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Bankruptcy Considerations In Asset Protection Planning

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IN BANKRUPTCY, ALL BETS ARE OFF

Bankruptcy is the place where many a well-structured asset protection plan has crashed and burned, for any of the reasons (and more) that are below discussed. Thus, some asset protection planners will tell their clients to the effect that "this plan will work, so long as you avoid bankruptcy."

Unfortunately, bankruptcy is indeed the most common place where distressed debtors finally end up, voluntarily or involuntarily. Thus, a decent asset protection plan implemented well in advance of creditor difficulties should give the client at least a reasonable chance of passing through the bankruptcy with some significant wealth preserved for the debtor's post-bankruptcy life.

A well-structured asset protection plan may effective protect the debtor's assets from collection, but of course an asset protection plan cannot quiet creditors who will not settle or go away. It is a common -- and quite lawful -- tactic of creditors to make the debtor's life so miserable through the collection process that she finally gets out her wallet and pays the creditor to go away.

For example, I can't even begin to tell you in how many cases I have seen the debtor's wallet come out just because the creditor served an examination subpoena on the debtor's spouse, and the debtor's spouse threatened divorce if he or she had to go to the examination. A buddy of mine famously relates how he once issued subpoenas for the debtor, the debtor's spouse, and the debtor's mistress to all show up for examination at the same time, and the debtor promptly settled for 100 cents on the dollar before their little get together.

The point is that various external pressures brought by the creditor, or a desire by the debtor to wash out creditors and get back to business, will often drive a debtor to attempt to seek a bankruptcy discharge of her creditors. These reasons vary from the continued (lawful) harassment of the debtor, to the debtor's desire to get rid of creditors so as to regain the ability to obtain financing. Increasingly, creditors will place a debtor into an involuntary bankruptcy proceeding, especially after the 2005 changes to the Bankruptcy Code that made bankruptcy much less pleasant for debtors.

For whatever reasons the debtor finds herself in bankruptcy, it often means an unfortunate result for the asset protection plan. But the debtor's possible bankruptcy is a reality that planners must face, and this article outlines some of the key issues for planners to consider.

THE BANKRUPTCY ESTATE

The key section is Bankruptcy Code § 541, which provides that upon the commencement of the bankruptcy case, i.e., the filing of the Bankruptcy Petition, all the debtor's interests in property immediately become part of the debtor's Bankruptcy Estate (hereinafter, the "Estate"). Essentially, the Bankruptcy Court will look at the filing of the Petition as creating a snapshot in time of all the debtor's interests in property. What constitutes the debtor's interests in property is determined by applicable state law, Butner v. United States, 440 U.S. 48, 54, 99 S. Ct. 914, 917-18, 59 L. Ed. 2d 136 (1979) ("The Bankruptcy Act does include provisions invalidating certain security interests as fraudulent, or as improper preferences over general creditors.Apart from these provisions, however, Congress has generally left the determination of property rights in the assets of a bankrupt's estate to state law." Ibid.).

It must be understood that a significant purpose to "marshal the debtor's assets". In this context, the term "marshal" means "to collect". The very job of the Bankruptcy Trustee is to hunt down and gather the debtor's assets, and then liquidate those assets and use the proceeds to pay creditors (after the Trustee's fees, of course, which provide significant motivation for Trustees to be quite aggressive in pursuing assets).

While the primary purpose of bankruptcy is often stated to be to "award the debtor a discharge", it should be noted that the marshaling of assets will continue even if the debtor is ultimately denied a discharge, i.e., the debtor may or may not be awarded a discharge, but marshaling goes on no matter what. Thus, a cynic might conclude that the true primary purpose of bankruptcy is to marshal the debtor's assets, with a rebuttable presumption being that the debtor will be awarded a discharge, and only if debtor is honest and cooperative in ponying up her assets.

