irrevocable, and thus it was irrevocable. They also argued that the 1997 Treasury Regulations which prohibited buy-back provisions in QPRTs were not enacted until after Robert's QPRT was formed in 1994.
The BK responded to the latter argument with the observation that although the 1997 Treasury Regulations were after the 1994 formation of the QPRT, those 1997 Regulations specifically provided that they would relate back to existing QPRTs and indeed create a short period for older QPRTs to be reformed so that they complied -- which nobody had done with Robert's QPRT (oops!).
As to the QPRT being irrevocable because it must be to qualify as a QPRT and a completed gift, the BKT contended that Robert had never made a completed gift because he had essentially retained the power to change the nature of the QPRT by either ceasing to use it as his personal residence or purchasing the property out of the QPRT.
The Bankruptcy Court agreed with the BKT. Repeating their arguments, Robert and his kids, plus the QPRT's Trustee, appealed to the Bankruptcy Appellate Panel ("BAP") of the Ninth Circuit Court of Appeals.
The BAP agreed across the board with the Bankruptcy Court. The BAP additionally pointed out that even if the 1997 Treasury Regulations didn't apply to the QPRT when it was formed in 1994, they certainly applied on a go-forward basis to the QPRT beginning in 1997, and the QPRT failed because it failed to comply (before or after) with the 1997 Treasury Regulations. Thus:
[T]he 518 Trust provides that the "trust shall terminate when it ceases to be a [QPRT], and on such termination the Trustee shall distribute all of the trust assets to the Grantor." Although [] the 518 Trust provides that within thirty days of the trust's termination the trustee may elect to convert it to a GRAT, this was not done. Thus, the 518 Trust terminated in 1998 and its terms required distribution of the trust assets, including the 518 Property, to Debtor at that time. As a result, these assets are property of Debtor's bankruptcy estate. sec. 541(a)(7). We reject Debtor's argument that failing to comply with QPRT regulations did nothing to change the fact that Debtor transferred a completed and irrevocable gift of property to the 518 Trust in 1994.
Thus, we conclude the bankruptcy court did not err in granting partial summary adjudication to Trustee on the basis that the 518 Trust failed to comply with QPRT regulations. Because we are able to affirm the MSJ Order on that basis, we need not address Appellants' other argument that the bankruptcy court erred in ruling that the 518 Trust is, and QPRTs in general are, revocable trusts as a matter of law.
And with that, the BAP affirmed the Bankruptcy Court. Adios, luxurious $7.5 million Newport Beach house on an exclusive island in Newport Beach harbor.
ANALYSIS
The first point that must be made is that this was an atypical and seriously-flawed QPRT from the get-go, but it does illustrate that a trust is not a "fire and forget" strategy, but rather are a legal structure that must be updated and maintained throughout its lifetime, just like any complicated piece of equipment. Very simply, the QPRT here actually died in 1997 when nobody updated it to comply with the 1997 Treasury Regulations.
However, this Opinion also illustrates the potentially significant interrelationship between creditor-debtor law and tax law in some circumstances. Very simply, creditor-debtor issues can sometimes negate tax benefits, and sometimes tax issues can negate creditor-debtor issues. We see this more frequently in cases where the creditor exemptions for IRAs are found not to apply where the IRA has failed for some tax reason or another.
Very simply, the greater the likelihood that something will fail from a tax perspective, due either to inherent complexity or because the tax law in the area is unclear, the less likely that it will work as intended for creditor-debtor purposes.
But we cannot simply dismiss this case involving a "flawed QPRT" and move on. The truth is that QPRTs are not as perfect an asset protection planning vehicle as some market them to be, since they have potential weaknesses even beyond those discussed in this case. Among these potential weaknesses are:
Fraudulent Transfer -- Because a QPRT must be settled by a gift of the home, if the creditor can prove either that the settlor meant to defeat the rights of creditors (including future creditors) or was insolvent when the transfer was made, the transfer to the QPRT is susceptible to being set aside as a fraudulent transfer. The good news is that the typical Statute of Limitations for a fraudulent transfer is four years (up to seven years in California), so if you can get past that period, this concern probably goes away.
Self-Settled Trust -- At least as to the settlor's beneficial right to live in the home, a QPRT is to some significant degree a self-settled trust. The primary ramification of this is that, in bankruptcy, a transfer to a QPRT may very well be a transfer to a "self-settled trust or similar device" such that the ten-year Statute of Limitations of Bankruptcy Code section 548(e) is implicated.
Alter Ego -- Since the settlor retains effective control of the home, a QPRT might be deemed to be the alter ego of the settlor, a theory that is increasingly applied to trust as in the Schwarzkopf case. Indeed, the Bankruptcy Court here specifically mentioned that a Schwarzkopf-style challenge to the QPRT might be effective, but the Court did not need to resolve that issue since it ruled in favor of the BKT on other grounds.
But then again, every asset protection strategy has its flaws, and the only thing we know about those who claim to have the "best" or always 100% effective silver-bullet asset protection strategy, is that they are 100% wrong. QPRTs will work for many people, more as an estate planning device than an asset protection device, but many times they will be fine for those clients who are at low risk of lawsuits.
Changing gears, we see once again a debtor's seemingly foolproof strategy come to grief in bankruptcy. Presumably, Robert was able to protect more than $7.5 million in assets by declaring bankruptcy, because that is what he lost by doing so. Outside of bankruptcy, the California Probate Court had already ruled in his favor, so creditors were stuck. Only by filing for bankruptcy did he re-open the door to give creditors another shot at his home, and this time they (though the BKT) were right on the money.
In situations where a debtor has engaged in asset protection, or many times just plain-vanilla estate planning, voluntarily filing for bankruptcy will be the wrong decision -- it is certainly not a decision that should be made without a great deal of careful analysis. Yet, it seems like every month I write about a case where the debtor voluntarily jumped into bankruptcy to stop the pain his creditors were inflicting, and bankruptcy just made the pain much worse.
Apparently, $7.5 million worse in this case alone. But, hey, Newport Beach has nice tour of the harbor that you can take with the rest of the tourists for just a few bucks.
CITE AS
Ferrante v. Casey (In re Ferrante), 2015 WL 5064087 (BAP 9th Cir., Unpublished Slip Opinion, Aug. 26, 2015). Full Opinion at http://goo.gl/iUB381
This Article at http://onforb.es/1P5Fs36 and http://goo.gl/M63Grc
