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

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

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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 PROTECTION PLANNING I. INTRODUCTION

The principal purpose of this outline is to examine the asset protection benefits of traditional and cutting edge estate planning and preservation techniques available in the United States, with an eye towards conservative asset protection planning. II. BASIC CONSIDERATIONS. A. Typical Reasons for Estate Planning.

1. To provide for family. 2. To save taxes. 3. To provide sound asset management for

children. 4. To assure the continuity of a family

business. 5. To provide for retirement.

B. Another Important Reason in These Litigious TimesBTo Protect Assets from Contingent, Unknown, and Often Overzealous Juries and Judgement Creditors. 1. Litigious Society. For the past two decades our society has become increasingly litigious. Lawsuits against lawyers, doctors, engineers, architects, and officers and directors of corporations and financial institutions have become commonplace C so have large (and often huge) judgments. 2. Economic Decline. In the mid-1980's, our economy began a steady decline culminating in a recession. This decline fostered more litigation. As a result several large financial institutions disappeared; the real estate industry suffered greatly; once powerful and wealthy families lost their wealth and influence; and law firm bankruptcy practices flourished. The recession and the steep decline in consumer and investment confidence will likely foster new and more intense rounds of litigation. 3. Increased Emphasis on Asset Protection. Because of the economic problems of the mid-80's and the economic slump in 2000, clients and their financial and legal advisors began focusing on techniques and arrangements designed to insulate a client’s assets from unexpected financial reversals. The centerpiece of the planning was often the all-encompassing family limited partnership or off shore asset protection trust (and sometimes both). Entire estate plans were built around these techniques in the hopes of allowing wealthy clients to attain the previously unattainable C the full use,

benefit and enjoyment of their wealth, free from the claims of contingent, unknown, unforeseeable and often overzealous creditors. Traditional estate planning (e.g., properly drafted wills, gift trusts, life insurance trusts) seemed to take a back seat to those techniques and arrangements thought to make a client “bulletproof.” The off shore trust played (and continues to play) a major role in asset protection planning. Under this arrangement, a wealthy client, with the advice and consent of a professional advisor, transfers assets to an irrevocable and unamendable “spendthrift trust” with a situs in a foreign jurisdiction (e.g., the Cook Islands) whose laws will not give full faith and credit to U.S. judgments. An off shore trust thus can pose a virtually insurmountable obstacle for the creditor seeking to recover against the settlor of such trust. But, that obstacle is not insurmountable, because when the stakes are high, creditors can be equally creative in their attempts to recover assets. When unusual or complicated “asset protection techniques” are discovered, creditors often increase their resolve to recover from the debtor. Bankruptcy Courts can get quite angry at off shore arrangements, prompting those courts to take out their wrath on such debtors. Furthermore, various laws have been passed providing certain types of creditors (e.g., the FDIC) with special powers that make life very difficult for debtors. Subjected to these attacks, the client may be left asking the question “Was it all worth it?” One is left wondering whether the client could have effectively insulated his assets for himself and his family by limiting his estate planning arrangements to traditional and cutting edge techniques available in the United States. The answer to this question is “yes” and a careful review of this outline will support such a conclusion. This outline will also address certain drafting implications of asset protection planning. C. Scope of Outline. This outline will proceed as follows: 1. Debtor and Creditor Rights and Marital Property Liability Rules. First, we will examine relevant debtor and creditor rights and marital property liability rules that may apply if a financially secure estate planning client should experience unexpected and serious financial reversals. However, examining the laws in all fifty states is beyond the scope of this outline. Accordingly, except with respect to the discussion of domestic asset protection trusts later in this outline, the authors will generally limit their analysis to the Uniform Fraudulent Transfer Act, the Federal Bankruptcy Code, and the laws of California, Colorado, Indiana, New York, and Texas. For purposes of this outline, those states shall sometimes be referred to herein as the “Focus States.”


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With regard to Federal bankruptcy, careful attention will be given to certain “estate planning related” provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”). 2. Estate Planning Techniques (including Domestic Asset Protection Trusts). Second, we will (a) briefly examine various estate planning techniques used by serious estate planning practitioners, (b) analyze how utilization of those techniques can protect a client’s assets from unexpected financial reversals, and (c) examine certain drafting considerations of interest to the estate planner. 3. Introduction of the Jones Family. Third, we will introduce the Jones family via a hypothetical, but hopefully realistic, case study. 4. Designing a Plan for the Jones Family. Finally, we will design and analyze a sophisticated estate plan for the Jones family that minimizes transfer taxes, provides asset management, and, as an added benefit, insulates assets from financial reversals. D. Definitions and Assumptions. The following definitions and assumptions will be used throughout this outline: 1. Preservation Planning. All references in this outline to the term “preservation planning” shall mean estate planning where insulation of a client’s assets from the claims of potential creditors is one of the client’s objectives. This outline will focus only on estate planning techniques available within the United States. We will not discuss or analyze off shore trusts. It is noteworthy that over the past two decades, preservation planning has received increased attention and acceptance from the estate planning bar. 2. Assumptions: No Actual or Constructive Fraudulent Intent. Unless otherwise noted, for all purposes of this outline, it will be assumed that the client is solvent immediately before and after any estate planning technique is implemented, and that no transfer described in this outline was made with an actual or constructive intent to hinder, delay or defraud creditors. E. What Clients Will Benefit From the Lessons of This Outline? Many clients should benefit from the lessons learned from this outline. These would include a professional concerned about malpractice or negligence exposure, (e.g., doctors, lawyers, dentist, accountants, engineers, architects, life insurance underwriters, etc.), (2) investment advisors and/or securities analysts (3) individuals who sit on the board of directors of one or

more corporations or financial institutions, or (4) wealthy or successful business persons. III. STATE LAW RULES C DEBTOR AND CREDITOR RIGHTS, MARITAL PROPERTY LIABILITY, AND EXEMPTIONS. An estate planning lawyer should have at least a fundamental knowledge of debtor and creditor rights under state and federal law and must have a thorough knowledge of the marital property liability rules of his particular state. Many jurisdictions, including Texas, have adopted a variation of the Uniform Fraudulent Transfer Act [hereinafter “UFTA”]. The following is a brief discussion of the debtor and creditor rights under the UFTA and the fraudulent transfer/conveyance statutes of the Focus States, marital property liability rules of the Focus States, and exemptions of the focus states. A. A Little Context – U.S. v. Townley. This case involves the foreclosure of an IRS tax lien against property held in an irrevocable trust created by a tax protester (which may explain, at least in part, the holdings in this case). 1. Facts. In 1995, the Townleys transferred their home and some investment property to the Beaver Trust” in 1995. Although there was an independent third party trustee, Mr. Townley remained the trust manager. He lived in the home rent free and had virtually no assets remaining after the transfers to the trust. He further admitted (evidently numerous times) that the trust was created to protect against future creditors even though none existed at the time and none were reasonably foreseeable. (Unless, of course, you count the IRS with respect to future taxes.) The Townleys filed for bankruptcy after the IRS asserted its lien, and claimed that the assets in the irrevocable trust were exempt from claims of creditors. 2. Opinion. The lower court relied primarily on two factors in deciding to find a fraudulent transfer and set aside the trust – the badges of fraud (discussed below) and the admissions that the trust was established to avoid future creditors. a. Badges of Fraud. The badges of fraud relied upon to set aside the trust were (i) retention of control over the trust, (ii) the failure to respect the separate nature of the trust, (iii) the use of trust assets for personal use, and (iv) the fact that they had virtually no assets left after the transfers. Note the similarity to the factors applied by the Tax Court in FLP cases because this may become important in analyzing whether a FLP is a device similar


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to a self settled trust under bankruptcy Code §548(e), discussed in detail in Section IV.J., below. b. Transfer with Intent to Defraud. Washington adopted the Uniform Fraudulent Transfer Act without changes to the definition of fraudulent transfer as discussed in B.2., below. The Townleys’ repeated admissions that they transferred property to the Trust in order to avoid future potential creditors provide direct evidence of fraud. (9th Cir. Slip copy, emphasis added.) 3. Impact of this Case. From a precedential standpoint, this case has relatively little value. Both the lower court opinion and the appellate opinion are unpublished and thus, under 9th Circuit rules cannot be cited. But as a window into possible future judicial reasoning, how does it foreshadow a court’s approach to admitted asset protection planning or transactions for which there is really no other plausible explanation? B. UFTA and Fraudulent Transfer/Conveyance Rules of Focus States. 1. What is a “Transfer”? The definition of “transfer” under the fraudulent transfer/conveyance statutes is important since other sections of such statutes (described below) require a transfer or conveyance of property as a precondition to actionable conduct. In all cases the definition of “transfer” is very broad. Thus, UFTA §1(12) defines “transfer” as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease, and creation of a lien or other encumbrance.” The same definition is used under the Texas Uniform Fraudulent Transfer Act (TEX. BUS. & COM. CODE ANN. ' 24.002(12) (Vernon 1987) [hereinafter cited as “TBCC”]) and the Uniform Fraudulent Transfer Acts of California, Colorado, and Indiana. New York defines a “conveyance” to include “every payment of money, assignment, release, transfer, lease, mortgage or pledge of tangible or intangible property, and also the creation of any lien or incumbrance”. (N.Y. DEBT. & CRED. LAW ' 270 (Consol. 2002) [hereinafter cited as “NYC&D Law”]). The above provisions, and the fraudulent conveyance statutes of the Focus States, include, expressly or by interpretation, both gratuitous transfers and transfers for consideration. (See, e.g., TBCC ' 24.005(a); Cal. Civ. Code ' 3439.04; C.R.S. ' 38-8-105(1); Ind. Code Ann. ' 32-18-2-14; and NYD&C Law ' 276).

2. Transfer with Actual Intent to Defraud Is Void. Section 4 of the UFTA provides that a transfer made . . . by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose within a reasonable time before or after the transfer was made . . . , if the debtor made the transfer with an actual intent to hinder, delay, or defraud any creditor of the debtor . . . . The same rule applies in Texas and other Focus States. (TBCC ' 24.005(a)(1); Cal. Civ. Code ' 3439.04(a); C.R.S. ' 38-8-105(1)(a); Ind. Code Ann. ' 32-18-2-14(1); NYD&C Law ' 276).

3. What Is “Actual” Fraudulent Intent? Certainly actual intent to defraud could void a conveyance even if the debtor is solvent after the transfer. (see TBCC ' 24.005(a)(1); McWhorter v. Langley, 220 S.W. 364 (Tex. Civ. App. C San Antonio 1920, no writ); Arnold v. Peoples, 34 S.W. 755 (Tex. Civ. App. 1896, no writ); see also In re Liquimatic Systems, Inc., 194 F. Supp. 625 (S.D. Cal. 1961); Freeman v. La Morte, 307 P.2d 734 (Cal. Ct. App. 1957); Millard v. Epsteen, 137 P.2d 717 (Cal. Ct. App. 1943)). However, since actual intent is difficult to prove, courts recognize that circumstantial evidence or “badges of fraud” can be used to prove “intent to delay, hinder or defraud” a creditor within the meaning of the relevant statute. Although no single factor may be sufficient to constitute fraud, if several of the badges are present in a particular transaction, a court will likely reach the conclusion that the transaction was undertaken with a fraudulent intent. (See, e.g., Telephone Equipment Network, Inc. v. TA/Westchase Place, Ltd., ___ S.W. 3d ___, 2002 Tex. App. LEXIS 2104 (Tex. App.-- Houston 1st Dist. March 21, 2002, no writ hist.); Blackthorne v. Bellush, 61 S.W. 3d 439 (Tex. App.BSan Antonio 2001, no writ); Reynolds v. Weinman, 40 S.W. 560 (Tex. Civ. App. 1897, writ ref’d); Rives v. Stephens, 28 S.W. 707 (Tex. Civ. App. 1894, writ ref’d); United States v. Leggett, 292 F.2d 423 (6th Cir.), cert. denied, 368 U.S. 914 (1961); Jackson v. Farmers State Bank, 481 N.E. 2d 395 (Ind. Ct. App. 1985)). 4. Important Badges of Fraud. The badges of fraud most relevant to estate or preservation planning include: a. Insolvency. Insolvency of the debtor at the time of or immediately after the conveyance. UFTA ' 4(b)(9); TBCC ' 24.005(b)(9). b. Secrecy. Undue secrecy surrounding the conveyance, such as the failure to record a deed or other document of transfer. UFTA ' 4(b)(3); TBCC ' 24.005(b)(3).


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c. Transfer of All Property. Transfer of all of a debtor’s property. UFTA ' 4(b)(5); TBCC ' 24.005(b)(5). d. Transfer to Closely Related Party. A transfer of property to a transferee who is closely related to the debtor-transferor. UFTA ' 4(b)(1); TBCC ' 24.001(b)(1). e. Pending Litigation. Pending or threatened litigation against the debtor. UFTA ' 4(b)(4); TBCC ' 24.005(b)(4). f. Deviation from Normal Formalities. Entering into a transaction (e.g., gift, creation of trust, partition agreement, etc.) without following usual formalities. R. G. Blossman & Co. v. Friske, 76 S.W. 73 (Tex. Civ. App. 1903, no writ); United States v. Leggett, 292 F.2d 423 (6th Cir.), cert. denied, 368 U.S. 914 (1961). g. Secret Reservation of An Interest. The debtor’s secret reservation of an interest or enjoyment from the transferred property. UFTA ' 4(b)(2); TBCC ' 24.005(b)(2). h. Continued Enjoyment of Property. Continued possession and use of the property by the debtor- transferor. UFTA ' 4(b)(2); TBCC 5 24.005(b)(2). i. Transfer Shortly Before or After Debt Incurred. The debtor transferred assets shortly before or after a substantial debt was incurred. UFTA ' 4(b)(10); TBCC ' 24.005(b)(10). 5. Insolvency Crucial Factor. Although there are many “badges of fraud”, courts have earmarked the debtor’s insolvency at and immediately after the conveyance as a crucial and often determinative badge of fraud. Accordingly, a conveyance will not usually be held to be fraudulent as to existing creditors if the debtor-transferor has retained sufficient assets subject to execution to satisfy the claims of those creditors, assuming of course that there is no direct evidence of an actual intent to hinder, delay or defraud such creditors. (See, e.g., Mitchell v. Porter, 349 S.W. 2d 785 (Tex. Civ. App. C Houston 1961, writ ref’d n.r.e.)). Courts have also held that a transfer without adequate consideration (such as a gift) gives rise to a presumption of fraud if the donor is insolvent at the time of the conveyance or is rendered insolvent as a result of the conveyance. Therefore, it is incumbent upon the donee to show that at the time of the gift, the donor had sufficient nonexempt property subject to execution to pay the donor-debtor’s debts. See, e.g., Maddox v. Summerlin, 49 S.W. 1033

(Tex. 1899) (Burden of proof lies with the donee to show that when gift was made, the donor-spouse had enough property remaining to pay off the donor’s debts). 6. Statute of Limitations for “Actual Intent” Actions. Statute of limitation provisions vary by state and the lawyer engaged in preservation planning should be aware of the relevant limitations period governing in his or her state. The Texas statute is typical. A fraudulent transfer action under TBCC ' 24.005(a)(1) (actual intent) must generally be brought within four years after the fraudulent transfer was made, or, if later, within one year after the fraudulent transfer was, or reasonably could have been, discovered; and a fraudulent transfer action under TBCC Section 24.006(a) (constructive fraud) must generally be brought within four years after the transfer. TBCC ' 24.010. This same limitations period applies in California, Colorado, and Indiana. (See Cal. Civ. Code ' 3439.09(a) and (b), C.R.S. ' 38-8-110(1)(a) and (b), and Ind. Code Ann. ' 32-18-2-19(1) and (2)).

7. Transfer Fraudulent if Debtor Insolvent. UFTA ' 5(a) provides that a transfer by a debtor who is insolvent or will be rendered insolvent by the transfer is fraudulent as to preexisting creditors unless the transfer is made for fair consideration. The Texas Uniform Fraudulent Transfer Act and the laws of the Focus States follow the same rule. (See TBCC ' 24.006(a); Cal. Civ. Code ' 3439.05; C.R.S. ' 38-8-106(1); Ind. Code Ann. 32-18-2-15; NYD&C Law ' 273). Thus, these provisions codify what appears to be the longstanding willingness of courts to insulate gifts from the existing creditors of the donor so long as, at the time of the gift and immediately after the gift, the donor has sufficient nonexempt assets to pay his or her debts. See, e.g., Pope Photo Records, Inc. v. Malone, 539 S.W. 2d 224 (Tex. Civ. App. C Amarillo 1976, no writ); Terry v. 0' Neal, 9 S.W. 673, 71 Tex. 592 (1888) (Husband gave land to his wife and children. At the time of the gift, husband was indebted but owned sufficient nonexempt assets to pay his debts. Held: conveyance of property to one’s spouse when one has sufficient property after the conveyance to pay existing debts is valid.). It should also be noted that intent to hinder, defraud or delay is not a prerequisite to bringing an action under UFTA ' 5(a), under TBCC ' 24.006(a) or under the fraudulent transfer/conveyance statutes of the remaining Focus States. (See Cal. Civ. Code ' 3439.05; C.R.S. '38-8 -106(1); Ind. Code Ann. ' 32-18-2-15; NYD&C Law ' 273). 8. Other Actionable Transfers. State fraudulent conveyance statutes may also include other types of transfers that may be considered fraudulent. Section