Bankruptcy Trustees have extraordinary powers, in addition to all the powers that ordinary creditors have in collecting debts. Most importantly, immediately upon the filing of a bankruptcy petition, a "Bankruptcy Estate" is created under Bankruptcy Code § 541 of all the debtor's non-exempt assets. The Trustee has broad powers to marshal the debtor's assets into the Bankruptcy Estate under § 704(a). The Trustee is sometimes said to "step into the shoes of the debtor" under 541(a), see In re Coomer, 375 B.R. 800, 807 (Bk.N.D.Ohio 2007).

Another example is that the Trustee can accept or reject executory contracts and unexpired leases under § 365. In English, the Trustee can decide whether to keep or terminate a lease, or a contract which is as yet uncompleted. This power will be of particular importance when we get to the debtor's interests in limited partnerships and LLCs below.

The Trustee also has "avoidance powers", which is the Trustee's ability to set aside certain transfers made by the debtor shortly before the filing of the bankruptcy petition. Section 547(b) allows the Trustee to avoid certain transfers (a/k/a "preferential transfers" made by the debtor in the 90 days preceding the filing of the bankruptcy petition (up to one year in the case of an insider).

However, there are numerous exceptions to the Trustee's avoidance powers, most notably:

♦ There was a contemporaneous exchange for value for the transfer, § 547(c)(1), meaning that the debtor paid cash for something or there was an asset swap of roughly equal value;

♦ The transfer was made in the ordinary course of business and according to "ordinary business terms" under §547(c)(2);

♦ If a creditor took a lien on the debtor's property, the Trustee cannot avoid the lien if the creditor gave "new value" to the debtor in an amount roughly equivalent to the lien, under § 547(c)(3);

♦ The Trustee cannot set aside the debtor's payment of spousal or child support obligations under § 547(c)(7); and

♦ The Trustee cannot set aside a transfer less than $600 in value if the debtor had primarily consumer debts, or $5,000 in value if the debtor had primarily non-consumer debts, under § 547(c)(8) and (9).

FRAUDULENT TRANSFERS

The Trustee also has the power to challenge fraudulent transfers, both under the Bankruptcy Code and applicable state law. Section 544(b) specifically allows the Trustee to apply state fraudulent transfer law to avoid transfers made by the debtor. This provision is often used by the Trustee, since state law typically provides for a longer Statute of Limitation for setting aside a fraudulent transfer (usually 4 years), as opposed to the bankruptcy fraudulent transfer provision of § 548 (2 years).

However, under § 544(b)(2), state fraudulent transfer law cannot be used to circumvent the § 548 exemption for certain charitable contributions that might otherwise be deemed as fraudulent transfers -- an exemption that is unique to bankruptcy (discussed more fully below), and the laws of some states.

The Bankruptcy Trustee can also choose to pursue "bankruptcy fraudulent transfer law", which is primarily found in § 548 (the defenses of the transferee and remedies are set forth in § 550). Usually, a Trustee will file an adversary action to set aside a fraudulent transfer under both § 548 and state law, and be quite happy if only one is successful.

Sections 548 and 550 largely conforms to the Uniform Fraudulent Transfer Act, and vice versa, with only a few exceptions. Most notably, the remedy for a fraudulent transfer under bankruptcy law (including fraudulent transfers under state law via 544(b)) is limited to avoidance of the transfer, as opposed to state fraudulent transfer law that usually gives the creditor the option of either avoidance of the transaction or a money judgment for the value of the transfer.

State collection proceedings often devolve into a cat-and-mouse game where the cat (the creditor) is trying to get the mouse's assets, but the mouse (the debtor) is moving those assets around and trying to keep them from the cat's reach. By contrast, bankruptcy proceedings are no game, and there are potential criminal penalties for the debtor who engages in serious misconduct.

The U.S. Criminal Code defines certain crimes arising from misconduct by a debtor or other person in a bankruptcy proceeding, primarily: 18 USC § 152, concealment of assets and false declarations; and 18 USC § 157, bankruptcy fraud, through "scheme or artifice".

Otherwise, misconduct and the hiding of assets by the debtor will often result in a denial of the debtor's discharge, which effectively means that the debts that the debtor was trying to discharge can never be discharged. Here, the Trustee's challenges to discharge can extend to certain transfers that were made even before the bankruptcy petition was filed.