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4(a)(2)(i) of the UFTA treats conveyances made without fair consideration by a person engaged or about to engage in business as fraudulent if the capital remaining after the conveyance is unreasonably small. The intent of the person is not considered. The same rule applies in Texas and most of the Focus States. (See TBCC ' 24.005(a)(2)(A); Cal. Civ. Code ' 3439.04(b)(1); C.R.S. ' 38-8-105(1)(b)(I); Ind. Code Ann. ' 32-18-2-14(2)(A); see also NYD&C Law ' 274. Section 4(a)(2)(ii) of the UFTA provides that every conveyance made and every obligation incurred without fair consideration is fraudulent if the person intends to or believes he will incur debts beyond his ability to pay as they mature. Texas and most of the Focus States have the same rule. TBCC ' 24.005(a)(2)(B); Cal. Civ. Code ' 3439.04(b)(2); C.R.S. ' 38-8-105(1)(b)(II); Ind. Code Ann. ' 32-18-2-14(2)(B). 9. Meaning of Insolvency. The insolvency of the debtor-transferor at or immediately after the transfer is often a crucial inquiry in avoiding the reach of fraudulent conveyance statutes because it is an important (if not determinative) badge of fraud. In some circumstances, the donee of a gift, as a result of a fraudulent conveyance action by the donor’s creditors, may be forced to prove that the donor was solvent at the time of and immediately after the gift. Accordingly, it is important for estate planners to understand how local law determines when an individual is insolvent. a. Balance Sheet Test vs. Ability to Pay? UFTA §2(a) provides that a person is insolvent when, at the time of transfer, the sum of the debtor’s debts is greater than the fair value of all the debtor’s assets. However, under UFTA §2(b), insolvency is presumed if the debtor is generally not paying his debts as they become due. Texas and the laws of the remaining Focus States provide similar rules. (See, e.g., TBCC ' 24.003 (a) and (b); Cal. Civ. Code ' 3439.02 (a) and (c); C.R.S. ' 38-8-103(1) and (2); Ind. Code Ann. ' 32-18-2-12(c) and (d); and NYD&C Law ' 271 (“A person is insolvent when the present fair salable value of his assets is less than the amount that will be required to pay his probable liability on his existing debts as they become absolute and matured.”)). b. How Assets Are Valued in Determining Insolvency.

i. What Assets are Considered? In determining whether an individual is insolvent under the UFTA, the debtor shall not include property that has been transferred, concealed, or removed with intent to hinder, delay, or defraud creditors or that has been transferred in

a manner making the transfer voidable. UFTA ' 2(d). The same rules apply in Texas and most of the Focus States. TBCC ' 24.003(d); Cal. Civ. Code ' 3439.02(d); C.R.S. ' 38-8-103(4); Ind. Code Ann. ' 32-18-2-12(a)(1) and (2). New York follows the same rule by implication since assets are valued at the “fair salable value.” NYD&C Law ' 271. The UFTA and the statutes of the Focus States provide that in determining insolvency, assets exempt from attachment by applicable nonbankruptcy laws shall not be considered. UFTA ' 1(2); TBCC ' 24.002(2)(B); Cal. Civ. Code ' 3439.01(a)(2); C.R.S. ' 38-8-102(2)(b); Ind. Code Ann. ' 32-18-2-2(b)(2); NYD&C Law ' 270.

ii. Fair Market Value or Forced Sales Value? In evaluating a person’s solvency, a key question is whether to value the person’s assets at fair market value or liquidation value. The Texas statute values assets at their fair valuation. TBCC ' 24.003(a). The same “fair value” test is used in California, Colorado, and Indiana. See Cal. Civ. Code ' 3439.02(a); C.R.S. ' 38-8-103(1); and Ind. Code Ann. ' 32-18-2-12(c). New York follows the “fair salable value” test. NYD&C Law ' 270.

iii. What Debts are Considered. The value of all “debts” is considered including the value of contingent liabilities as discussed infra.

iv. How to Account for Contingent Liabilities. In determining whether a debtor is solvent, every debt or enforceable claim against the debtor must be considered, including accounting for the debtor’s contingent liabilities. However, valuation of a contingent liability may be difficult and should take into account such factors as serious disputes over validity, the likelihood it will mature into present debt, set-off or contribution rights, and availability of defenses to the claim. These (and other) factors could result in discount from stated value. C. Marital Property Liability Rules. 1. Relevant Marital Property Concepts. a. Separate Property. In Texas and California, both community property states, a spouse’s separate property includes, in pertinent part, property owned or claimed by that spouse before marriage and property acquired by that spouse during the marriage by gift, devise, or descent. In both Texas and California, property directly traceable to separate property is also separate property. Colorado, Indiana, and New York, so-called common law states, likewise expressly or by implication classify a married spouse’s property as his or her separate property if such property was acquired by that spouse before marriage or during marriage (1) by gift, devise, or


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descent, (2) in exchange for separate property, or (3) by agreement of the spouses. In Texas and in most of the Focus States, property received by a spouse during the marriage by virtue of a valid partition or exchange with the other spouse is likewise separate property. b. Community Property. Community property generally includes property acquired during marriage by residents of community property states other than by gift, inheritance or devise. In Texas, community property is negatively defined as all property acquired by either spouse during the marriage that is not separate property. Tex. Fam. Code ' 3.002. Separate property is generally defined to include all property on hand at the time of the marriage, and all property acquired thereafter by gift, inheritance, devise or by partition between the spouses of community property. Tex. Fam. Code ' 3.001. In California, community property includes all property acquired by either spouse during the marriage except as otherwise provided by statute. Cal. Fam. Code ' 760. In California, rents and income from separate property are also separate property. Cal. Fam. Code ' 770. However, Texas treats such rent and income as community property unless the contrary is provided by agreement. Tex. Fam. Code ' 3.002 (The statute defines “community property” as property acquired by either spouse during the marriage, other than “separate property.” Further, the term “separate property” is not defined, under Tex. Fam. Code ' 3.001, to include rent and income from separate property.) Presumptions generally play a key role in determining the characterization of property as community or separate. In Texas, property possessed by either spouse during or on the dissolution of a marriage is presumed to be community property unless proven to the contrary by clear and convincing evidence. Tex. Fam. Code ' 3.003. The same presumption exists in California through the interpretation of Section 760 of the California Family Code. Notwithstanding the separate characterization of property, if such separate property becomes so commingled with the community property of the spouses so as to defy tracing and proper classification, all such commingled property will become community property. See, e.g., Tarver v. Tarver, 354 S.W.2d 780 (Tex. 1965); Fountain v. Maxim, 210 Cal. 48, 290 P. 576 (1930). In Texas, each spouse has the sole management, control, and disposition rights of the community property that he or she would have owned if single, including, but not limited to, that spouse’s personal earnings, revenue from separate property, recoveries from personal injuries, and any increases and mutations of, and the revenue from, all property subject to the spouse’s sole management, control, and disposition. Tex. Fam. Code '

3.102(a). When Texas spouses combine and commingle their respective sole management community property, that property becomes joint management community property. Tex. Fam. Code '3.102.

In California, either spouse generally has the management and control of community personal property with the absolute power of disposition (other than testamentary dispositions). Cal. Fam. Code ' 1100(a). However, a spouse may not make gifts [or transfers for less than fair and adequate consideration] to a third party without the other spouse’s written consent. Cal. Fam. Code ' 1100(b). Furthermore, in California, either spouse may manage and control community real property without the consent of the other spouse, but as to that real property, both spouses must agree to any sale, conveyance or encumbrance of such property or in any lease for longer than one year. Cal. Fam. Code ' 1102. 2. Relevant Rules of Marital Property Liability. a. General Rules in Noncommunity Property States. Absent an agreement or contract to the contrary, a spouse’s separate property is generally not liable for the debts and obligations of the other spouse. De Votie v. McGerr, 15 Colo. 467, 24 p. 923 (1890). b. General Rules in California and Texas. In Texas, a spouse’s creditor can reach the separate property of the debtor-spouse, both halves of the sole management community property of the debtor-spouse, and both halves of all joint management community property. Tex. Fam. Code ' 3.202. In Texas, if the liability arises because of the debtor’s tort, all community property will be liable for the debt. Tex. Fam. Code ' 3.202(d). In California, jointly managed community property may be seized by creditors to the same extent as community property managed by the debtor-spouse. Thus, because both spouses have equal management over community property in California, a creditor of either spouse may reach all of the community property and the separate property of the spouse who incurred the obligation. Cal. Fam. Code ' 910(a). However, if the spouse incurs the obligation during a period of separation prior to divorce, the assets of the other spouse (including community property) shall not be subject to that debt. Cal. Fam. Code ' 910(b). c. Distinction Between Community Debt and Joint Liability.

i. General C Presumption of Community Debt C Community Property States. In Texas, debts incurred by either spouse (hereinafter sometimes referred to as the “contracting spouse” ) during marriage are presumed to be community debts, unless evidence can be


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shown of no community benefit or that the creditor agreed to look solely to the separate estate of the contracting spouse for satisfaction of the debt. See, e.g., Cockerham v. Cockerham, 527 S.W. 2d 162, 171 (Tex. 1975). The same rule applies in California. Cal. Fam. Code ' 910.

ii. Community Debt May Not Give Rise to Joint Liability. In Texas and California, the separate property of the noncontracting spouse will not be subject to a community debt unless the noncontracting spouse is jointly liable on the debt. The fact that a debt is a community obligation does not, without more, mean that the spouses are jointly liable on the debt. See, e.g., Cockerham v. Cockerham, 527 S.W. 2d 162, 171 (Tex. 1975); Cal. Fam. Code ' 913(b)(1). Whether a noncontracting spouse is jointly liable with the contracting spouse on a community debt depends upon the facts and circumstances of each case, and more particularly whether the noncontracting spouse expressly or impliedly agreed to be liable. Cockerham v. Cockerham, 527 S.W. 2d 162 (Tex. 1975).

iii. Conclusion. In the context of creditor rights, it is often crucial to determine if a community obligation gives rise to the joint liability of the spouses. If a noncontracting spouse is found to be jointly liable on the community indebtedness, all of his or her nonexempt property (whether separate or community) is subject to execution in repayment of that debt in the event of default. On the other hand, if a community obligation does not give rise to joint spousal liability, the noncontracting spouse may be afforded a degree of creditor protection in that his or her separate property may be exempt from execution. D. Homestead Exemptions. 1. General. Homestead laws may offer a client considerable protection from the claims of creditors. However, this insulation is often obtained at the expense of lost liquidity. Although traditional estate planning does not typically include a lawyer’s recommendation to pay off a homestead (rural, urban or business), the estate planner would be remiss in not pointing out to the client the scope of the applicable homestead exemption, especially in those states where the exemption is substantial. Homestead exemptions vary from state to state. For example, in Texas, there are three types of homesteads, the rural homestead, urban homestead and business homestead, respectively. Tex. Prop. Code ' 41.002. a. Rural Homestead. The rural homestead exempts from most creditors 200 acres of land (with improvements thereon) if used or intended to be used by

a family as a homestead (100 acres for a single, adult person) and if the land is not part of a city or municipality. Tex. Prop. Code ' 41.002(b). b. Urban Homestead. The urban homestead exempts up to ten acres of land, together with all improvements thereon, if the land is used or intended to be used as a homestead by the family or a single, adult person. Texas Constitution Art. XVI, ' 51; see also Tex. Prop. Code ' 41.002(a). c. Business Homestead. The business homestead exempts land situated at a single location in the same urban area as the urban homestead (so long as that land is used for a family business). Tex. Prop. Code ' 41.002(a). It is clear the same family or single, adult individual can have a business homestead and an urban homestead so long as the total amount of land involved does not exceed ten acres. Indiana’s homestead exemption is $7,500 in value. Ind. Code Ann. ' 34-55-10-2. In California, the exemption can be as low as $50,000.00 or as high as $125,000.00 (e.g., if the debtor is 65 or older). CAL. CIV. PROC. CODE ' 704.730 (Deering 2002) [hereinafter cited as “Cal. Civ. Proc.”]; Cal. Civ. Proc. ' 704.730(a)(3). In Colorado and New York, the exemption is $45,000.00 and $10,000.00, respectively. C.R.S. ' 38-41-201; N.Y. C.P.L.R. ' 5206(a) (Consol. 2002) [hereinafter cited as “NY CPLR”]. The estate planner should consult his or her state’s homestead exemption statute to determine the size of the exemption. 2. Scope of Liability for Owner Occupant’s Debts. A homestead is not exempted from all types of creditor claims. The homestead is generally liable for:

a. Purchase Money Debts. Purchase money debts (i.e., one has to pay back the loan used to acquire the homestead). See, e.g., Tex. Prop. Code ' 41.001(b)(1); NY CPLR Law ' 5206(a).

b. Home Improvements. Improvement liens if contracted for in writing and acknowledged by both spouses. See, e.g., Tex. Prop. Code ' 41.001(b)(3).

c. Property Taxes. Ad valorem taxes against the homestead. See, e.g., Tex. Prop. Code ' 41.001(b)(2).

d. Federal Tax Liabilities. Federal tax liabilities. See e.g. United States v. Rogers, 461 U.S. 677 (1983).


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3. Who is Protected? The owner of the homestead receives full protection for the homestead in accordance with the foregoing if the residence is occupied as a homestead. At the homeowner’s death, if he is survived by a spouse, minor children, or an adult unmarried child remaining with the decedent’s family, those individuals are generally entitled to the homestead exemption. Texas Constitution Art. XVI, ' 52 (spouse and minor children receive benefit of exemption); C.R.S. ' 38-41-204 (surviving spouse and minor children are entitled to exemption at debtor’s death); NY CPLR Law ' 5206(b) (surviving spouse and minor children receive the benefit of the exemption). However, if none of those individuals survives the decedent, the homestead is subject to all creditor claims of the decedent’s estate. See, e.g., Givens v. Hudson, 64 Tex. 471 (1885); C.R.S. ' 38-41-204; NY CPLR Law ' 5206(b). 4. How Strong is the Exemption? Homestead rules are liberally and generously construed. Tolman v. Overstreet, 590 S.W. 2d 635 (Tex. Civ. App. C Tyler 1979, no writ); Haas v. DeLaney, 165 F. Supp. 488 (D. Colo. 1958). This liberal construction has in some instances been applied to tolerate near fraudulent transfers. See, e.g., Bell v. Beazley, 45 S.W. 401 (Tex. Civ. App. 1898, no writ) (The court stated, “The fact that one in failing circumstances, or practically insolvent, disposes of all his available assets in exchange for a homestead, is not, in law, considered a fraud upon creditors. . . . The insolvent debtor has the right to devote what property he may own and possess to the acquisition of a homestead.”) and Garrard v. Henderson, 209 S.W. 2d 225 (Tex. Civ. App. C Dallas 1948, no writ) (where Chief Justice Bond noted, “The policy of courts is to uphold and enforce the homestead laws notwithstanding the fact that in so doing they sometimes directly assist a dishonest debtor in wrongfully defeating his creditors.”). But there are limits as indicated in Matter of Reed, 700 F. 2d 986 (5th Cir. 1983). In Reed the debtor converted in excess of $50,000.00 of cash and property to a homestead exemption two weeks before filing for bankruptcy. Under the egregious facts (which included a clear manifestation of actual fraudulent intent), the court refused to grant a bankruptcy discharge but nonetheless allowed the exemption to stand. 5. Preservation Planning Potential. a. Paying Off Homestead. If a state has a liberal homestead exemption, advising a client to pay off his or her homestead could insulate a substantial asset from the reach of creditors. Moreover, if a client is circumspect about when he pays off the home (i.e., if he avoids “eve of bankruptcy” and outwardly fraudulent behavior), he may be able to take advantage of this exemption even

during times of financial difficulties. See, e.g., In Re Carey, 938 F. 2d 1073 (10th Cir. 1991); In Re Bowyer, 932 F.2d 1100 (5th Cir. 1991); but see, In re Reed, 700 F.2d 986 (5th Cir. 1983) (“eve of bankruptcy” discharge of homestead debt prevented debtor’s discharge); In re Sayler, 98 B.R. 536 (U.S. Dist. Kan. 1987) (use of nonexempt assets to, among other things, retire mortgage on homestead is fraudulent conveyance); Michelson v. Anderson, 31 B.R. 635, 638 (Bankr. D. Minn. 1982) (conversion of nonexempt assets into cash which was used to pay off mortgage on homestead was fraudulent). However, the lawyer should be very careful about recommending such transfers when the client is insolvent or is close to insolvency. While the client may be protected, the lawyer may not be! CAVEAT: If the client may need to file bankruptcy, the limitations imposed by BAPCPA (discussed at IV.F., infra, must be carefully considered. b. Combining a Homestead with a Qualified Personal Residence Trust. The client might consider transferring the homestead to a 10-15 year qualified personal residence trust (“QPRT”). By analogy to a life estate, an individual who retains a term interest in the homestead (and occupies same as such) may be entitled to the homestead exemption. Shaw v. Head, 55 S.W. 2d 190 (Tex. Civ. App. C Waco 1932, no writ); Chestnut v. Specht, 272 S.W. 830 (Tex. Civ. App. C San Antonio 1925, no writ). This would combine the exemption benefits of the homestead with the estate planning potential of the QPRT. 6. Drafting PointerBHomestead Designation. Some states permit and individual to voluntarily designate certain property as his homestead. This may be particularly important in those states with very generous homestead exemptions. For example, Section 41.005 of the Texas Property Code, a person can designate certain property as his homestead by a voluntary designation signed by the person and filed of record in the county where the property is located. However, care must be taken that the property described on recorded declaration is the same property claimed as a homestead for ad valorem tax purposes; otherwise, the filed declaration will abrogate the hoped for tax break. Tex. Prop. Code ' 41.005(c). An example of a declaration that complies with Texas law is attached at Annex D. 7. Beware Revocable Management Trusts. In many jurisdictions and many situations, revocable management trusts are used as the principal dispositive device, and the homestead is often placed into such trust. However, the cost of doing this may be a loss of the homestead exemption under state law. The loss of exemption is


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dependent upon state law and will vary from state to state. For example, a Connecticut case held that state law required that the residence be “owner-occupied” and that the equitable interest of the trustor was not sufficient to qualify as a homestead. In re Estrellas, 338 B.R. 538 (Bankr. D. Conn. 2006). See also In re Bosonetto, 271 B.R. 403 (Bankr. M.D. Fla. 2001), denying the homestead exemption on a horrible set of facts. The Bankruptcy Appeals Panel for the 10th Circuit, interpreting Kansas law, found that an equitable interest in the settlor was enough interest to support the homestead exemption claim in the face of language similar to that in the Connecticut statute. In re Kester, 339 B.R. 749 (B.A.P. 10th Cir. 2006). Likewise, Florida law would seem to provide that an equitable interest will support a claim of homestead exemption. In re Buonopane, 344 B.R. 675 (Bankr. M.D. Fla. 2006); In re Alexander, 346 B.R. 546 (Bankr. M.D. Fla. Tampa Div. 2006). Extending this doctrine to QPRTs goes into another whole set of issues. E. Personal Property Exemptions. 1. General. In addition to the homestead exemptions discussed above, certain types of personal property may be exempt from the claims of creditors. Those exemptions may be an additional option for consideration by a client interested in preservation planning. 2. Types of Protected Assets. Personal property exemption statutes exempt property by type and amount. Generally, the types of assets exempt include personal effects, family bible, family pictures, musical instruments, keepsakes or family heirlooms, household goods, clothing, bedding, furniture, tools and books used in a trade or business, a burial plot, a seat or pew, an automobile, and livestock and other animals (generally setting forth the specific number of each type of animal that may be treated as exempt). See, e.g., Tex. Prop. Code ' 42.002; Colo. Rev. Stat. ' 13-54-102 (1987) Ind. Code Ann. ' 34-2-28-1 (Burns 1986). In Texas, each family is allowed a personal property exemption of $60,000 ($30,000 for a single adult not a member of a family) and may exempt assets from a list of eligible types of personal property up to such limit. Tex. Prop. Code '' 42.001, 42.002. In Texas the personal property exemption includes unpaid personal service commissions (other than wages), home furnishings, provisions for consumption, farm and ranch vehicles, wearing apparel, jewelry, firearms, athletic and sporting equipment, personal motor vehicles, animals and livestock, and cash value of life insurance. In Texas, current wages for personal services (other than court ordered child support) are also exempt. Tex. Prop. Code ' 42.001(b)(1). Similar types of exemptions are provided by the laws of some of the Focus States. See, e.g., C.R.S.

' 13-54-102; Ind. Code Ann. ' 34-55-10-2; NY CPLR ' 5205(a). 3. Designation of Exempt Assets. The individual debtor may be permitted to select which assets will be treated as exempt for purposes of the personal property exemption statutes. See, e.g., Tex. Prop. Code ' 42.003; Cal. Civ. Proc. ' 703.520; C.R.S. ' 13-55-101. F. Life Insurance Exemption 1. Are Proceeds (and other benefits) Insulated from the Claims of the Insured’s and/or Beneficiary’s Creditors? Life insurance proceeds payable to a named beneficiary also may receive some special creditor protection. See, e.g., Tex. Ins. Code Art. 1108.051 (unlimited exemption if proceeds paid to a designated beneficiary); C.R.S. ' 13-54-102(l)(I)(B); Ind. Code Ann. ' 27-1-12-14. But see In Re Mueller, 867 F.2d 568 (10th Cir. 1989) (life insurance policies not exempt when, in contemplation of bankruptcy and while insolvent, debtor used nonexempt assets to repay insurance policy loans and prepay insurance policy premiums) and In re Sayler, 68 B.R. 111 (Bankr. D. Kansas 1986). The estate planner should be familiar with the scope of this exemption in his or her state. a. Restrictions as to Beneficiary. The life insurance exemption may be limited to proceeds payable to the spouse or dependent of the insured, or other specific beneficiary. See, e.g., Ind. Code Ann. ' 12-1-12-14(e) (spouse, children, dependent relative or creditor). If the policy does not designate a beneficiary within the protected class, if the insured changes the beneficiary to a person not within such class, or if the relationship between the insured and the beneficiary ceases, the exemption may be lost. Texas does not limit the exemption either by amount or identity of a beneficiary. Tex. Ins. Code Art. 1108.051. b. Cash Surrender Values. State statutes may also specifically exempt cash values from the claims of creditors. Some courts of certain states have judicially interpreted the applicable statutes to exempt cash values so as to enforce the purpose of the statute (i.e., to provide for beneficiaries who are dependent upon the insured for their support and maintenance). See, e.g., In re Bertram, 59 B.R. 186 (Bankr. N.D. Iowa 1986); Westinghouse Credit Corp. v. Crotts, 250 Iowa 1273, 98 N.W. 2d 843 (1959); but see, In re Tveten, 402 N.W. 2d 551 (Minn. 1987) (holding that Minnesota life insurance exemption statute should be interpreted to exempt an unlimited cash surrender value, but further holding that such a broad exemption provision was unconstitutional). Texas


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exempts an unlimited amount of cash values. See, e.g., Tex. Ins. Code Art. 1108.051. c. Power to Change Beneficiary. In Texas and Indiana, a power reserved by the insured to change the beneficiary will not affect the exemption. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 2(1); Ind. Code Ann. ' 27-1-12-14. d. Limits on Dollar Amount. Some states may limit the dollar amount that will be protected from creditors’ claims. See, e.g., C.R.S. ' 13-54-102(l)(A) (exempt up to $25,000.00). Texas appears to provide an unlimited exemption. Tex. Ins. Code ' art. 1108.051; see also, N.Y. INS. LAW ' 3212 (Consol. 2002) [hereinafter cited as “N.Y. Ins. Law”). e. Property Acquired with Proceeds. While it is clear the proceeds themselves are exempt, it is unclear if the exemption extends to property acquired with such exempt proceeds. f. Spendthrift Provisions. When the insurance contract limits the alienability of a beneficiary’s interest under the contract and the rights of creditors to reach such interest, some states’ statutes expressly validate such provisions. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 5; Ind. Code Ann. ' 27-2-5-1 (b); N.Y. Ins. Law ' 3212(d)(3). 2. Liability of Separate Proceeds for Debts Incurred by Insured. One crucial inquiry is the extent to which the proceeds received by the beneficiary would be liable for the claims of the insured’s creditors or the creditors of the beneficiary (in particular, the beneficiary-spouse). a. Extent of Exemption. State exemptions for life insurance proceeds may vary regarding the effect of the exemptions on creditor claims of the insured, the beneficiary, or both. Some states exempt life insurance proceeds paid to a named beneficiary. See, e.g., Tex. Ins. Code Art. 1108.051 (exempting proceeds from the claims of the beneficiary’s creditors in an unlimited amount) and Ind. Code Ann. ' 27-1-12-14. b. Exceptions to Protection. In some circumstances, life insurance proceeds will not be exempt from the claims of creditors, even though such proceeds otherwise fall within the exemption statute.

i. Validly Assigned to Creditor. It is clear that the proceeds will be subject to the claims of a creditor of the insured to the extent the insurance policy was validly assigned to that creditor as collateral for the debt. Tex. Ins. Code Art. 1108.051, Sec. 3(2); Pope Photo Records,

Inc. v. Malone, 539 S.W. 2d 224, 226 (Tex. Civ. App. C Amarillo 1976, no writ); Parker Square State Bank v. Huttash, 484 S.W. 2d 429, 432 (Tex. Civ. App. C Ft. Worth 1972, writ ref’d n. re.).

ii. Fraud in the Formation of the Insurance Contract. The insurance proceeds will generally be subject to the claims of the insured’s creditors if the insured committed fraud in the formation of the insurance contract and the beneficiary and insurance company were actually or constructively aware of such fraud. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 3(1); San Jacinto Bldg. v. Brown, 79 S.W. 2d 164, 166 (Tex. Civ. App. C Beaumont 1934, writ ref’d). This would seem to be consistent with the anti-avoidance provisions of state fraudulent conveyance statutes. Arguably the transfer of cash to the insurance company by the debtor for the purchase of insurance on the debtor’s life would be a transfer for fair and adequate consideration and therefore voidable only if the insurance company (a direct party to the transaction) and the beneficiary (a third party beneficiary to the insurance contract) has notice of the debtor’s fraudulent intent. See, e.g., UFTA ' 4, 7; but see Tex. Ins. Code Art. 1108.051, Sec. 3(1) (exemption will not apply to premium payments made in fraud of creditors); and In Re Mueller, 867 F.2d 568 (10th Cir. 1989).

iii. Insolvency When Beneficiary is Designated. It may be the insurance proceeds will be subject to the claims of the insured’s creditors if the insured is insolvent when he or she designates the beneficiary. Pope Photo Records, Inc. v. Malone, 539 S.W. 2d at 226 (Tex. Civ. App. C Amarillo 1976, no writ); Parker Square State Bank v. Huttash, 484 S.W. 2d at 432 (Tex. Civ. App. C Ft. Worth 1972, writ ref’d n.r.e.). The insured’s creditors may be able to reach the proceeds if, notwithstanding the insured’s solvency, the insured designated the beneficiary with an actual intent to hinder, delay or defraud his or her creditors within the meaning of state fraudulent conveyance statutes.

iv. Fraudulent Payment of Premiums. If the formation of the contract and initial beneficiary designation is not in actual or constructive fraud of creditors (because of insolvency or otherwise), or is not pledged as security, but subsequent premiums are made with a fraudulent intent or when the insured is insolvent, creditors of the insured are able, in some states, to recover such premiums from the insurance proceeds. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 3(1) (exemption will not apply to premium payments made in fraud of creditors); In Re Mueller, 867 F.2d 568 (10th Cir. 1989).


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However, recovery of premiums paid in fraud of creditors may be available under fraudulent conveyances statutes or Bankruptcy Code ' 548. See, e.g., Tex. Ins. Code Art. 1108.051, Sec. 3(1); In Re Mueller, 867 F.2d 568 (10th Cir. 1989). 3. Exemption Cumulative. Is the exemption provided under life insurance exemption statutes with respect to a beneficiary in addition to the personal property exemptions provided under general exemption statutes? It would appear that the answer to that question is generally yes. In Re Roper, 49 B.R. 4 (Bankr. N.D. Tex. 1984) cf. In Re Thompson, 103 F. Supp. 942 (D.C. Texas 1952) (holding that a federal bankruptcy court has the duty to interpret state exemption statutes liberally in favor of the debtor). In Roper, the Bankruptcy Court specifically held that the exemptions provided by special Texas exemption statutes are supplementary to the general exemptions provided by Tex. Prop. Code ' 42.001 et seq. The life insurance exemption in Colorado is under the general exemption provisions. C.R.S. 13-54-102(l). In Indiana and New York, the exemption is provided by a specific statute relating to insurance. Ind. Code Ann. ' 27-1-12-14; N.Y. Ins. Law ' 3212. G. Retirement Plans. A discussion of the creditor protection features of retirement benefits can be found at IV.G infra. H. Estates by the Entirety 1. General. When property was conveyed or devised to husband and wife, an estate by the entirety was created at common law. Although estates by the entirety are no longer recognized in some states, other states continue to give them effect. The practitioner should consult the law of his particular state to determine the legal effect given estates by the entirety. Under an estate by the entirety, the husband and wife take the whole estate as a single person with the right of survivorship. The estate by the entirety resembles a joint tenancy in that there is a right of survivorship in both, but is distinguishable in that the estate by the entirety may only be between husband and wife and generally may not be partitioned. 2. Liability for Debts of Spouses. Generally, an estate by the entirety cannot be destroyed by the voluntary or involuntary act of either spouse. See, e.g., Schram v. Burt, 111 F.2d 557 (6th Cir. 1940). Courts are divided as to whether and to what extent a creditor of one spouse can reach an interest of such spouse in an estate by the entirety. Compare Cullon v. Kearns, 8 F.2d 437 (4th Cir. 1925), cert. denied, 269 U.S. 587 (1926); with Hoffman v. Newell, 249 Ky. 270, 60 S.W. 2d 607 (1932). An estate by the entirety, however, is generally

subject to a joint liability of both spouses. See, e.g., First Nat’1 Bank v. Pothuisje, 217 Ind. 1, 25 N.E. 2d 436 (1940). 3. Preservation Planning Potential. In those states that recognize estates by the entirety and protect the spouses’ interest therein from the reach of creditors, substantial protection could be achieved by taking property as tenants by the entirety. The practitioner would be well advised to determine the extent of protection afforded such estates in his or her particular jurisdiction. I. 529 Plans. A so-called “529 Plan” is an investment plan offered by a state that enables an individual to invest money on a tax effective basis to help pay for “higher education expenses.” Basically, there are two types of 529 Plans: prepaid tuition plans and savings plans. The more popular of the two plans is the so called 529 savings program because the full value of the account can be used at any accredited college, university (or other education institution) in the United States. Use of the 529 savings plan offers the following main advantages: 1. Gifts to Plan Are Complete Even If Donor is the Account Holder. Gifts to a 529 Savings Plan are complete for federal gift tax purposes even though the donor is the account holder and can decide when the funds shall be used. I.R.C. '529(c)(2)(A)(i). 2. No Estate Tax Inclusion. If the donor/account holder dies, the account value will not be included in his or her estate for federal estate tax purposes. I.R.C. '529(c)(4)(A). 3. No Income Tax. Earnings in the account grow free from Federal income tax even when distributed, but only if the funds are used for qualified educational expenses. I.R.C. ''529(a), 529(c)(1), and 529(c)(3). 4. Account Holder Can Get Money Back If Needed. Amazingly, despite the above advantages, the account holder can distribute the funds to himself or herself. However, if the account holder does so, he or she will be taxed on the distribution to the extent of attributable earnings and will be subject to a 10% penalty. I.R.C. ''529(c)(6), 530(d)(1), and 530(d)(4)(A). 5. May Have Creditor Protection Too. An account holder’s 529 Plan balance may also be insulated from the claims of the account holder’s creditors if the account holder is a resident domiciliary of Alaska, Colorado, Kentucky, Louisiana, Maine, Nebraska, Ohio, Pennsylvania, Tennessee, Virginia, or Wisconsin and establishes the account in his domiciliary state. See


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generally Jeffrey T. Kwall, J.D., “Can Creditors Invade Qualified College Savings Plans?”, Journal of Financial Planning, March 2001. 6. CBAPCPA Provides Added Protection. BAPCPA offers additional protection for Education IRAs and 529 Plans. For a thorough discussion of such protection, see IV.H infra. IV. RELEVANT FEDERAL BANKRUPTCY RULES. A. Purpose and Scope of BAPCPA. Pushed largely by credit card companies, The Bankruptcy Abuse Prevention And Consumer Protection Act Of 2005 (“BAPCPA”, though denominated by several members of the bankruptcy bar simply as “BARF”) concentrates on consumer debt, but has several provisions dealing with matters that affect estate planning clients in their asset protection planning. The reader must keep in mind several key points which are easy to forget about when trying to analyze the Act. First and foremost, THE RULES DISCUSSED BELOW APPLY ONLY IN BANKRUPTCY. They have no effect whatsoever in creditor rights proceeding outside of the bankruptcy context. Thus, state law exemptions as to homestead and IRAs are unaffected outside of the jurisdiction of the bankruptcy courts. Second, certain state law exemptions (as discussed below), may have to be foregone to avail oneself of bankruptcy protection. Third, many changes which receive media attention apply only to “consumer debts”. Bankruptcy Code §101(8) (“debt incurred by an individual primarily for a personal, family or household purpose”. Note: References to the Bankruptcy Code, Title 11, U.S.C. are sometimes noted as “BC”). These “consumer debt” changes include, for example, the means testing provisions in BC §707(b) and the definition of “debt relief agency” which includes an attorney who advises a debtor in a bankruptcy proceeding. B. Effective Dates. BAPCPA was enacted on April 20, 2005, and most provisions become effective 180 days thereafter on October 17, 2005. However, certain key provisions became effective upon enactment. Such effective dates are noted in the discussion of those amendments. The entire Act is now effective. C. Exemptions. BC §522 was substantially amended to create some additional exemptions for “retirement funds” and to limit state law homestead exemptions. It basically left intact, however, the ability of a debtor to choose between state law exemptions and listed federal exemptions in bankruptcy. BC §522(b)(3)(A) is specifically made subject to BC §§522(o) and (p), dealing with homesteads, to make it clear that state law

exemptions, even in opt-out states, are subject to the homestead caps. One commentator states that this is “a significant limitation on the opt-out clause that was a crucial part of the 1978 Code’s exemption provisions.” See Brown & Ahearn, “2005 Bankruptcy Reform Legislation with Analysis”, Thomson-West (2005). D. Domicile Requirements. In prior law, the state exemptions which could be claimed by a debtor was determined by the place of the debtor’s domicile for 180 days preceding the date of filing or for a “longer portion of such 180 day period than in any other place.” That rule has been substantially changed by BAPCPA, and the change is likely to produce some bizarre results. The purpose is to prevent a debtor from moving to a jurisdiction with liberal state exemptions (e.g., Texas or Florida) and then filing bankruptcy within a relatively short time thereafter. Parenthetically, the way the new rules operate may or may not prevent gaming the system. 730 days has been substituted for 180 days, but “if the debtor’s domicile has not been located in a single State for such 730-day period, the place in which the debtor’s domicile was located for 180 days immediately preceding the 730-day period or for a longer portion of such 180-day period than any other. For example, a bankrupt lives in Indiana for 18 months prior to filing bankruptcy. Before that, the bankrupt lived in Ohio for two months, California for six months, and New York for four or more months before that. The bankrupt must, if she chooses state exemptions, claim exemptions under New York law, even though she has had no connection with New York for over two years. Bankruptcy Code §522(b)((3)(A). E. The Bankruptcy Estate, Exemptions and Exclusions. The essence of obtaining Chapter 7 bankruptcy protection (i.e., liquidation bankruptcy, which is the only type of bankruptcy really discussion in this article) is that the debtor must turn over all the assets of the debtor except those assets which are excluded or exempted from the bankruptcy estate. The debtor is allowed to elect whether to use exemptions granted under state law (except in opt-out states where state law exemptions must be used) or those granted under federal bankruptcy exemptions. Bankruptcy Code §522(d). Exclusions are available to every bankrupt, whether the bankrupt chooses state or federal law exemption. 1. The Bankruptcy Estate. Property of the bankruptcy estate is broadly defined under Section 541(a) of the Bankruptcy Code. In relevant part, this section provides that the bankruptcy estate shall include each of the following:


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a. All Interests in Property Except Exempt (or Excluded) Assets. All legal or equitable interests of the debtor in property as of the date the petition for bankruptcy was filed (the “filing date”), less exemptions (and most certainly exclusions even though exclusions are not mentioned in the statute nor in the Bankruptcy Rules. Other than as noted, there appears to be little practical difference between exemptions and exclusions. It would seem that the party objecting to an exclusion should have the burden of proof. It would also seem that the debtor should have the burden of sustaining a claimed exemption. However, Bankruptcy Rule 4003(c) places the burden on the objecting party. See In re Greenfield, 289 B.R. 146 (Bankr. S.D. Cal. 2003), which challenges the validity of the Rule. b. Debtor’s Interests in Controlled Community Property. All interests of the debtor and the debtor’s spouse in community property as of the filing date that either (a) is under the sole, equal, or joint management and control of the debtor, or (b) is liable for an allowable claim against the debtor and an allowable claim against the debtor and the debtor’s spouse, to the extent such claim is allowable. c. Fraudulent Conveyances. Property that is recovered by the trustee in bankruptcy (or debtor in possession) which was the subject of a prior conveyance which was subsequently avoided. d. Property Preserved for the Benefit of the Estate. Any property preserved for the benefit of or transferred to the estate under subordination or the subject of an avoided transfer. e. Certain After-Acquired Interests – 180 Day Property. Any interest in property that would have been property of the estate if that interest had belonged to the debtor on the filing date, and that the debtor acquires or becomes entitled to acquire within 180 days after that date (a) by bequest, devise, or inheritance; (b) as a result of a property settlement agreement with debtor’s spouse or an interlocutory or final divorce decree; or (c) as a beneficiary of a life insurance policy or of a death benefit plan. f. Income and Revenue from Property. Proceeds, product, offspring, rents, or profits of or from property of the estate, except as such as are earnings from the services performed by an individual debtor after the commencement of the case. g. Other After-Acquired Interests. An interest in property that the estate acquires after the commencement of the case.