Bankruptcy Code § 727(a)(2)(A) provides that a debtor can be denied a discharge where the debtor was involving in “transferring, removing, destroying, or concealing any of the debtor’ property” in the one-year period prior to the debtor’s bankruptcy petition, where the debtor did so with the intent to hinder, delay or defraud a creditor. See, e.g., In re Hiett, 2014 WL 4929053 (M.D.Ala., Sept. 30, 2014) (Debtor who attempted to hide money in his law firm's account prior to filing for bankruptcy was denied discharge under § 727).

The immediate benefit of bankruptcy to the debtor is the stay of all collection proceedings against the debtor, which is automatically triggered by the filing of the bankruptcy petition under § 362. The idea here is to give the debtor time to catch her breath, and prepare for an orderly winding down of her affairs and liquidation of her assets ("assisted" by the Trustee who will marshal those assets

Debtors may protect their exempt assets in bankruptcy. The bankruptcy exemptions are set forth in § 522. However, debtors may choose instead the exemptions that are available under state law, if state law so allows.

ESTATE PLANNING TRANSFERS

Let's now look at some estate planning vehicles and see how they fare in bankruptcy.

In asset protection planning, the term "gift" is often a four-letter word with a profane meaning. The reason is that gifts are inherently without any "reasonably equivalent value" or "new value" given by the recipient back to the debtor and, as such, are relatively easy for a creditor to avoid as a fraudulent transfer, or a preferential transfer if close enough to the bankruptcy filing.

If the debtor is insolvent at the time the gift is made, or rendered insolvent as a result of the gift, then such is a per se "constructive fraudulent transfer" under § 548(a)(1)(B) any may be avoided.

There is an intense bias in fraudulent transfer law (both in bankruptcy and under state fraudulent transfer laws) against gifts made by folks in financial distress, based on the quite logical conclusion that one should be using their spare bucks to pay down their creditors and not in making gratuitous transfers to others. In general, gifts are the worst form of transfers that one can make for asset protection planning purposes, unless (and this is a big unless) they think the debtor can get past the Statute of Limitations before the transfer is challenged -- which is two years under § 548, four years under the fraudulent transfer laws of most states, and as long as seven years in California.

Family members are often considered "insiders", which makes it easier for a Trustee to avoid transfers of the debtor's gifts to family members under both § 548 and state fraudulent transfer law. Section 547(b) also allows a gift to an insider to be set aside as a preferential transfer if made within one year of the filing of the filing of the bankruptcy petition.

In general, if gifts are to be made for asset protection purposes, it is better to make the gifts to an institutional trustee than to a private trustee related by family or friendship to the debtor, as the latter may be considered an "insider". The upside to a gift is that if the Fraudulent Transfer Statute of Limitations runs on the gift, it is probably thereafter unassailable by creditors and the Trustee (unless made to a "self-settled trust or similar device" which has a longer, 10-year Statute of Limitations under § 548(e)).

Charitable gifts are treated differently under bankruptcy (which protects them in part) and state fraudulent transfer laws (which usually do not protect them at all). Section 548(a)(2) protects gifts made to a "qualified religious or charitable entity or organization" of up to 15% of the debtor's gross annual income in the year that the contribution was made, or a larger amount if consistent with the debtor's (established) practices of charitable giving.

A much better method of transferring assets for asset protection purposes is by a sales transaction. A cash sale that is for the value of the asset is probably the least likely to be set aside as a fraudulent transfer. The debtor gives up the asset, but gets back cash of the same value, which makes it very hard for a creditor to argue that a fraudulent transfer has occurred since "reasonably equivalent value" or "new value" has obviously passed.

But probably few transfers for estate planning purposes are cash transactions, since the recipient of the transaction (a trust or business entity) may not have the liquidity to buy the asset that the client is selling. Thus, many estate planning transfers are accomplished by a note passing back to the asset seller.

Sales of assets for promissory notes, a common advanced estate tax planning strategy, presents a far safer type of transaction than making gifts, since such Notes are often calculated to return like value to the debtor, and thus are less susceptible to being set aside as fraudulent transfers. However, the Note must be "real" in the sense that it must be a bona fide Note on commercially-reasonable terms, and the transferee must have the financial strength to make the Note payments as they come due. "Sham Notes" will likely be treated as a gift.