2. Choice of Exemptions. BAPCPA generally retains the choice of the debtor to choose between state and federal exemptions, and retains the ability of states to mandate that their residents may claim only the exemptions granted under state law. Most states have exercised this right and restrict exemptions to those allowed under state law. These states are known as “opt-out states.” Fifteen states and the District of Columbia are not opt-out states, and allow their residents to choose between state or federal exemptions. These states are: Arkansas, Connecticut, Hawaii, Massachusetts, Michigan, Minnesota, New Jersey, New Mexico, Pennsylvania, Rhode Island, South Carolina, Texas, Vermont, Washington, and Wisconsin. BAPCPA does add a new class of federal exemptions in the retirement plan area and substantially restricts the availability of state homestead exemptions in certain cases. 3. Interplay With State Exemptions. It may be difficult to understand that the provisions regarding certain state law exemptions, e.g., homesteads, no longer apply in bankruptcy even when the state exemptions are elected by the debtor or when the debtor has no choice but to use state exemptions because the state has “opted out” of the federal exemptions. BAPCPA even overrides some existing state exemptions (See, e.g., Bankruptcy Code §§ 522(b)(1) - (3)). The cardinal rule here is the bankruptcy relief is a matter of legislative grace created by the Congress to give debtors a “fresh start.” It begins with the general proposition, noted above, that all property of the debtor is property of the bankruptcy estate. In the exemption provisions, the debtor is normally allowed (or even required in the opt-out states) to use state exemptions. While this may strike some as taking away the benefits of state exemption laws (which it may), the important factor is that if an individual wants to avail himself or herself of the fresh start under bankruptcy, the debtor must forego certain rights which the debtor may have outside of bankruptcy. In other words, if a debtor wants the benefit of bankruptcy protection, then the debtor must play by the rules established by Congress. An issue is raised as to the constitutionality of the loss of state exemptions in an involuntary bankruptcy, in which the debtor is forced into the clutches of the bankruptcy rules rather than seeking their protection. The issue is a due process issue. If a debtor elects bankruptcy, then the debtor has voluntarily given up the claim to the state exemptions not allowed by the Bankruptcy Code. However, if the debtor is forced into bankruptcy, then state law exemptions are not given up, but rather denied. However, the validity of this argument is best left to the bankruptcy bar.


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4. Exclusions. BAPCPA also adds new exclusions concerning IRC section 529 plans, educational IRAs, employer withholding for and employee contributions to retirement benefits, and contributions to certain health insurance plans. Bankruptcy Code §§541(b)(5)-(7). F. Homestead Exemptions. The current BAPCPA rules regarding homestead exemptions are found at Bankruptcy Code §§522(o)-(q). In an earlier House version of BAPCPA, homestead exemptions were capped at $125,000. However, as the final bill emerged, that restriction was substantially lessened to allow residents of states with large or unlimited homestead exemptions, such as Texas and Florida, to retain that exemption in bankruptcy, while still restricting the ability of a debtor to move to those jurisdictions, buy a large homestead and effectively convert non-exempt assets to exempt assets in the form of a homestead. Keep in mind that if the debtor’s state does not provide for significant homestead exemptions, this section acts only as a cap and does not increase the allowed state exemption. 1. Effective Date. The amendments concerning homestead became effective at date of enactment. 2. Limitation on Amount Dependent on Time. The principal technique chosen by Congress was to provide that, if the debtor elected state exemptions (the federal exemption for homesteads under BC §522(d)(1) is $18,450.00), a debtor could not exempt “any amount of interest that was acquired by the debtor during the 1215- day period preceding the date of the filing of the petition that exceeds in the aggregate $125,000 of value in” (emphasis added) a residence, cooperative, burial plot for the debtor or a dependent, or property claimed as a homestead. Bankruptcy Code §522(p). This limitation does not apply to family farmers as defined in Bankruptcy Code §101(18). Bankruptcy Code §522(p)(2)(A). While the goal of this section is relatively clear, the language is open to some interpretive questions. Bankruptcy Code §522(m) directs that §522 applies separately to each debtor. Thus, in a situation in which both spouses file, the exemption may go up to $250,000.

3. Necessity for Occupancy. An open question under the statute is whether the debtor must have occupied the residence as his homestead prior to the 1215 period, or whether he simply must have owned it. For example, debtor buys a home in Florida outside the 1215 day period, but then moves to Florida and moves into the home within the 1215 day period. One Florida court has

held that the debtor must occupy the home prior to the 1215 day period. In re Buonopane, 344 B.R. 675 (Bankr. M.D. Fla. 2006). Query: Does it (or should it make a difference if the debtor lived in Florida prior to the beginning of the 1215 day period? 4. Definition of “Value”. “Value” means fair market value as of the date of filing the petition (or the date acquired for after-acquired property). Bankruptcy Code §522(a)(2). This definition raises serious issues and, in some circumstances, arguably could subject a portion of the homestead or residence to claims of creditors. This argument was raised in In re Kaplan, in which the bankrupt acquired a home within the 1215 day period. 331 B.R. 483 (Bankr. S.D. Fla. 2005). The trustee in bankruptcy asserted one value which would have brought the §522(p) cap into play, and the bankrupt asserted a different value below $125,000. There were no facts in the opinion concerning the cost of the home. The court deferred resolution of that issue to deal with the opt-out issue. See discussion of In re McNabb, infra. The valuation issue was settled by the parties subsequent to the opinion. 5. Increase in Market Value. The statute speaks in terms of amount of interest acquired that exceeds $125,000 of value. In a booming real estate market with double digit increases in value, would that increase be counted as an “interest acquired”? Logic would dictate that the interest should be related only to the debtor’s funds expended on the home, since that is all that would have been available had such funds not been expended, but if the statute is read to impose a market value balance sheet test, the debtor’s equity is clearly increased by the increase in value which is arguably acquired during that period. And, the bankruptcy courts that have considered this issue seem to agree. In a Texas case in which the homestead was acquired almost 5 years before the bankruptcy filing, the court, in a somewhat simplistic analysis, construed the phrase “interest acquired” to mean the date that title to the homestead was acquired without regard to any increase in value during the 1215 day period. In re Blair, 2005 WL 3108495 (Bankr. N.D. Tex. 2005). See also In Re Sainlar, 344 B.R. 669 (Bankr. M.D. Fla, Orlando Division 2006), in which the Florida court agreed with the holding in Blair that “interest acquired” does not include appreciation during the time the home was owned, but that “acquired” refers to date of acquisition of title. 6. Payment on Debt Related to Home. Principal payments on mortgage debt, home equity loans or home improvement loans during the 1215-day period should be treated as an “interest acquired”, at least to the extent that


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they exceed normally scheduled payments necessary to amortize the debt. The Blair court would seem to contradict this when it states, “However, one does not actually ‘acquire’ equity in a home. One acquires title to a home.” Following this reasoning, a debtor could make a minimal down payment, and then pay off the mortgage with non-exempt assets during the 1215 day period without losing the unlimited homestead exemption under state law (assuming that such payment would not be a prohibited transfer). 7. Previous Residence. The amount of such interest (i.e., of an interest acquired during the 1215-day period, which is subject to BAPCPA limitation ) does not include any interest transferred within the 1215-day period from the debtor’s previous residence acquired before the 1215-day period, but only if the debtor’s previous and current residences are located in the same state. Bankruptcy Code §522(p)(2)(B). Note, ironically, that if a debtor moves from Florida to Texas, there is a new 1215-day period even though both states have unlimited homestead exemptions. A Florida court has construed this exemption to allow the rollover in values from one property to another to consider all residences owned while living in Florida. In re Wayrynen, 332 B.R. 479 (Bankr. S.D. Fla. 2005). In Wayrynen, the debtor had acquired two homes within the 1215 day period and a third home outside of that period. The court found that the exemption for amounts from earlier homes dated back to the first residence. Interestingly enough, the home purchased during the 1,215 day period was less expensive than the previous home. It is still an open question as to whether there is a time limit on the sale of the previous home if the debtor continued to reside in the same state even if the funds could be traced. 8. Bad Acts. A debtor may not exempt an “amount of an interest” in excess of $125,000 if the debtor has (i) been convicted of a felony (i.e., a crime punishable by imprisonment for more than one year – See 18 U.S.C. §3156(a)(3)) “which, under the circumstances, demonstrates that the filing of the case was an abuse of the provisions of this title”; or (ii) the debtor owes a debt arising from (w) a violation of state or federal securities laws; (x) “fraud, deceit or manipulation” in a fiduciary capacity with respect to securities registered under 1933 Act or the 1934 Act; (y) any civil remedy under section 1964 of Title 18 (RICO); or (z) “any criminal act, intentional tort, or willful or reckless misconduct that caused serious physical injury or death to another in the preceding 5 years.” Bankruptcy Code §522(q). In a recent Massachusetts case (In re Larson, 340 B.R. 444, Bankr. D. Mass. 2006) the court found that “criminal act” did not require a felony conviction in a case involving

criminally negligent homicide with a motor vehicle. Could this section also apply to medical malpractice cases where gross negligence was found? a. Time of Acquisition Irrelevant. The limitation in §522(q)(1) does not appear to be limited to residences acquired within the 1,215 day period in §522(p)(1). Thus, the issue of “interest acquired” and “value” are irrelevant for purposes of the limitation in this section. b. Necessary for Debtor or Dependent. Bankruptcy Code §522(q)(2) provides that the limitation in §522(q)(1) shall not apply to the amount of an interest if the residence “is reasonably necessary to the support of the debtor and any dependent of the debtor.” The fact that there is no time limit on the applicability of this limitation probably accounts for the fact that there is no corresponding relief under subsection (p). 9. Adjustment for Inflation. The amount in §§522(p) and (q) is subject to adjustment beginning April 1, 1998 and every three years thereafter for changes in the Consumer Price Index for All Urban Consumers based on the most recent three year period ending before January 1 of the year of adjustment. Bankruptcy Code §104(b)(1). 10. Fraudulent Transfers. While fraudulent transfers will be discussed in more detail below, it seems appropriate to note here that the homestead exemption will be reduced for any transfer made by the debtor of non-exempt property (determined as if the debtor had owned the property at date of filing) during a ten-year period preceding the date of filing with the actual intent to hinder, delay or defraud a creditor. Bankruptcy Code §522(o). 11. The Temporary Opt-Out State Controversy. In the first opinion after the homestead provisions of BAPCPA became effective, an Arizona bankruptcy court severely limited the application of the homestead exemption cap. In re McNabb, 326 B.R. 785 (Bankr. D. Ariz.2005). Strictly construing the statutory language, the court held that the cap did not apply in opt-out states. §522(p)(1) states”...[A]s a result of electing under subsection (b)(3)(A) to exempt property under state or local law....” The court held that debtors in Arizona, an opt-out state (which has a $150,000 homestead exemption), the debtor did not elect under Arizona law, since that law required him to use the state’s exemptions and thus deprived him of any election. To bolster its conclusion, the court noted that §522(o) applied to all states because its language, “For purposes of subsection (b)(3)(A)...,” which was not dependent upon an election. The court also concluded that the statutory language was


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unambiguous, and therefore resort to the legislative history was not only unnecessary, it was impermissible. And finally, the court invited Congress to fix this “glitch” in a Technical Corrections Bill which is said to be in the works. Until then, the court felt that it had to apply the statute as written. Of the states with unlimited homestead exemptions, only Texas is not an opt-out state. Of the non opt-out states with dollar limits, only Minnesota’s exemption of $200,000 exceeds the $125,000 in BAPCPA. The Court also noted that California law would apply under BAPCPA, but that the residency provision did not take effect until October 17. Subsequent courts have unanimously disagreed with the decision in McNabb, including another Arizona court. In re Summers, 344 B.R. 108 (Bankr. D. Ariz.). Florida courts found that the language in the statute was not “unambiguous” and thus resort to legislative history was not only permissible, but necessary, and that the legislative history was clear that the section was intended 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 Div. 2006) and In re Wayrynen, supra. Two Nevada courts reached the same result using the same reasoning as Kaplan. In re Virissimo, 332 B.R. 201 (Bankr. D. Nev 2005). See also In re Kane, 336 B. R. 477 (Bankr. D. Nev. 2006). 12. Tenancy by the Entirety. The application of §522(p) is dependent upon election, or at least application of state law exemptions. As discussed below, in addition to state law and federal law exemptions, §522(b)(3)(B) exempts property held as tenants by the entirety or joint tenancy with right of survivorship if such property is exempt from process under applicable nonbankruptcy law. Thus, homesteads acquired within the 1,215 day period may still be exempt if the title is held in such a way as to meet the (b)(3)(B) exemption and only one spouse or joint tenant files for bankruptcy. However, if the transfer of non-exempt assets into the homestead is a fraudulent transfer or one to which §522(o) applies, then there is no protection under (b)(3)(B). See In re Wagstaff, 2006 WL 1075382 (Bankr. S.D. Fla 2006), slip opinion. Note that joint tenancy property is not exempt to the extent of joint debts. G. Retirement Benefits. BAPCPA also contains provisions relating to retirement benefits, creating several new exemptions which apparently override state law exemptions, even if such exemptions are elected, as well as providing new federal exemptions. It provides a huge liberalization in the protection of qualified plans, IRAs and some non-qualified plans by providing exemptions from the bankruptcy estate. As a reminder, it should be noted that this protection is available only in the

context of a bankruptcy proceeding, and does not affect the rights of creditors in other contexts. 1. Governing Law Prior to BAPCPA. a. Patterson v. Shumate (504 U.S. 753 (1992). After many years of wrangling over the status of qualified plans in bankruptcy, the Supreme Court finally settled the issue as to plans which were subject to the anti-alienation clause of ERISA. 29 U.S.C. §1056(d)(1) [ERISA §206(d)(1)]. The Supreme Court decided that ERISA was “applicable non-bankruptcy law” (under Bankruptcy Code §541(c)(2)) and thus retirement plans were excluded from the bankruptcy estate. Some lower courts have tried to limit the applicability of this case by considering whether the plan in question met the qualifications of ERISA and the Internal Revenue Code. This case does not apply to situations in which the business owner and the business owner’s spouse were the only participants in the plan. b. Rousey v. Jacoway (544 U.S. 320 (2005. On April 4, 2005, the Supreme Court issued its opinion in Rousey v. Jacoway, opinion by Mr. Justice Thomas. In that case, the Court resolved a conflict among the circuit courts as to whether the exemption from the bankruptcy estate in 11 U.S.C. §522(d)(10)(E) [the “(d)(10)(E) exemption”] applied to IRAs. The (d)(10)(E) exemption provides an exemption for:

a payment under a stock bonus, pension, profit-sharing, annuity, or similar plan or contract on account of illness, disability, death, age or length of service, to the extent reasonably necessary for the support of the debtor and any dependent of the debtor.... (emphasis added)

There are several things which should be noted about this exemption. First, it is available only if the debtor does not claim state law exemptions, which are much more liberal in many cases. Second, the exemption is limited to the amount necessary for the support of the debtor. Third, although it remains in the Bankruptcy Code, its efficacy is somewhat questionable in that it is effectively overridden for all practical purposes by the new exemption in §522(d)(12) added by BAPCPA. The Court decided that an IRA (in this case, a rollover IRA) was similar to the types of plans enumerated in §522(d)(10)(E) in that in each case the plan “provide[s] income that substitutes for wages earned as salary or compensation.” Further, the Court determined that the 10% early withdrawal penalty was not insubstantial (noting that they need not decide whether a lesser penalty would be) and thus distributions were made on account of age, unlike those from a simple


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savings account which could be accessed penalty free without regard to age. The Court engaged in further analysis to support its conclusion, but in light of BAPCPA, the continuing importance of this opinion is questionable. 2. Benefits Exempted Under State Exemption Election. As discussed earlier, §522(b)(1) allows debtors to elect between federal exemptions under §522(b)(2) and state law exemptions under §522(b)(3). There are three exemptions in §522(b)(3), and they are listed in the conjunctive. If the state exemptions are elected, §522(b)(3)(A) exempts property that is exempt under federal law other than under §522(d) and state or local law of the debtor’s domicile, §522(b)(3)(B) retains the existing exemption for joint tenancy and tenancy by the entirety property, and §522(b)(3)(C) exempts “retirement funds” to the extent those funds are in a fund or account that is exempt from taxation under sections 401 [a qualified pension, profit sharing or employee stock bonus plan established by an employer for the exclusive benefit of the employees], 403 [qualified annuity plans established by an employer for an employee], 408 [IRA], 408A [Roth IRA], 414 [retirement plans for controlled groups], 457 [eligible deferred compensation plans maintained by an eligible employer for an eligible employee], or 501(a) [retirement plans by qualified charities] of the Internal Revenue Code.” a. Apparently Additional Exemption. It would seem that because §522(b)(3) is written in the conjunctive, that a debtor claiming state law exemptions would have available to the debtor the greater of the (3)(C) exemption or the exemption of qualified plans and IRAs under state law. There does not appear to be any sort of preemption of state law, which could easily have been done. Thus, if a debtor elects state exemptions, and the state law provides little or no shelter for retirement benefits, the federal exemption would protect the plans. b. Based on Tax Qualification. While the exclusion provided under Patterson v. Shumate was based on the application of ERISA, Title I, the (3)(C) exemption is based only on tax qualification under the enumerated sections of the Internal Revenue Code. BAPCPA also provides a method for determining whether the plans meet the qualifications of those sections. Bankruptcy Code §522(b)(4).

i. Subsection (A) creates a presumption that plans which have received a favorable determination under IRC §7805, which determination is still in effect at the date of filing the bankruptcy petition, are exempt under §§522(b)(3)(C) and 522(d)(12).

ii. Subsection (B) provides that, even if there is no favorable determination under §7805, those funds are exempt if the debtor demonstrates that (x) no prior determination to the contrary has been made by a court or the IRS, and (y) the retirement fund is in substantial compliance with the IRC, or (z) if not in substantial compliance, the debtor is not materially responsible for that failure. Note, curiously enough, that in the case of a plan which has not received a favorable determination, such plan will still be exempt if it meets the other requirements of (B), while a plan that has a received a favorable determination is only entitled to a presumption.

iii. Subsection (C) provides that direct trustee

to trustee transfers will not cause a loss of the (b)(3)(C) or (d)(12) exemption (discussed below).

iv. Subsection (D) states that a qualified rollover will not cause a loss of the exemption. 3. New Federal Exemption. Under Bankruptcy Code §522(d)(12), a new exemption is created under if the federal exemptions are elected. This exemption is identical to the §522(b)(3)(C) exemption and applies to “(12) Retirement funds to the extent that those funds are exempt from taxation under sections 401, 403, 408, 408A, 414, 457, or 501(a) of the Internal Revenue Code of 1986.” With the addition of this paragraph (d)(12), it is difficult to understand the need for the §522(d)(10)(E) exemption, which was the subject of Rousey v. Jacoway, supra. Even with the $1,000,000 limitation on the exemption for non-rollover IRAs and Roth IRAs (discussed below), the relief under (d)(12) would seem to be so much more liberal than the “need of the debtor” requirement in the (d)(10)(E) exemption that the latter section is unnecessary. 4. Limitation of Exemptions. The blanket exemptions which (3)(C) and (d)(12) would appear to grant, are subject to a limitation under Bankruptcy Code §522(n), which reads:

(n) For assets in individual retirement accounts described in section 408 or 408A...other than a simplified employee pension under 408(k)...or a simple retirement plan under 408(p)..., the aggregate value of such assets exempted under this section, without regard to amounts attributable to rollover contributions under section 402(c), 402(e)(6), 303(a)(4), 403(a)(5) and 403(b)(8)...and earnings thereon, shall not exceed $1,000,000 in a case filed by a debtor who is an individual, except that such amount


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may be increased if the interests of justice so require. (Emphasis added).

5. Plans Affected by Limitation. The $1,000,000 limitation is apparently designed to apply to other than employer plans and rollovers from employer plans to IRAs; i.e., to individually established IRAs and Roth IRAs. A rollover consists of a distribution to the participant followed by a contribution within 60 days to another tax exempt plan. Without the rollover provisions, the initial distribution would be taxable to the participant irrespective of what the participant did with the money. The exemption for a rollover is defined by reference to specific Internal Revenue Code sections, which sections do not include rollovers from one IRA to another under IRC §408(d)(3). The apparent result of this is that an IRA rolled over to another IRA will be subject to the $1,000,0000 limitation, while a rollover from an employer plan to an IRA would not. This should not be the case if the funds in the original IRA were rolled over from an employer plan and thus were exempt from the limitation in the original IRA. Note that limitation applies only to rollovers, and the issue of an IRA to IRA rollover can be avoided by the use of a trustee to trustee transfer, which, unlike a rollover, is not treated as a distribution. Rev. Rul. 78-406, 1978-2 C.B. However, this technique cannot exempt an IRA originally subject to the limitation. 6. Applicability to State Law Exemptions. If state law exemptions are elected and provide unlimited exemptions for IRAs, a question arises whether the highlighted language in §522(n), supra, applies only to the (3)(C) exemption or whether it also applies to limit the state law exemptions under (3)(A). Certainly there is an argument that the (3)(C) exemptions are the assets “exempted under this section” and that the state law exemptions are not limited since the exemptions, as pointed out earlier, are in the conjunctive. On the other hand, the phrase may be interpreted as applying to all of §522. However, given the effect of the limitation, this question would appear more academic than real, unless the IRA contains an “explosive” asset. 7. Applicability to Federal Exemptions. The limitation clearly applies to the (d)(12) exemption (and presumably, [but who cares?] to the (d)(10(E) exemption also.) 8. Application of Limitation. In the real world, this limitation would appear to have little effect, except in the event that a rollover IRA is commingled with a non-rollover IRA.

a. Adjusted for Inflation. The amount of the limitation is adjusted for inflation under Bankruptcy Code §104. Given the limitations on contributions to IRAs and Roth IRAs, it is very difficult to accumulate more than $1,000,000 in an individually established IRA, particularly given the increase in the limitation due to inflation. A person who began making maximum contributions 30 years ago would have contributed less than $70,000 to the IRA. It would have taken greater than a 15% compound annual return to reach $1 million. b. IRAs are Commingled. If the IRA is a commingled IRA, is tracing available to segregate the rollover portion (and its earnings) from the non-rollover portion so that the limitation does not somehow get exceeded by the rollover portion? There is no answer to this in the Act, but certainly it would be worth a try. 9. Discretionary Increase in Amount of Limitation. It is most mystifying under what circumstances the “interests of justice” would require an increase in that amount. Perhaps this could refer to a situation in which a rollover IRA also has contributions, therefore taking it out of the safe harbor. If it could be shown that the contributory portions (including earnings on that portion) were less than $1,000,000, then arguably there would be a reason to raise the limitation. Obviously, to the extent possible, rollover IRAs and contributory IRAs should be kept separate. 10. Rollovers and Trustee to Trustee Transfers. As a general rule, neither the transfer from one exempt plan to another nor a qualified rollover distribution will cause a loss of the (3)(C) or (d)(12) exemption. Bankruptcy Code §§522(b)(4)(C) and (D). 11. Spousal Rollovers. There are still (surprise!) some important questions left. Is a spousal rollover under Treas. Regs. §1.408-8, A-5 subject to the §522(n) limitation? The better argument is that it should not be if the account from which it is rolled over was protected as a rollover or a plan for which there is an unlimited exemption. If the spousal rollover is from an IRA which is not a rollover, it should be subject to the same $1,000,000 limitation. It seems this would be consistent with the treatment as an inherited IRA which should retain its exemption from the §522(n) limitation because there has been no change other than the distributee. 12. Inherited IRAs. Suppose the beneficiary of the IRA is not the spouse or the spouse does not elect to treat the IRA as his or her own? In that case, does this asset 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


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one commentator has raised the issue as to whether such funds are “retirement funds” (the asset which is described as exempt) in the hands of the beneficiary. The better reading of the statute would be that it exempts any funds in the described accounts, and that “retirement funds” is simply a convenient rubric. After all, what other than “retirement funds” ever went into accounts under the enumerated IRC sections? H. Exclusions of Education Account Benefits. In addition to the new exemptions detailed above, BAPCPA also added exclusions with relation to educational individual retirement accounts and IRC §529 plans. Bankruptcy Code §541(b)(5) and (6). 1. Education IRAs. Contributions to education individual retirement accounts are excluded from the bankruptcy estate if made more than 1 year prior to filing and (A) the designated beneficiary was a child, grandchild, stepchild or step grandchild of the debtor in the year of the contributions; (B) only to the extent that such funds are not pledged or promised to any entity in connection with any extension of credit and are not excess contributions under IRC §4973(e); and (C) in the case of funds placed in all accounts having the same designated beneficiary not earlier than 720 (sic) days nor later than 365 days, only so much of such funds as does not exceed $5,000. Thus, contributions within one year of bankruptcy are included in the estate and any contribution in the second year preceding bankruptcy filing is excluded only to the extent of $5,000 per beneficiary. 2. §529 Plans. The exclusion for §529 plans includes the purchase of a tuition credit or certificate or amounts contributed to an account in accordance with IRC §529(b)(1)(A) under a qualified State tuition program. The exclusion contains similar limitations as to the one-year and two-year time limits and the $5,000 limitation as the preceding section. Additionally, “with respect to the aggregate amount paid or contributed,” the exclusion is limited to “the total contributions permitted under [IRC] 529(b)(7) [sic]...as adjusted beginning on the date of the filing of the petition...by the annual increase or decrease...in the education expenditure category...” of the CPI. 3. Interplay with State Exemptions. If the debtor elects state law exemptions, and the state law exemptions exempt education IRAs and/or §529 plans and do not contain similar limitations, then it would seem that the excess of the excluded amount would be included in the bankruptcy estate and then exempted under state law.

I. Fraudulent Transfers in General. Bankruptcy law has long allowed trustees to set aside what are commonly denominated as fraudulent transfers or conveyances if made within one year of the filing of the petition in bankruptcy. The Bankruptcy Code provisions are comparable to the Uniform Fraudulent Transfer Act (“UFTA”) rules, and provide for two classes of fraudulent transfers. Bankruptcy Code §548. 1. Avoidance by Trustee in Bankruptcy – General Rule. A trustee may avoid certain transfers made by the bankrupt with “actual intent to hinder, delay or defraud” any creditor. Bankruptcy Code §548(a)(1)(A). a. Actual Intent and Badges of Fraud. Bankruptcy Code §548(a) (1)(A) provides that a transfer within one year of the bankruptcy filing is voidable by the trustee in bankruptcy if it can be shown to have been made with an actual intent to hinder, delay or defraud creditors. (As noted below, that will increase to two years for cases filed after one year of the date of enactment.) Since the Bankruptcy Code does not define “actual intent”, and since actual intent is so difficult to prove without resorting to circumstantial evidence, the court exercising jurisdiction over the bankruptcy matter will inquire as to whether “badges of fraud” exist which can be used to prove actual intent. See Collier, 15th Ed. Para. 548.02(5) at pp. 548-37 – 548-43 and cases cited therein; see also McWilliams v. Edmonson, 162 F.2d 454 (5th Cir. 1947), cert denied, 332 U.S. 835 (1947) and In re Roco Corp., 701 F. 2d 978, 984 (1st Cir, 1983). All of the “badges of fraud” which can be used to find an actual intent to hinder, defraud or delay a creditor under state fraudulent conveyance statutes would be badges of fraud under BC §548. A presumption of fraudulent intent may be found to exist if the trustee in bankruptcy can prove the existence of several badges of fraud. Kelly v. Armstrong, 206 F.3d 794 (8th Cir. 2000); Max Sugarman Funeral Home, Inc. v. A.D.B. Investors, 926 F. 2d 1248 (1st Cir. 1991). b. Effective Date. The changes made by TITLE XIV of BAPCPA, Preventing Corporate Bankruptcy Abuse (which includes the amendments to §548), were effective with respect to cases commenced after the date of enactment. The change extending the one-year period for avoidance to two-years took effect with respect to cases commenced more than one-year after date of enactment of the Act; i.e., April 20, 2006. BAPCPA §1406(b)(1) and (2).

2. Avoidance by Trustee in Bankruptcy – Transfer 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 exchange for such transfer” and (i) the debtor was insolvent at the time of such transfer or became insolvent as a result of such transfer, (ii) “was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital,” or (iii) if the debtor “intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured.” Bankruptcy Code §548(a)(1)(B). a. Insolvency the Key Factor. Note in this section that insolvency alone is sufficient to allow the trustee to set aside the transfer if the bankrupt did not receive adequate consideration. b. Protection of Good Faith Purchaser. This section also generally protects good faith purchasers for value. Accordingly, if a purchaser buys an asset from the debtor-transferor and pays fair and adequate consideration and has no actual or constructive notice of the debtor-transferor’s fraudulent intent, then the purchaser may retain the property. Bankruptcy Code §548(c). c. What is a “Transfer”? For purposes of the fraudulent transfer rules, a “transfer” of property to a transferee will be deemed to have occurred when a bona fide purchaser of the same property from the debtor cannot acquire an interest in the property that is superior to that of the transferee. Bankruptcy Code §548(d)(1). d. Charitable Gift Exception. Certain qualified charitable gifts are excepted from the constructive fraud provisions of §548(a)(1)(B) of the Bankruptcy Code. Bankruptcy Code §548(a)(2), added in 1998. In re Zohdi, 234 B.R. 371 (Bankr. N. D. La. 1999); In re Witt, 231 B.R. 92 (Bankr. N.D. Okla. 1999). An individual debtor’s gift to a qualified religious or charitable organization, as that term is defined under I.R.C. §170(c)(1) and (2), is not a constructively fraudulent transfer provided the gift does not exceed 15% of the debtor’s gross income for the year within which the transfer was made. Further, even if the gift does exceed the 15% threshold, the contribution will not be considered constructively fraudulent if the transfer was consistent with the debtor’s prior practice of charitable giving. Note this charitable gift exception does not apply to charitable transfers where the debtor made the transfer with an actual intent to hinder, defraud, and delay creditors. 3. Meaning of Insolvency Under Federal

Bankruptcy Rules.

a. The Balance Sheet Test. Section 101(32)(A) of the Bankruptcy Code generally defines the term “insolvent” as a financial condition such that the sum of an entity’s debts is greater than all of that entity’s property, at fair valuation, exclusive of (a) property transferred, concealed, or removed with intent to hinder, delay or defraud such entity’s creditors and (b) property that may be exempted from property of the estate under Section 522 of the Bankruptcy Code. Thus, the test of insolvency for individual debtors under the Bankruptcy Code is a balance sheet test. However, this test measures only property includible in the bankruptcy estate; i.e., property that is neither excludible nor exempt. Bankruptcy Code §101(32); see also Bankruptcy Code §101(15) (which defines “entity” to include a “person,” which in turn is defined in Bankruptcy Code §101(41) to include an individual, partnership and corporation). b. Valuation of Assets and Liabilities. As noted earlier, property of the bankruptcy estate is quite inclusive and extends to virtually any interest in property owned by a debtor. For purposes of determining insolvency, then, one must look to what is a “fair valuation.” One noted commentator has described that value as “an estimate of what can be realized out of the assets within a reasonable time, either through collection or sale at the regular market value, conceiving [market value] as the amount which could be obtained for the property in question within such period by a ‘capable and diligent business man’ from an interested buyer ‘who is willing to purchase under the ordinary selling conditions.’” See Collier 15th Ed., para. 101.29 at pp. 101-57 and 58, and cases cited under note 64. Thus, under the Bankruptcy Code a forced sale valuation of assets is inappropriate in determining insolvency. c. Inclusion of Contingent Liabilities. Under Bankruptcy Code §101(12), “debt” is defined as liability on a claim. Under Bankruptcy Code § 101(5)(A), “claim” includes those that are contingent, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured. Therefore, contingent liabilities, including potential liabilities arising as a surety, guarantor or endorser, must be included in the computation of insolvency or solvency. However, the value of those contingent liabilities may be adjusted for possible rights of subrogation or reimbursement and the likelihood that the debtor will be required to repay the debt. See Collier 15th Ed. para. 101.29 and cases cited at notes 97 and 98. 4. Trustee’s Power to Void Transfers Under State Law and Denial of Discharge. The trustee in bankruptcy has the rights of an unsecured creditor of the


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bankrupt-debtor to void transfers that could have been voided by the creditor under state law. Bankruptcy Code §544(b). This provision is particularly important since, as to alleged fraudulent transfers under state law, the trustee may rely on these statutes and the accompanying statute of limitations (which would have been available to a creditor under state law) rather than the two-year statute described in Bankruptcy Code §548. J. Transfers to “Self-Settled Trust or Similar Device”. A new provision was added to BC §548 allowing the trustee in bankruptcy to look back ten years to avoid certain transfers. Bankruptcy Code §548(e). 1. Scope of this Section. While the section was aimed specifically at DAPTs, its reach is actually much longer and much broader. The effect of the section is to extend the usual four year statute of limitations on fraudulent transfers to 10 years in the case of any transfer “self settled trust or similar device”. 2. Inclusion of Self-Settled Trusts under State Law. The trustee in bankruptcy could, under pre-BAPCPA law, bring into the bankruptcy estate only the debtor’s interest in self-settled trusts which were not protected as DAPTs under state law and which were not fraudulent transfers. a. The Shurley Analysis. In 1997, the 5th Circuit issued a landmark opinion regarding spendthrift trusts. Shurley v. Texas Commerce Bank, 115 F.3d 333 (5th Cir. 1997). In that case, one daughter (who later filed for bankruptcy) contributed her ranch, which was still in the trust at date of filing. The other daughter and the parents contributed their ranch properties. Both parents later died and their substantial estates poured over into the trust. The trust provided for distributions of income to the two sisters and invasion of principal for support. The bankrupt had a special testamentary power of appointment. The bankruptcy court found that the whole trust was self settled, and that creditors could reach the entire trust. The 5th Circuit, in a carefully reasoned opinion, found that the trust was self-settled only as to the ranch that the debtor contributed, and earnings thereon. The bankrupt argued that the only thing that a creditor could reach was her income interest, but the court rejected that argument. Citing Bank of Dallas v. Republic National Bank (540 S.W.2d 499 (Tex. Civ. App. - Waco 1976, writ ref’d n.r.e.), and Restatement 2d of Trusts, §156, the court held that the discretion in the trustee for support payments gave the debtor access to the entire self-settled portion of the trust, and thus the ranch and not merely her income interest was subject to claims of creditors.

b. General Rule. Shurley is nothing more than a restatement of the general rule that the amount included in the bankruptcy estate – i.e., the amount not excluded under §541(c)(2) as exempt under applicable nonbankruptcy law – is the debtor’s interest in the trust, including any benefit which might accrue as a result of trustee discretion. Stated another way, to the extent that the settlor has irrevocably parted with any beneficial interest (such as the remainder interest in a charitable remainder trust or a grantor retained annuity trust), such interest is not part of the bankruptcy estate unless the transfer was a fraudulent transfer. 3. Effective Date. This section became effective upon enactment. 4. Need for this Provision. It is important to note, at the outset, that, absent a provision of state law creating an exemption for self-settled trusts, those trusts are included in the bankruptcy estate to the extent of the debtor’s interest because they do not fit within the applicable non-bankruptcy law exclusion of §541(c)(2). Thus, if state law provides an exemption, then §548(e) is necessary to trump that exemption. 5. Conditions of Avoidance. A transfer may be avoided if “(A)... made to a self-settled trust or similar device; (B) such transfer was by the debtor; (C) the debtor is a beneficiary of such trust or similar device, and (D) the debtor made the transfer with actual intent to hinder, delay or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.” Bankruptcy Code §548(e)(1). An analysis of each of those provisions follows, with the analysis of “self-settled trust or similar device” being discussed last. 6. Transfer by Debtor. While this may seem fairly obvious and easy to determine, clever debtors may use subterfuges to try to avail themselves of the exclusion under BC §541(c)(2) concerning spendthrift trusts. In a case tried in the Bankruptcy Court of the Western District of Texas, Austin Division and affirmed by the federal district court of the Western District of Texas, which case is presently on appeal to the 5th Circuit, the debtor argued that transfers to third persons who later transferred the same assets to a trust established by the debtor’s sister of which the debtor was the sole beneficiary during his life, were not transfers by the debtor for purposes of determining if the trust was self-settled. In re Bradley, Case No.02-12741-FRM, Bankr. W. D. Texas-Austin (2005). The trial court and district court vigorously rejected this argument, but, nonetheless the issue was raised.