The obvious downside to Note transactions is that the debtor ends up with a Note, and the Note becomes part of the Bankruptcy Estate under § 541, which the Trustee will sale so as to be able to close the bankruptcy case. This will put the debtor into the position of finding somebody friendly to try to outbid creditors for the Note, or else most likely see it pass to a creditor. Therefore, additional planning may be required to protect the Note from being exposed to creditors or otherwise passing directly into the Bankruptcy Estate.

Like Notes, asset exchanges are preferred to gifts, since the former has a chance of defeating a fraudulent transfer challenge. However, it must be considered that "reasonably equivalent value" is always measured from the creditor's perspective with the asset received by the debtor having the same "utility to creditors" as the asset which the debtor transferred.

For example, assume that the debtor transfers $1 million in cash in exchange for a membership interest of like value in a closely-held LLC. The creditor could have levied upon the debtor's cash and realized $1 million in value, but (because of the anti-alienation provisions and state law that would restrict the creditor to a charging order against the debtor's interest) the LLC membership interest would not have the same "utility to creditors" as the $1 million in cash, and therefore would be much more susceptible to a fraudulent transfer claim.

ESTATE PLANNING TRUSTS

Most estate planning transfers are to trusts, so it is important to understand how the Bankruptcy Code treats certain types of trusts.

Revocable trusts are those where the creator of the trust (the "settlor") retains the power to wind up the trust at any time; the most popular type of revocable trust being the "living trust". The assets of revocable trusts are typically deemed under state law to be available the creditors of the debtor/settlor, and thus become part of the bankruptcy estate under § 541. For this reason, revocable trusts are typically not used for asset protection planning (although they are sometimes, and quite misleadingly, advertised for this purpose), though they can later provide protection for the creditors of the successor beneficiaries just like any other spendthrift trust.

Irrevocable trusts are those where the settlor gives up the power to reverse or wind up the trust -- it's like a bullet fired from a gun, the bullet may go somewhere, but not back in the barrel. There are myriad types of irrevocable trusts, but in the bankruptcy world they can be divided into two types, being self-settled trusts (where the settlor is also a beneficiary) and non-self-settled trusts.

Assets which are transferred to a trust which is not self-settled should not become part of the debtor/settlor's bankruptcy estate, unless the transfer to the trust can be set aside as a fraudulent transfer under § 548 or under state fraudulent transfer laws under § 544. This is why the by-far best type of asset protection trust is the good old plain-vanilla irrevocable trust that a client sets up with their kids as the beneficiaries: So long as a transfer to the trust was not a fraudulent transfer, the trust assets should be completely protected in all but the rarest cases against both the creditors of the settlor and the creditors of the beneficiaries.

The problem with non-self-settled trusts is that for them to work, the client must actually give up the right to the money. Sure, Dad wants to take care of his kids, but Dad is also concerned that he may not have enough money to retire on, especially if all those condo investments in South Beach that he has personally guaranteed don't work out just right. This means that Dad wants to be the beneficiary of the Trust, hoping that he'll never need any money from it, but having the right to that money all the same.

The solution to Dad's problem (some planners would suggest) is the irrevocable self-settled trust, commonly known as the "Asset Protection Trust" or "APT". The APT comes in two varieties: The Foreign Asset Protection Trust ("FAPT" or "Offshore Trust") which is created outside the U.S., and the Domestic Asset Protection Trust ("DAPT") which is created in one of the states whose laws protect the beneficial interests in such trusts from creditors. FAPTs and DAPTs may work slightly differently in bankruptcy, as noted below.

The first question is whether the assets of a particular APT become part of the debtor's Bankruptcy Estate under § 541 upon the filing of the bankruptcy petition. As mentioned above, what constitutes the debtor's interest in property is determined by state law.

If the debtor is resident in a state that protects the debtor's interest in a self-settled trust (a/k/a a "DAPT state"), then the debtor's interest should not pass into the Bankruptcy Estate under § 541. Conversely, if the debtor is not resident in a DAPT state, then the debtor's interest should pass into the Bankruptcy Estate.

For example, if the debtor is a resident of Alaska, then upon the filing of the Bankruptcy Petition, the debtor's interest in an Alaska DAPT will likely not pass into the debtor's Bankruptcy Estate under § 541. However, if the debtor is a resident of Washington State, that debtor's same interest in an Alaska DAPT will pass into the debtor's Bankruptcy Estate.

There is a potential trap, however. Even if the debtor is resident in a DAPT state, it might be that the debtor's beneficial interest in the trust will still pass into the Bankruptcy Estate under § 541 if the trust did not comply with local law. If, for instance, the debtor has formed a DAPT in another state, but local law requires that the trust's trustee be local, then the trust will not comply with local law and the debtor's beneficial interest in the DAPT will pass into the Bankruptcy Estate despite the fact that the debtor's estate would not have passed into the Bankruptcy Estate had the trust had a local trustee.

It is this trap that will likely cause the inclusion of the debtor's beneficial interest in an FAPT to be included in the debtor's Bankruptcy Estate under § 541 since most FAPTs fail to comply with various requirements of the local state's DAPT laws, such as having a local trustee. Again, this will very much be a facts and circumstances test based on language and structure of the particular FAPT.

If the debtor's beneficial interest in an APT (whether onshore or offshore) does not pass into the debtor's Bankruptcy Estate under § 541, then the Trustee may still attempt to bring back certain transfers to those trusts back into the Bankruptcy Estate by filing an adversary action alleging a fraudulent transfer under § 544 (state law fraudulent transfer) or § 548 (bankruptcy law fraudulent transfer).

In cases involving APTs, the Trustee will likely proceed under § 548(e) which provides for a 10-year Statute of Limitations for transfers to "self-settled trusts and similar devices". This elongated period runs backwards from the date the initial Bankruptcy Petition was filed, and effectively allows the Bankruptcy Trustee to avoid any transfers to an APT if made within the 10-year period preceding the filing of the Bankruptcy Petition.

In the case of FAPTs, however, that a court may avoid a transfer does not ipso facto mean the Bankruptcy Trustee will be able to recover against the FAPT's assets; to the contrary, FAPTs are designed precisely so the Bankruptcy Trustee cannot recover against the FAPT's assets.

This does not mean that the Bankruptcy Trustee is totally out-of-luck. First, the Bankruptcy Trustee can seek so-called "Anderson relief" and ask the Court to hold the debtor in contempt (and possibly incarcerate the debtor) if the FAPT's assets are not repatriated and turned over to the Trustee. Second, the Court's avoidance order means that the FAPT's assets have been deemed to be an asset of the debtor's Bankruptcy Estate, such that no person (and particularly the debtor) can receive or enjoy those assets without risking contempt of court, and possibly more onerous penalties.

When Congress in 2005 amended the Bankruptcy Code add the new § 548(e), it recognized that debtors and their planners might attempt to come up with new schemes that are fundamentally similar to self-settled trusts, but technically are not self-trusts. Thus, Congress extended the elongated 10-year Statute of Limitations to not only transfers to "self-settled trusts" but also to "similar devices".

It is this "similar devices" language that will probably pick up the newer types of asset protection trusts, such as the "Special Power of Attorney Trust" and their offshoots such as "Hybrid Trusts". These trusts are designed so that they are not self-settled at the outset, i.e., at the point in time when the trust is settled, the settlor is not any beneficiary of the trust. However, the settlor (or somebody very close to the settlor) is at some point given a right to "appoint" interests in the trust assets, such that the settlor can become a later, "springing" beneficiary. While these provisions probably sound neat to planners who never actually go into Bankruptcy Court, it is probably unlikely that the average Bankruptcy Judge will be much fooled by these machinations.