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7. Debtor as Beneficiary. If the debtor retained any interest at all or is a beneficiary, does this make the entire transfer voidable by the trustee? The answer is yes, since the statute simply requires that the debtor be “a beneficiary.” There is an open question as to whether this applies if the debtor is a contingent beneficiary. 8. Actual Intent. The concept of actual intent (as discussed above) is prevalent in the Bankruptcy Code, and indeed this section can be thought of as merely an exception to the general two-year rule under BAPCPA. a. Are DAPTs Always Made with the Proscribed Intent? With respect to DAPTs, and despite the arguments of their advocates, in a bankruptcy context, it may be difficult to argue that the transfer does not meet this test with creditors vigorously complaining. Many have argued that DAPT’s, particularly when the trust situs is outside of the settlor’s state of residency, serve no viable purpose other than removing assets from the reach of the settlor’s creditors. b. Pattern of Distributions. It would seem that a pattern of distributions either for support or based upon requests from the settlor/beneficiary might reinforce the argument that the sole purpose of the DAPT was to hinder creditors. (This would be the same argument in a non-bankruptcy setting, but with a shorter limitations period.) c. Badges of Fraud. As with the other provisions in the Bankruptcy Code dealing with actual intent, such intent may be proven by a finding of the presence of sufficient badges of fraud. d. Is There a Presumption? Does §548(e) create a presumption that a DAPT created under state law, that is exempt under state law, was not a fraudulent conveyance? Definitely not since state law does not create such presumption. After all, all state statutes deny creditor protection if the trust’s creation was itself a fraudulent transfer. e. Proving Fraudulent Intent. One practical issue with the ten year time frame is that the farther away the transfer the more difficult the proof of actual intent. Four year statutes of limitation are in place not only to allow people to get on with their life after a certain period, but also because memories tend to fade and proof disappears after a certain period. 9. Self-Settled Trusts. For estate planning lawyers, the most troublesome language in the section is that which makes a transfer to a “self-settled trust or similar

device” subject to avoidance by the trustee in bankruptcy. a. Domestic Asset Protection Trust. The DAPT is a self-settled trust that is exempt under state law, so that if state law exemptions are chosen, this provision is designed to override the state law exemption. Note that all DAPT laws exclude transfers that are fraudulent under state law from the protection of a DAPT, so that even if the debtor elects state law exemptions, the trustee can proceed under §544(b) if state law is more exacting than federal law or if the trustee is within the usual four year statute of limitations. If federal exemptions are elected, the DAPT would offer no protection because the DAPT would not be (i) exempt under the federal exemptions and (ii) excluded under the “applicable nonbankruptcy law” rubric of BC §541(c)(2). b. Self-Settled Estate Planning Trusts. Arguably, split interests trusts which are specifically sanctioned by the Internal Revenue Code or Regulations should be presumed to have been created for purposes other than the actual intent to delay, hinder or avoid creditors, except in egregious circumstances. Whether the provision will be so interpreted remains to be seen. To the extent the trustee is successful in avoiding the conveyance, the trustee should be able to reach the entire trust and not just the debtor’s retained interest therein.

i. Grantor Retained Annuity Trust. Because GRATs are clearly self-settled trusts which are not exempt under most state laws, the annuity interest would be includible in the bankruptcy estate and would not qualify as a spendthrift trust under other nonbankruptcy law of §541(c)(2). If the GRAT (or GRUT) is conventionally designed for maximum gift tax leverage (e.g., a Walton GRAT), then establishing actual intent would be extremely difficult in view of the fact the grantor retained an annuity equal to the contribution plus some return thereon. Another issue with GRATs is that most of them are very short term so that the transfer to the remainder person will probably be complete before filing for bankruptcy. In that event, the settlor would no longer be a beneficiary, and §548(e) should not apply and conventional fraudulent transfer analysis and statute of limitation rules would apply.

ii. Qualified Personal Residence Trust. The trustee in bankruptcy is entitled to set aside the entire transfer under §548(e) and not just to acquire the right of occupancy which is the debtor’s sole interest.

iii. Charitable Remainder Trust. The trustee in bankruptcy can reach the entire transfer. It will be interesting to see how many trustees would try to take


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assets away from a charity? And there really is no statutory authority to set aside a portion of the transfer. Again, fraudulent intent in this kind of transfer may be difficult to prove. 10. Similar Device. As pointed out above, there are issues even with the direct object of this provision. Still more frightening is what the bankruptcy trustee and the bankruptcy court might determine to be a similar device. Estate planners use many techniques for discounting or wealth transfer that may contain an element of creditor protection, but such estate planners would not consider many of them to be “similar devices” to a DAPT. And, even if such technique is a similar device, §548(e) does not apply unless actual intent can be shown. Because most of these techniques (a term vastly preferable to the more pejorative term “device”) are used in connection with traditional tax favored wealth transfer planning, there ought to be almost a presumption that the technique, even if considered a “similar device” usually is not entered into with the “actual intent” required by the statute. While advocates of DAPTs would argue that they are also wealth transfer devices, the author does not believe that their primary function is wealth transfer and/or estate tax avoidance. a. Retirement Plans. Some commentators have suggested that an IRA or retirement plan by a controlling shareholder (or perhaps even one by an employer where participation is elective) is a similar device. That proposition would seem difficult to sustain in view of the elaborate provisions in §522(b)(3)(C) and 522(d)(12), not to mention the exclusion of ERISA qualified employer plans under §541(c)(2). b. Life Insurance and Annuities. Many states have statutes that are extremely favorable to life insurance and annuity policies, exempting both the policies and their proceeds from claims of creditors of the owner of the policy and the beneficiary unless the transfer to acquire or maintain the policies constituted a fraudulent transfer. Absent egregious facts, it would seem difficult to attach badges of fraud to such policies. It may be slightly easier to attack anuities if the debtor was wealthy at the time the policy was acquired because of the apparent lack of need of an income stream in later years. However, there are the arguments concerning tax deferred growth and even creditor protection if there were no reasonably foreseeable creditors on the horizon. c. Life Insurance Trusts. In life insurance trusts, the settlor is not a beneficiary and thus this would not meet the definition of a self-settled trust. A “similar device” must also meet the requirement that the person establishing the device be a beneficiary.

d. Partition of Community Property. While it would seem that this technique would fall outside the scope of §548(e)(1) because the spouse who files bankruptcy is not a beneficiary of the property partitioned to her spouse, under the law of certain states, income from separate property is still community property, and thus the bankrupt spouse could arguably be a beneficiary, even though the income may be subject to the sole management of the owner-spouse. (Note that Texas has a presumption that income from a gift of community property is the separate property of the donee-spouse. However, by statute, the income from partitioned property is community property unless the partition agreement provides to the contrary). In many ways, however, the partition is simply another way of rearranging ownership and should not be subject to the similar device analysis. Even if the partition is unequal, the analysis should be a “fraudulent transfer” analysis rather than a “similar device” analysis. This should be true even if the partition puts exempt assets in the hands of the potential debtor and non-exempt assets in the hands of the spouse. e. Inter-Vivos QTIP. This technique is frequently used in common law jurisdictions to assure the ability of each spouse to take advantage of the full unified credit. While it has the effect of putting assets out of the reach of the donor spouse’s creditors, its use would seem not to be a similar device since the donor spouse is not a current beneficiary. However, note the question raised above about contingent interests. Suppose the donee spouse has a special power of appointment which includes the donor among the class of potential appointees. The better argument would seem to be that this transfer is not a similar device, but how many bankruptcy judges (or lawyers for that matter) are going to understand the workings of an inter-vivos QTIP. f. Family Limited Partnerships. The most difficult technique to analyze is the FLP, which typically combines wealth transfer planning with asset protection. And with a long series of FLP cases requiring substantial purposes other than estate tax avoidance, there may be a danger (for asset protection purposes) in expressly arguing before the IRS or in tax court that one such non-tax purpose FLP’s serve is asset protection. However, the analysis used in many tax cases may be instructive in the bankruptcy context. One of the elements relied upon in Strangi v. Commissioner, 429 F.3d 1154 (5th Cir. 2005) as well as other similar cases was the amount of assets the transferor placed in the partnership in relation to total wealth. This is very similar to the badges of fraud and insolvency test. And, if asset protection is only one


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benefit, does that, in itself, rise to the level of actual intent? 11. Transfers by Evil People. Bankruptcy Code §548(e)(2) includes in the definition of a “transfer” certain transfers involving judgments and criminal fines, “incurred or which the debtor believed would be incurred” for certain securities laws violations and “fraud, deceit or manipulation in a fiduciary capacity.” Some have argued that this is a limitation on (e)(1), but the better view is that it is in addition to the general self-settled trust rule. It is believed that this section provides the “actual intent” as a matter of law. 12. Why This Is So Unsettling. Uncertainty in the law brings an inability to properly advise clients in the planning and structuring of their affairs. As with the rest of BAPCPA, this provision is so poorly drafted that it is inevitable that it will create uncertainty. Compound this with the fact that it will be argued by bankruptcy lawyers who have no knowledge of estate planning techniques, and will be decided by bankruptcy judges, who probably have even less knowledge, and you have a recipe for disaster reminiscent of the early days of arguments as to the effect of bankruptcy on qualified retirement plans. K. Dismissal For Abuse. As to a non-consumer debtor, the standards under which a bankruptcy case may be dismissed have not changed. Bankruptcy Code §707(a). As for consumer debtors, a multitude of new requirements must be met. The case can be dismissed if the consumer debtor meets the means test but does not voluntarily convert to a Chapter 11 or Chapter 13. L. Involuntary Bankruptcy. The rules on involuntary bankruptcy are not materially changed by BAPCPA. Bankruptcy Code §303. If the bankrupt has 12 or more unsecured creditors it takes three creditors to force the debtor into involuntary bankruptcy; with less than 12, it takes only one. In either case, the debts among the three or one debtor must aggregate $12,300.00. 1. Who Are Creditors? While almost everyone has twelve creditors when recurring monthly bills are counted, some bankruptcy courts have held that such “de minims” debts do not count toward the twelve creditors. See Denham v. Shelman, 444 F.2d 1376 (5th Cir. 1971) (“It is a well settled proposition that insignificant debts which are customarily paid on a regular basis should not be counted to defeat an involuntary petition.”) Cited in In re Smith, 123 B.R. 423 (M.D. Fla. 1990). For a professional then, it might be difficult to find 12 creditors, and thus one malpractice claim could result in an involuntary bankruptcy.

2. Constitutional Issue. It is clear that if a debtor voluntary elects to avail himself or herself of the protections of bankruptcy law, the debtor cannot complain about the loss of certain state law exemptions. But there appears to be a serious constitutional question, raised by bankruptcy judges and academics, as to whether such rights may be taken away involuntarily. This could be one of the more interesting issues to watch. 3. Can You Even Have An Involuntary Bankruptcy? One commentator has argued that the credit counseling requirement under Bankruptcy Code §109(h) applies to every individual bankrupt, and thus, if the debtor simply fails to take the credit counseling, the bankruptcy action, even an involuntary bankruptcy, must be dismissed. This argument seems to go a bit too far to be credible, and will meet the same fate as the opt-out state controversy on homesteads.. M. A Closing Thought. Despite the fact that Congress had more than ample time to refine the language of the Act, BAPCPA is a very poorly drafted statute which will create problems for estate planners (and bankruptcy lawyers) for many years to come. In discussing the homestead exemption, the Kaplan court (331 B.R. 483, Bankr. S.D. Fla. 2005) stated in a microcosm what is true of the entire act:

Over the coming months, or years, courts will need to wrestle with some interpretation issues in calculating the available exemptions under the cap in §§522(p) and (q), including, for example, how to handle appreciation in the property. Courts should focus on these issues and the scores of other issues arising under the Reform Act that will engender bona fide debate.”

If anything, that observation is an understatement. V. PRELIMNARY CONSIDERATIONS FOR PRESERVATION PLANNING. In designing a preservation plan for a client, care must be taken to document the that all estate planning techniques which include the transfer of assets were not undertaken in actual or constructive fraud of preexisting or anticipated creditors and that the client was “solvent” immediately before and immediately after the transfer. A. First Satisfy Yourself You Can Represent the Client. Before the practitioner accepts the representation, he must first satisfy himself that the client’s motives are clean, i.e., the client is not undertaking the plan with an actual or constructive intent


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to hinder, defraud, or delay creditors. This will require a careful examination of the client’s motives and a careful review of the client’s current financial condition. In many instances, the client’s clean motives and obvious solvency (as described below) can be determined during the initial interview (e.g., if the client is a long-time client). B. Solvency Balance Sheet and Affidavit of Solvency and General Intent. It is very important for the practitioner to satisfy himself that the client is [and will] remain “solvent” both before and immediately after the plan is implemented. However, as noted above, in the context of asset protection planning, a person is considered “solvent” if the fair market value of his nonexempt assets exceeds the fair value of his liabilities including contingent liabilities. Consideration should therefore be given to requiring the client to prepare a solvency balance sheet both before and immediately after the plan is implemented. An example of such a balance sheet with regard to our hypothetical family is attached as Annex A. A few comments regarding the “solvency balance sheet” are in order:

i. The balance sheet should be signed by the client(s).

ii. If practicable, the balance sheet should be certified as accurate by the client’s CPA, to the best of the CPA’s knowledge and belief.

iii. Rule of Thumb: If the fair market value of the liquid assets is not 200% of the client’s liabilities (including contingent liabilities), consideration should be given to obtaining formal valuations of hard-to-value assets (e.g., real estate, limited partnership interests, closely held stock) and such valuations must reflect lack of control and lack of marketability discounts.

iv. Valuing contingent liabilities may be particularly problematic. If the client is defendant in an actual or threatened lawsuit, an attempt should be made to have defense counsel assess a value to the claim including the client’s out- of-pocket defense costs. In some instances, a client can easily obtain such a letter. In other cases, defense counsel may refuse to provide any information regarding the value of the claim. In those instances, the practitioner may have no choice but to include the entire value of the claim as a debt.

After the practitioner has been provided with a “solvency balance sheet” demonstrating that the client is solvent, the Client should be asked to provide the practitioner with an affidavit regarding his solvency (with the

solvency balance sheet attached) and general intent. As mentioned above, the insolvency of a client before or immediately after a transfer, is an important [and often conclusive] badge of fraud, however evidence of other badges of fraud can also tip the scale against the client and against the practitioner’s representation of the client. A few comments about the affidavit of solvency are appropriate: C. Affidavit Helps Avoid Implications of Fraud. The affidavit is admittedly self serving but does offer some protection for the practitioner if a judgment creditor makes a claim against the practitioner for participating in a fraud:

i. The affidavit attempts to address the nonexistence of the following nonfinancial badges of fraud: pending litigation, threatened litigation, secret reservation of an interest in any transferred property, transfer shortly before or after substantial debt is likely to be incurred, transfer shortly before the client intends to enter into a risky business that could give rise to liabilities beyond the client’s ability to pay.

ii. The client should consider signing another affidavit (and providing another “solvency balance sheet”) shortly after the preservation plan is fully implemented. The latter affidavit would allow the client to affirm that he did not retain a secret reservation of an interest in the transferred property or continued to enjoy the transferred property.

D. Engagement Letter. After the practitioner has satisfied himself that he can ethically represent the client, he should require the client to sign an engagement letter that sets forth the scope of the representation and the fee arrangements.

VI. EXAMINATION OF VARIOUS ESTATE PLANNING TECHNIQUES AND TOOLS IN THE CONTEXT OF PRESERVATION PLANNING. A. Outright Gifts C Advantages. Outright gifts of property have long been an important and effective estate planning tool. Those gifts (1) are easy and inexpensive to make; (2) can permanently remove property (and appreciation) from the donor’s estate for federal estate tax purposes even if the donor dies within three years of a gift (thereby saving tax dollars); (3) can achieve some limited income shifting benefits for donees who are fourteen and


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older; and (4) enable the donor to observe how the donee handles money, which provides insight into testamentary planning. Assuming no actual or constructive fraud, the effectiveness of outright gifts as a “preservation planning” tool will in large part depend on whether the parties can establish that the gifts were not fraudulent as against preexisting creditors especially if the donee is a family member. If the gift is attacked as a fraudulent conveyance, it is critical the donee be able to prove that the gift did not render the donor insolvent (exclusive of the gift and property not available for execution) and was not made when the donor was insolvent (exclusive of the gift and property not available for execution). See, e.g., Maddox v. Summerlin, 49 S.W. 1033 (Tex. 1899) (burden of proof lies with the donee to show that when gift was made, the donor-spouse had enough property remaining to pay off his debts). If the donee cannot sustain such proof, the gift may be voidable under state law and under federal bankruptcy law. Bankruptcy Code ' 548. B. Gifts to Spendthrift Trust C Donor Not a Beneficiary. 1. Advantages. Gifts in trust offer all of the same advantages of outright gifts, with the added advantage of ongoing management for trust beneficiaries. If the trust does not permit voluntary assignment or alienation by the beneficiary of his or her beneficial interest in trust, or involuntary attachment of such interest by the beneficiary’s creditors, the so-called “spendthrift trust” may also offer the added advantage of insulation of trust assets from the claims of a beneficiary’s creditors. 2. General Rules Re: Spendthrift Trusts. Although the differences of the various state laws are wide, most states have long recognized that an individual is free to establish a trust for the support and maintenance of a beneficiary which prevents the beneficiary from voluntarily or involuntarily assigning or alienating his interest. See, e.g., Tex. Prop. Code ' 112.035. Some common exceptions to this rule are that spendthrift trust protection will not generally be available if the settlor is also a beneficiary of the trust or if a creditor seeks reimbursement from the trust for expenses incurred for the legal support and maintenance of a beneficiary’s dependents. See e.g. Tex. Prop. Code ' 112.035(d). However, the legislatures of a handful of states (most Notably Alaska and Delaware) have reformed their trust laws specifically to allow for self-settled spendthrift trusts, as discussed below. Practitioners should determine the status of spendthrift trusts in their particular jurisdiction as well as the exceptions and/or limitations that may apply.