On the other hand, it is anybody's guess what would happen in the instance of a SPA Trust where the Power of Appointment has never been exercised. It might well be that a Bankruptcy Court might treat such a trust similarly to a plain-vanilla irrevocable trust, and not a "similar device" to a self-settled trust. The most likely outcome is that the Bankruptcy Court will look at how the particular trust being challenged has been marketed and sold to the debtor: If as an asset protection device, then the trust will likely be a "similar device"; but if it is not marketed and sold to the debtor for asset protection purposes, it will be more difficult (but not impossible) for a Bankruptcy Trustee to make a successful challenge under § 548.

A debtor's beneficial interest in a revocable trust that was settled by a third-party (most typically a parent) should typically be excluded from the debtor's bankruptcy estate if (1) that trust has not terminated upon the settlor's death, see, e.g., In re Castellano, 2014 WL 3881338 (Bk.N.D.Ill., Aug. 6, 2014).; (2) distributions are discretionary and not mandatory, and (3) an enforceable spendthrift clause is present. Again, to withstand a challenge in bankruptcy, the ordinary non-self-settled irrevocable estate planning trust bereft of many bells & whistles probably has the best chance of avoiding challenge.

BUSINESS ENTITIES

If the debtors lands in bankruptcy while owning an interest in a business entities (corporations, partnerships, LLCs, etc.), that interest immediately becomes part of the Bankruptcy Estate under § 541 and may be administered by the Trustee.

A debtor's shares in a corporation must be turned over to the Trustee for liquidation. This includes the debtor's shares in a professional corporation; while the debtor may argue that shares of a professional corporation may only be owned by a like professional, this has been repeatedly held not to prevent the Trustee from realizing the value of those shares by selling them to other like professionals.

Interests in "unincorporated entities" (partnerships and LLCs) are treated quite differently in bankruptcy than corporate shares. While these interests pass into the Bankruptcy Estate under § 541, just like corporate shares, the Trustee may be limited in what he or she can do with those interests depending on state law and the Partnerships Agreement or Operating Agreement for the entity.

Interests in executory interests (i.e., interests where the partner or member must take some action to be entitled to a distribution) are subject to the anti-alienation provisions of the Partnership Agreement or Operating Agreement, and thus the Trustee may be limited to a charging order against the interest, and other restrictions in the Partnership Agreement or Operating Agreement. See, e.g., Movitz v. Fiesta Investments LLC (In re Ehmann), 319 B.R. 200 (Bankr. D. Ariz. 2005; but see In re Denman, 513 B.R. 720 (W.D.Tenn., July 24, 2014) (An LLC Operating Agreement is not an "agreement" for purposes of § 365).

Interests in non-executory interests (i.e., passive investment interests) are not subject to the anti-alienation provisions of the Partnership Agreement or Operating Agreement, and thus the Trustee becomes an assignee of the interests and may exercise all the rights held by the Debtor, including the right to vote to dissolve the entity.

Interests in a Single-Member LLC "SMLLC" become property of the bankruptcy estate under § 541 just like other LLC interests. The difference is that with a SMLLC, the Trustee effectively takes control of the LLC and its assets. In re Albright, 291 B.R. 538 (Bk.D.Colo., 2003).

CONCLUSION

These days, bankruptcy law is a very difficult and specialized area. The foregoing rules are no more than General Rules, and the admonition that "General Rules Are Generally Inapplicable" must come to mind here. Bankruptcy law is chock full of counterintuitive traps that await the novice.

But bankruptcy does follow various themes, one of the most important which is that the debtor is expected to make a full and fair disclosure of assets as a precondition to being considered for a discharge. The debtor who does not make such a disclosure, or who has engaged in hiding assets before filing for bankruptcy, should not expect a discharge -- but should expect the Trustee to claw back assets from transferees.

Therefore, asset protection planning in anticipation of bankruptcy is difficult, if not impossible in many cases, and carries many risks. Clients should be advised that no matter how painful creditors make things outside of bankruptcy, the result may be much worse in bankruptcy. Clients should also be warned that normal asset protection planning that would work just fine outside of bankruptcy, may very well fall apart in bankruptcy.

Or, as I started this article, "In Bankruptcy, All Bets Are Off". That turns out to be true far more often than not.

This article at http://onforb.es/1v8rKyH and http://goo.gl/zQkog5