3. Insulation from Creditor Claims. a. Of Donor. Whether gifts under a spendthrift trust, under which the donor is not a beneficiary, will be useful as a “preservation planning” tool will generally require examination of the same factors as are examined with respect to the preservation planning potential of outright gifts. Accordingly, absent a clearly manifested actual intent to hinder, delay or defraud creditors, the main inquiry will be on whether the gift to the trust rendered the donor insolvent or was made at a time when the donor was insolvent. If at or after the gift in trust, the donor does not have sufficient nonexempt assets to pay his debts, it is unlikely that the gift in trust will afford any real protection. b. Of Beneficiary. In those states which recognize spendthrift trusts, it is clear that if the spendthrift trust is validly created, the creditors of a beneficiary will have no greater claim to the assets of the trust than the beneficiary could have. Accordingly, if the trust is a purely discretionary trust and the beneficiary has no right of withdrawal, the beneficiary’s interest should be insulated from the claims of his creditors and any attempt at alienating, pledging, or otherwise charging his beneficial interest in the trust should be void. First Bank & Trust v. Goss, 533 S.W. 2d 93 (Tex. Civ. App. C Houston [1st Dist.] 1976, no writ); Baker v. The Vermont Bank & Trust Co., 342 F.2d 12 (2d Cir. 1965) (applying Vermont law); Johnson v. Morawitz, 292 F.2d 341 (10th Cir. 1961) (applying Kansas law); Patton v. Patrick, 123 Wis. 218, 101 N.W. 408 (1904). This rule is subject, of course, to the special rule regarding indebtedness incurred by a beneficiary relating to the support of dependents. Thus, the preservation planning usefulness of a spendthrift trust from the focus of a beneficiary is quite good assuming that the fraudulent conveyance obstacles can be avoided.

4. Extra Care if Donor is Trustee of the Trust. The donor should not be a trustee of the trust. This prohibition makes sense from an estate and income tax standpoint since a trust under which the settlor is a trustee could, if not properly drafted, be included in the donor-settlor’s estate for federal estate tax purposes, or be a complete failure as an income shifting tool. Cf. Rev. Rul. 79-353, 1979-2 C.B. 325; United States v. O’Malley, 383 U.S. 627 (1966); Cf. I.R.C. ' 674. However, if the donor insists on being the trustee, extra care should be taken (1) to insure the gift is complete for federal gift tax purposes, (2) to avoid inclusion of the trust in the donor’s estate, and (3) to avoid violating the grantor trust rules (unless a defective grantor trust is desired).


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5. Creditor Protection if Beneficiary is Sole Trustee. Section 541(a) of the Bankruptcy Code provides that if the debtor is a beneficiary of a spendthrift trust valid under applicable state law, then the assets of the trust are not considered property of the bankruptcy estate. However, does this rule apply if the beneficiary is the sole trustee of the trust under which the beneficiary is not the settlor? Answer: It depends on the state law applicable to the trust and/or how the trust is actually administered. a. Individual is Sole Trustee and Sole Beneficiary. If the beneficiary is the sole trustee and also has the entire beneficial interest, then the legal title and beneficial title will merge and the spendthrift provision will no longer apply because the trust will terminate as a matter of law. 2 A. Scott & Fratcher, The Law of Trusts ' 99. As a practical matter, in a well drafted trust, legal title and beneficial title will not merge because of the existence of remainder beneficiaries. In such instances, the spendthrift provision may be valid even if the sole current beneficiary is also the sole trustee. b. Texas Saves Sole Trustee Spendthrift Trusts. Texas law avoids application of the merger doctrine in a sole trustee/sole beneficiary trust if the trust is designated a spendthrift trust and if the settlor is not the trustee. In such instances, Texas courts will appoint a new trustee or co-trustee thereby avoiding the merger of interests and termination of the trust. ' 112.034(c).Tex. Prop. Code. Furthermore, Texas law specifically provides that spendthrift trust protection is not lost if the beneficiary is the sole trustee so long as distributions to that beneficiary are limited to an ascertainable standard such as health, education, maintenance and support. ' 112.035(f).Tex. Prop. Code. c. But Certain Bankruptcy Decisions and Restatement Put Sole Beneficiary/Sole Trustee “Spendthrift Trusts” At Risk B at Least in Certain States. Practitioners must look to local law to determine if sole trustee/sole beneficiary trusts will be accorded spendthrift trust protection.

i. In Re McCoy, 2002 U.S. Dist. LEXIS 13239 (ND, Ill. 2002). In this case, Wife died and created a testamentary trust naming Husband as trustee. Under the trust, Husband was to receive all income at least quarter-annually for Husband’s lifetime. Husband/trustee was also empowered, under the trust instrument, to distribute corpus to himself as he required or desired for Husband’s health, support, and maintenance without regard to the interests of any other beneficiary. The trust had a typical anti-alienation (i.e., spendthrift) clause. Husband filed for bankruptcy and the Chapter 7 trustee sought to include

the trust assets as part of Husband’s bankruptcy estate. Held: trust was not a valid spendthrift trust under Illinois law because Husband had “unregulated dominion and control over the corpus of the trust.”

ii. In Re Pugh, 274 B.R. 883 (AZ 2002). In this case, Mother died and created a discretionary testamentary trust for Son and named Son as trustee. The trust had an anti-alienation (i.e., spendthrift) clause. The trust provided that no distributions can be made to Son unless Son appointed a “person of suitable age and discretion to serve as co-trustee.” Son appointed Sister as a co-trustee but never told her of the appointment and continued to use the trust assets without any oversight from Sister or anyone else. Son filed for Chapter 7 bankruptcy and the bankruptcy trustee sought to include assets of the trust as part of the bankruptcy estate. Held: Court found that Son was in fact the sole trustee. Accordingly, because Son was the sole trustee, Arizona statutory and case law invalidated the spendthrift provisions.

iii. Restatement (Third) of the Law of Trusts. Section 60, Comment g of the Restatement (Third) of the Law of Trusts states that sole trustee of a trust under which the trustee is a beneficiary does not receive spendthrift trust protection even though subject to a distribution standard such as HEMS. The theory is that the trustee has effective control over the trust assets and their distribution. The Restatement (Third) thus applies the same rule that Restatement (Second) applied to self settled trusts, i.e., that a creditor of a trustee-beneficiary can reach as much of the trust assets as could have been distributed to the trustee-beneficiary. d. Drafting Pointers. In those states, such as Texas, that give effect to spendthrift trust language even if the beneficiary is the sole trustee, drafting trusts to permit the beneficiary to be the sole trustee of his “spendthrift” trust would appear to be effective to insulate the trust’s assets from the claims of the beneficiary’s creditors. Nonetheless, if asset protection is an important consideration, consider the following:

i. First and foremost, make sure the trust has an anti-alienation (i.e., spendthrift) provision. A form of spendthrift clause is as follows:

Spendthrift Trust Provision. Each trust created hereunder is a spendthrift trust. Accordingly, prior to the actual receipt of property by any beneficiary under the terms of any trust created by this instrument, no property (income or principal) distributable under that trust shall be subject to anticipation or assignment by any


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beneficiary, or to attachment by, or interference or control of, any creditor or assignee of any beneficiary, or be taken or reached by any legal or equitable process in satisfaction of any debt or liability of any beneficiary. Any attempted transfer or encumbrance of any interest in that property by any beneficiary hereunder prior to distribution shall be void.

ii. Appoint an independent corporate fiduciary as

the sole trustee of the trust. iii. Provide for a very strong facility of payment

clause so that the trustee may make distributions for the benefit of the beneficiary directly to third parties without making actual distributions to the beneficiary.

iv. Or appoint one or more independent individual trustees as the only trustee(s) of the trust. In this context, an independent trustee would be a individual who is not related or subordinate to the beneficiary.

v. Or appoint the beneficiary as a co-trustee with a corporate fiduciary or individual independent trustee but give investment powers to the beneficiary/trustee and distribution powers to the corporate of individual independent co-trustee.

vi. If the beneficiary is a sole or co-trustee and the trust is a discretionary trust, the trustee(s) should be limited to making distributions to the beneficiary for his health, education, maintenance and support, after taking into account other financial resources available to the beneficiary.

vii. If the beneficiary is a sole or co-trustee of a trust which may be used for his support, do not include a provision that says that the trustee’s shall act in his sole and absolute discretion or that the exercise of his discretion shall be binding and conclusive on all parties.

viii. Do not give the beneficiary a withdrawal right over the trust.

ix. Include a provision in the governing instrument empowering one or more independent individuals to remove and replace a trustee. This power can even be given to the beneficiary, but in that case the power should be limited to the appointment of a corporate trustee or an individual who is not related or subordinate to the beneficiary, and, of course, should include a prohibition against the trustee appointing himself. If it is desired to use a committee, the following language could be included in the trust to achieve this result:

Trust Committee. A. Appointment of Trust Committee. I hereby appoint a Trust Committee (herein so-called) for each trust created hereunder and that committee shall be composed of [MEMBERS]. If membership in a committee is reduced to less than three (3) individuals, the remaining member or members of that committee shall appoint a sufficient number of individuals to bring the total membership of the committee to a total of three (3) individuals. If at any time there are no members serving under a Trust Committee, then the adult beneficiaries of the applicable trust who are entitled to have income distributed to or accumulated for their benefit, if any, and if none, any beneficiary of any trust created hereunder, may appoint three (3) individuals to serve on that committee. Such an appointment shall be by an acknowledged instrument delivered to all individuals so appointed. Under no circumstances shall any Trustee who is removed by a Trust Committee serve on any Trust Committee hereunder. No beneficiary of any trust created hereunder or Trustee of that trust shall serve as a member of the Trust Committee for that trust. It is my intention that there shall always be three (3) members serving on each Trust Committee hereunder. B. Powers of Trust Committee. The Trust Committee for each trust created hereunder shall have the discretionary power, by majority vote, to remove at any time a Trustee of that trust (other than my Spouse but including, if applicable, a Co-Trustee appointed by any individual Trustee) and, in its discretion, appoint a successor Trustee. The powers granted under this subsection must be exercised by acknowledged instrument, signed by those members of the committee intending to exercise those powers, and delivered to the Trustee being removed and, if applicable, to the successor Trustee being appointed. No Trustee or member of the Trust Committee for that trust shall be liable for the exercise of or failure to exercise that committee’s discretionary powers granted hereunder. No member of any Trust Committee hereunder shall have any duty to monitor the performance of a Trustee or to take any action with respect to that trust. Further, each member of each Trust Committee hereunder shall be held harmless and indemnified from the assets of the applicable trust for any claim or cause of action filed against that committee member for


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exercising or failing to exercise that committee’s discretionary powers hereunder. Any Trustee appointed by a Trust Committee must be an Independent Trustee.

C. Life Insurance. 1. General. Life insurance has long been a favored estate planning (and estate creation) tool. Furthermore, despite the seven-pay test of I.R.C. ' 7702A, it has also been “tax favored.” For example, the so-called “inside build-up” on participating (i.e., dividend paying) and nonparticipating cash value policies can occur on a “tax deferred” basis, and with few exceptions, the insurance proceeds will be received by the beneficiary(ies) free from any income tax. Theodore H. Cohen, 39 T.C. 1055 (1963) (cash values); I.R.C. ' 72(e)(1)(b) (dividends); I.R.C. ' 101(a). 2. Preservation Planning Potential. Assuming the client has not violated state or federal fraudulent conveyance statutes through the purchase of insurance or a plan or program of annuities, state life insurance exemption provisions seem to offer some interesting preservation planning as follows: a. Purchase of Interest Sensitive Life Insurance Policies including Whole Life, Universal Life and Variable Life. A client who seeks to achieve certain preservation planning objectives, should consider purchasing an interest sensitive life insurance policy, including whole life, universal life, or variable life (which provides the potential for market appreciation) rather than term insurance. This would appear to offer substantial protection to a designated beneficiary assuming that the client has not purchased such policy with an intent to hinder, defraud or delay creditors. Notwithstanding the rules for modified endowment contracts as provided under I.R.C. ' 7702A, single premium whole life may also be a useful preservation planning tool. The adverse income tax consequences can be minimized if the taxpayer/insured waits until he or she attains age 59-1/2 before borrowing from or otherwise receiving distributions from the policy. Although some states limit the protection afforded life insurance cash surrender values, other states appear to grant an unlimited exemption. For example, Texas appears to offer unlimited protection. See, e.g., Tex. Ins. Code Art. 1108.051. b. Nonqualified Deferred Annuity. Consideration could also be given to implementing a deferred annuity program either independently or through the client’s employer if the client is an owner of a closely held business or is in a position to influence the employer’s decisions in this regard. The statutes of several states

specifically protect benefits under an annuity contract from the reach of creditors. Tex. Ins. Code Art. 1108.051; Ind. Code Ann. ' 27-2-5-1. D. Irrevocable Life Insurance Trusts. 1. Description of Technique. a. General. The irrevocable life insurance trust has long been a useful and popular estate planning tool. Under this arrangement, the settlor generally establishes an irrevocable trust for certain designated beneficiaries (e.g., his children). The trustee of the trust then becomes the owner and beneficiary of a life insurance policy on the settlor’s life or on the lives of the settlor and the settlor’s spouse (either through an original purchase by the trustee or through a gift of the policy to the trustee). Since the trust does not generally have sufficient cash with which to make premium payments that cash is generally provided by the settlor or other individuals through cash gifts to the trust. A distinguishing characteristic of an irrevocable life insurance trust is that each beneficiary is generally given a 30- to 60-day right to withdraw his or her pro rata portion of each gift to the trust. If the withdrawal right is not exercised, it lapses as to that year. The purpose of the withdrawal right is to cause such gifts to be considered gifts of a “present interest” thereby qualifying for the annual per donee gift tax exclusion under I.R.C. ' 2503(b). See Crummey v. C.I.R., 397 F.2d 82 (9th Cir. 1968); Rev. Rul. 73-405, 1973-2 C.B. 321; Mary Hull Naumoff, 46 T.C.M. 852 (1983). b. Primary Reasons for Use. The primary estate planning advantages in using these trusts are: (1) complete exclusion of the insurance proceeds from the gross estates of the settlor and the settlor’s spouse, (2) avoidance of the onerous generation-skipping transfer tax, and (3) availability of the insurance proceeds to the estate of the settlor and the settlor’s spouse by empowering the trustee, on a discretionary and nonbinding basis, to purchase assets from or loan money to an estate. 2. Effectiveness of Technique As a Preservation Planning Tool: a. Insulation from Claims of Settlor’s Creditors. Since the settlor-insured should never be a beneficiary of this trust, the effectiveness of the irrevocable trust to insulate life insurance trust assets (including proceeds paid to the trust upon the death of the settlor) from the claims of settlor’s creditors will largely depend upon whether any transfers to the trust are considered fraudulent conveyances or ineffective gifts within the meaning of state fraudulent conveyance provisions or Bankruptcy Code ' 548. If any portion of the trust is attributable to prior fraudulent conveyances, that portion


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may be reachable by the creditors of the settlor or the settlor’s estate. b. Insulation from Trust’s (or Trust Beneficiaries’) Creditors.

i. Invariably Designated a Spendthrift Trust. Irrevocable life insurance trusts are invariably designated as spendthrift trusts by the practitioner. This is done to protect the proceeds from the claims of the trust beneficiaries’ creditors. As indicated earlier, spendthrift trusts are generally upheld under the laws of most jurisdictions. Accordingly, prior to distribution, trust assets should be insulated from the beneficiaries’ creditors because of the “spendthrift trust provisions.” But see discussion below regarding the lapse of a withdrawal right.

ii. Applicability of Exemption Provisions. Even if the spendthrift provision is found to be invalid, state life insurance exemption statutes may insulate trust assets from the trust beneficiaries’ creditors. Because many of such statutes offer protection from the beneficiary’s creditors, a literal reading of such statutes would offer protection to the trust itself since it is literally the beneficiary of the life insurance proceeds. However, if such provisions are interpreted to include, within the definition of beneficiary, “beneficiaries of the trust”, additional creditor protection may be available.

iii. Does Beneficiary Become a Grantor When Withdrawal Right Lapses? As discussed earlier, when gifts are made to an irrevocable life insurance trust, each beneficiary is usually given a right to withdraw his or her pro rata portion of the gift for a specified period. When a beneficiary allows his or her withdrawal right to lapse, for gift tax purposes, the beneficiary is deemed to have made a gift of the property subject to the power, subject to the so-called “$5,000 or 5%” exclusion. I.R.C. '' 2514(b) and (e); I.R.C. ' 2041(b)(2). Although no case addressing the issue was found, it may also be true that under state property law, a beneficiary is deemed to have made a transfer of property when he or she allows his or her withdrawal right to lapse. If so, that beneficiary has then become both a settlor and beneficiary of the trust possibly invalidating the spendthrift feature of the trust. The argument would be that the spendthrift trust provision is invalid with respect to any portion of the trust attributable to the beneficiary-debtor’s lapsed withdrawal rights. For examples in which gifts to a trust by a settlor under which he was a permissible beneficiary were held to be incomplete gifts because of the invalidity of underlying spendthrift clauses, see Outwin v. Commissioner, 76 T.C. 153 (1981), Rev. Rul. 76-103,

1976-1 C.B. 293, and Ltr. Rul. 8350004 (August 17, 1983). However, state exemption statutes may prevent creditors of the beneficiary from reaching those proceeds so long as the lapse of a withdrawal right itself is not considered a transfer subject to the fraudulent conveyance statutes. See, e.g., Tex. Prop. Code ' 112.035(e). E. Marital Property Partitions (Community

Property States). 1. Traditional Uses for Such Agreements. Marital property partition and exchange agreements between spouses domiciled in community property states (hereinafter called “marital property agreements”) have been used by estate planning lawyers for a variety of reasons. Some of the more common uses are as follows: a. In Funding Irrevocable Life Insurance Trusts. It may be advisable to create separate property out of community property to enable the noninsured spouse to fund, with her separate property, an irrevocable life insurance trust that purchases and maintains a life insurance policy on the life of the insured-spouse. If the insured dies within three years after the trust purchases the insurance, the proceeds would arguably be removed from the insured’s estate. See I.R.C. ' 2035(d)(2) (which appears to apply only if the transferor (or deemed transferor) of the life insurance policy was the insured; Headrick v. Commissioner, 918 F.2d 1263 (6th Cir. 1990); Estate of Joseph Leder, 893 F.2d 237 (10th Cir. 1989); Ltr. Rul. 8906003 (September 16, 1988). Alternatively, the insured-spouse may need separate property to fund the irrevocable life insurance trust so that the noninsured spouse can be a beneficiary of the trust without running afoul of I.R.C. '' 2036 and 2038. If the noninsured spouse is a beneficiary and is deemed to have made one-half of the gifts (e.g., because of community property laws), one-half of the trust proceeds would arguably be includable in her estate at her subsequent death. b. To Create an Estate in the Nonwage Earning Spouse. The spouses may wish to partition community property (e.g., cash, marketable securities or other liquid assets) to create an estate in the spouse who works inside the home raising the children and managing the household. 2. Background. a. General. Marital property agreements are specifically authorized by statute in Texas and California. For example, Section 4.102 of the Texas Family Code provides that spouses, at any time, may enter into a partition or exchange agreement between themselves with respect to any part of their community property then


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existing, or to be acquired, and that the property transferred to a spouse as a result of such agreement shall become that spouse’s sole and separate property. The Texas Family Code also provides that spouses may agree that income or property arising from the separate property then owned by either of them, or which may thereafter be acquired, shall also be the separate property of the owner. Tex. Fam. Code ' 4.103. In Texas, such an agreement must be in writing and must be signed by both spouses. Tex. Fam. Code ' 4.104. b. Effect of Marital Property Agreements on Creditors. Generally, if a conveyance between spouses is supported by adequate consideration and does not involve fraud or undue influence, the transaction will be enforced by courts. If such a transaction is in fraud of creditors, the conveyance may be set aside under state fraudulent conveyance statutes. See e.g. Tex. Fam. Code ' 4.106. 3. Marital Property Partition as Preservation Planning Tool. Assuming that the partition agreement is entered into without an actual or constructive intent to commit fraud against a preexisting creditor and the transferor-spouse is not insolvent at the time of the partition or rendered insolvent because of the partition, the marital property agreement can be a useful preservation planning tool. This is because the property set aside to a nondebtor spouse would become the sole and separate property of that spouse and may not be subject to the liabilities of the other spouse unless both spouses become liable by other principles of law. 4. Post Partition Safeguards. If a marital property partition agreement is entered into between the spouses for the purpose of creating separate property in a nondebtor spouse, it is essential that the integrity of the agreement be preserved by following certain post partition safeguards. Consider the following checklist: a. Retitle Property. Take all necessary steps to retitle (in the sole name of the wife) separate property set aside to the wife as her sole and separate property; and retitle (in the sole name of the husband) separate property set aside to the husband as his sole and separate property. b. Proper Tax ID Number. Make sure bank accounts, brokerage accounts, and similar accounts bear the social security number of the spouse in whose name the account is styled. c. Sign and Record Deeds. Make sure deeds conveying real and personal property are properly signed and recorded.

d. Consider Recording Marital Property Agreements. If practical, record the marital property partition agreement to take advantage of statutes providing for constructive notice when such an agreement is properly recorded. For example, Texas Family Code '4.106(b) provides that a marital property agreement between spouses may be recorded in the deed records where the spouses reside and in each county where real property affected by the agreement is located. The statute goes on to provide that with respect to real property, if the partition or exchange agreement is recorded in the county where the real property is located, such recordation shall serve as constructive notice to a good faith purchaser for value or a creditor without actual notice. Tex. Fam. Code '4.106(b).

Practice Pointer. Some clients are timid about recording a partition agreement that lists the values of the assets to be partitioned. If so, consider having the spouses execute several copies of the partition agreement and make sure that one of the copies has omitted the values of the assets. Use that executed original for purposes of recordation. If the document is to be recorded in several counties, consider execution of multiple copies.

Recordation also eliminates the element of secrecy in the transaction. As discussed earlier, undue secrecy is a common badge of fraud. TBCC ' 24.005(b)(3); United States v. Leggett, 292 F.2d 423 (6th Cir.), cert. denied, 368 U.S. 914 (1961). e. Revise Financial Statements. Remove the property set aside to the nondebtor spouse from the debtor spouse’s balance sheet. f. Separate Books. Have the nondebtor spouse maintain a separate set of books with respect to his or her separate property. g. Document Nondebtor Spouse Loans to the Debtor Spouse. If it is necessary for the nondebtor spouse to advance funds to the debtor spouse, document all such advancements as loans and consider securing such loans. h. Sign No Agreements Creating a Charge Against Nondebtor Spouse’s Estate. If one of the purposes of the marital property partition agreement is to insulate the separate property set aside to the nondebtor spouse from the business risks thereafter assumed by the debtor spouse, caution the nondebtor spouse against signing loan guarantees, promissory notes, partnership


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agreements, or any other agreements which could create a charge against the nondebtor spouse’s assets. i. Avoid Commingling of Assets. Avoid commingling any jointly owned or community property with the separate property set aside to the nondebtor spouse. j. Periodically Reaffirm the Agreement. Reexecute the marital property partition agreement every few years. This could serve as a useful cleanup of problems if commingling has occurred. F. Qualified Personal Residence Trust. 1. Background. Chapter 14 of the Code contains valuation rules applicable to certain gifts under which the transferor retains an interest. These rules are designed to prevent the overvaluation of the retained interest (and therefore the undervaluation of the residual or remainder interest passing to the donee) by requiring that the retained interest meet certain conditions. If those conditions are not met, the retained interest is required to have a zero value. Since the thrust of Chapter 14 is that the valuation of the gift is equal to the valuation of the entire interest minus the retained interest, a zero valuation for the retained interest can result in a much larger gift. Under Chapter 14, the retained interest must be in the form of an annuity interest (that is, a fixed payment payable at least annually) or a unitrust interest (that is, annual payments equal to a fixed percentage of the fair market value of the trust as determined annually). If the retained interest is not in the form of an annuity or unitrust interest, the value of the retained interest is zero and therefore the value of the gift to the trust is equal to the value of the entire interest in the property. I.R.C. ' 2702(a)(2). 2. Qualified Personal Residence Trust. An exception to the required annuity or unitrust payments is found in the rules relating to qualified personal residence trusts, or “QPRT.” Under this arrangement, the taxpayer transfers his homestead and/or a vacation home to his children while retaining the exclusive use, possession and enjoyment of the house for a fixed term. The gift is equal to the fair market value of the residence less the value of the retained interest The QPRT may be a very effective wealth shifting technique.

Example: Assume Jane, age 50, transfers a personal residence worth $1 million to a fifteen year QPRT. Assume the applicable rate under I.R.C. ' 7520 is 6%. At this interest rate, the retained (i.e., “use value”) of the house would be $640,750.00. Accordingly, the transferred

interest (i.e., the gift) would be valued at $352,210.00. If the home appreciates at 6% per year, at the end of fifteen years the home would be worth approximately $2.4 million. If Jane has outlived the trust term, substantial value has been transferred at a very low gift tax cost. Moreover, since the home has a use value rather than an income stream, Jane had no accumulation of income as in the case of a GRAT or GRUT.

3. Advantages of Qualified Personal Residence Trust. The main estate planning advantages to this technique are as follows: a. Value Shifting With Minimum Gift Tax Consequences. If properly structured and implemented, if the term holder outlives the term of the QPRT, none of the residence should be included in the term holder’s estate for federal estate tax purposes. Thus, any appreciation in value occurring after the gift will be shifted to the remainderman. b. Retained Use and Enjoyment. The term holder is entitled to the use, possession, benefit, management and control of the residence during the term of his or her estate. Authority for this proposition should be the life estate cases. Blackwell v. Blackwell, 24 S.W. 389 (Tex. 1893); Gonzales v. Gonzalez, 457 S.W. 2d 440 (Tex. Civ. App. C Corpus Christi 1970, writ ref’d n.r.e.). Despite these benefits, the term holder, by analogy to the duty of a remainderman who succeeds to the interest of a life tenant, should also have a duty not to commit waste on the property and, by agreement, would generally be required to act prudently toward the property. Gonzalez, 457 S.W. 2d at 447; Bryson v. Connecticut General Life Ins. Co., 196 S.W. 2d 532 (Tex. Civ. App. C Austin 1946, writ ref’d) (in general, a life tenant owes a duty to the remainderman to protect the remainderman’s interest from forfeiture by reason of any act or omission on the part of the life tenant). 4. Technique as Preservation Planning Tool. a. Transfer of Remainder Valid if Not in Fraud of Creditors. A QPRT should be upheld as valid as long as the transfer is not in actual or constructive fraud of creditors. However, if transfer is made with actual intent to defraud, BAPCPA brings back the entire interest for a period of ten years. b. Limitation on Sale Without Consent of Remainderman. This technique could be attractive as a preservation planning tool. This is because, unless otherwise provided by the instrument creating the QPRT or by agreement between the term holder and


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remainderman, the term holder would not likely have a power of sale over the entire fee interest in the property without the consent of the remainderman. Again, authority for this proposition would likely rest with life estate/remaindermen cases. Although the term interest would certainly be subject to execution and sale in payment of the term holder’s debts, the term interest is likely to be an unattractive asset to a creditor because upon expiration of the term, the property would automatically pass to the remainderman. If anyone is willing to purchase the term interest, it would likely be the bankrupt and then at a substantial discount. c. Bankruptcy Trustee’s Inability to Sell

Remainder Upon Term Holder’s Bankruptcy. i. Bankruptcy Code ' 363(h). Subsection

363(b) generally empowers a trustee in bankruptcy to sell property of the bankruptcy estate after proper notice and hearing. In addition, if certain conditions are met, Subsection 363(h) empowers the trustee to sell an asset of the bankruptcy estate free and clear of an interest any other individual (or individuals) may have had in that asset as joint tenants, tenants in common or tenants by the entirety with the debtor-bankrupt. Such sale can only occur if (a) a partition of the estate’s interest is impracticable, (b) a sale of the estate’s undivided interest would realize significantly less than if the whole property is sold (and parcels allocated), (c) the benefit of sale to the estate outweighs the detriment, if any, to co-owners, and (d) such property is not used in the production, transmission, or distribution, for sale, of electrical energy or of gas for heat, light or power.

ii. In Re Livingston. An important limitation on the scope of Bankruptcy Code ' 363 was announced by the United States Court of Appeals for the Eleventh Circuit in In Re Livingston. 804 F.2d 1219 (11th Cir. 1986) [hereinafter cited as Livingston]. In Livingston, a married couple purchased a home and because of the peculiarities of local (Alabama) law, the couple’s joint ownership interest was found to be a tenancy in common for life with a cross contingent remainder in fee. Thus, upon the death of a spouse, the surviving spouse would take the entire interest by operation of law. The husband became a bankrupt. The trustee in bankruptcy attempted to sell the entire interest in the home under the authority of Section 363(h). The Eleventh Circuit upheld the decision of the federal district court and held that the trustee was not empowered (under Section 363(h)) to sell the Debtor’s wife’s contingent remainder interest without her permission. See also In re Spain, 831 F.2d 236 (11th Cir. 1987).

iii. Significance of Livingston in Preservation Planning Context. Livingston is significant in the

context of preservation planning because of the trustee’s apparent inability under Bankruptcy Code ' 363(h) to sell the remainder interest (without permission from the remainderman) in an asset in which the bankrupt debtor held a life estate at the time of filing. Thus, so long as the creation of the life estate and remainder arrangement was not in fraud of creditors, the remainderman’s interest should remain intact. This same logic should apply to a term holder’s interest in the QPRT. But the expanded powers of a trustee in bankruptcy to set aside a transfer in fraud of creditors under Bankruptcy Code §548(e) will apply to QPRTs. G. Grantor Retained Annuity Trusts (“GRATS”)

and Grantor Retained Unitrusts (“GRUTS”). 1. Description of GRATS and GRUTS. A grantor retained annuity trust (“GRAT”) or a grantor retained unitrust (“GRUT”) could also be very useful estate planning techniques if the trust can outperform the required payment (either by earning more income than is required to be paid or by appreciating at a rate higher than the required payment). In this instance, value may be able to be shifted to the remaindermen at a relatively low gift tax cost.

Example: Assume Dad, age 55, transfers $1 million of X Corporation, publicly-traded common stock, to a fifteen year GRAT retaining a level annuity equal to 6% of the initial fair market value of the GRAT. If IRC Sec. 7520 rate is 6%, the annuity interest would be equal to $541,410.00 and the remainder interest would be equal to $458,590.00. One year after the transfer, X Corporation begins marketing a microchip that revolutionizes portable personal computers. Despite the annual payment, the value of the trust at the end of fifteen years is worth $5 million. Accordingly, $5 million of value has been transferred at a relatively low gift tax cost (i.e., $458,590.00).

2. Techniques as Preservation Planning Tools. The same considerations discussed above with regard to a QPRT apply as well to a GRAT or GRUT. In the absence of any intent to hinder, defraud or delay the grantor’s creditors, the transfer to the GRAT or GRUT should be upheld. In such a case, neither the grantor’s creditors nor a trustee in bankruptcy should be able to sell the remainder interest without the consent of the remainder man. In Re Livingston, 804 F.2d 1219 (11th Cir. 1986). But see discussion at IV.J9 supra suggesting that assets of the entire GRAT could be reachable by the Grantor’s creditors if transfer made in fraud of creditors.


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H. Qualified Plans. It appears that BAPCPA’s amendment to BC §522(b)(3) provides significant asset protection to qualified plans and IRAs. See discussion at IV.G supra. Pension and profit sharing plans will continue to be useful and popular asset accumulation arrangements so long as they retain their tax favored status. Furthermore, they enjoy the added benefit of being exempt from the claims of the participant’s creditors. Shumate v. Patterson, 504 U.S. 753 (1992). I. Disclaimers. Assume that within a few months prior to filing for bankruptcy, during a period when a debtor is clearly insolvent, the debtor’s great aunt dies leaving him $1,000,000 under her will and further providing that if the debtor had predeceased his aunt, the $1,000,000 would pass in trust for the debtor’s children. Alternatively, what if the debtor’s great aunt died after he filed his petition in bankruptcy but before the expiration of 180 days after the filing? If the debtor validly disclaims this $1,000,000 gift thereby causing it to pass in trust for the debtor’s children, will this disclaimer be deemed to be a fraudulent transfer under federal bankruptcy law? What if no bankruptcy proceeding is ever filed? 1. State Law. Some states have addressed the issue and held that a valid disclaimer is not a fraudulent transfer because the disclaimer causes the property to pass from the decedent to the alternate beneficiaries, not from the disclaimant to the alternate beneficiaries. See, e.g., Dyer v. Eckols, 808 S.W. 2d 531 (Tex. App. C Houston 14th Dist. 1991, writ dism’d) (court held judgment debtor had a right to disclaim a bequest to her without being found to have made a conveyance); Colacci v. United Bank of Boulder, 549 P.2d 1096 (Ct. App. 1976) and Estate of Hansen, 248 N.E. 2d 709 (Ct. App. 1969). Other courts have found a disclaimer to be a fraudulent transfer. In re Estate of Kalt, 108 P.2d 401 (1940). 2. Federal Bankruptcy. The result in a federal bankruptcy context is less certain. The success or failure of the disclaimer may depend on when the disclaimer is effected. Thus, if the disclaimer is executed before filing of the petition in bankruptcy, the disclaimer may be upheld so long as applicable state law does not characterize the disclaimer as a transfer of the disclaimed assets from the disclaimant. See, e.g., Blackwell v. Lurie, 223 F.3d 764 (8th Cir. 2000); Simpson v. Penner, 36 F.3d 450 (5th Cir. 1994) (disclaimer one-day before bankruptcy petition filed is not a fraudulent transfer); see also Leggett v. United States, 120 F.3d 592 (5th Cir. 1997); Hocker v. United Bank of Boulder. 476 F.2d 838 (10th Cir. 1973). However, if the disclaimer is of a gift occurring within 180 days after the petition is filed, it

is arguable that a literal reading of Section 541(a)(5)(A) of the Bankruptcy Code would treat such a disclaimer as a voidable transfer. See, e.g., In Re Cornell, 95 Bankr. 219 (Bankr. W.D. Okla., 1989). J. Family Limited Partnership. The family limited partnership can also be a useful preservation planning tool depending upon the rights accorded under local law to a judgment creditor of a partner and the applicable transfer restrictions imposed on a partner under the partnership agreement. Under the typical family limited partnership, a husband and wife would each contribute assets to the partnership in exchange for large limited partnership interests (99%) and general partnership interests (1%). One of the spouses typically serves as managing general partner either individually or through a corporate entity that he or she controls. The partnership agreement requires the consent of a large majority in interest (e.g., 80%) of the partners as a condition precedent to distributions, dissolution or partition. Husband and wife would then make gifts of limited partnership interests to their children, grandchildren, and/or trusts for their benefit. If husband has financial reversals and loses his interest in the partnership to a judgment creditor, many states’ local partnership law could relegate the judgment creditor’s rights to that of an assignee of a partnership interest. For example, under Section 7.03 of the Texas Revised Limited Partnership Act, the rights of a judgment creditor of a partner are limited to a charging order against the income produced from the partnership interest of a partner. As one author puts it, “Does this mean that a limited partner’s interest cannot be lost to a judgment creditor? If the general partner has the right to withhold a distribution of income under the limited partnership agreement, does this mean that a creditor having a charging order must pay income tax on income he, she or it never receives?” Gibbs, Faerie, Gold: How to Protect and Conserve Family Resources, Article presented to 1989 Texas Bar Convention. Furthermore, restrictions in the partnership agreement may make it virtually impossible for the creditor to effect a dissolution of the partnership without the consent of a substantial percentage in interest of the limited partners. Thus, the creditor can find himself as an assignee of a partnership interest in a closely-held family enterprise. Commentators have begun to speculate whether the ten year recovery period afforded trustees in bankruptcy with regard to transfers to a “self settled trust” or “similar device” would apply to transfers to family limited partnerships if these transfers are considered fraudulent. See discussion at IV.J.10 supra. Only time (and an active judiciary) will tell.


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K. Domestic Assets Protection Trusts. 1. Background: From Off Shore to Domestic Asset

Protection Trusts. a. Traditional Rule. Until the late 1990's, nearly every state prohibited a settlor from creating an irrevocable “spendthrift trust” that protected trust assets from the claims of the settlor’s past, present, and future creditors if the settlor was a beneficiary of the trust. This rule against insulating assets from the claims of a settlor’s creditors with respect to self-settled, spendthrift trusts (a/k/a domestic asset protection trusts) dates back to the Statute of Elizabeth which was passed in 1570. The statute voided any transfer made with the intent to defraud one’s creditors and abolished the statute of limitations on claims to set aside such transfers. The Restatement (Second) of Trusts adopted the Statute of Elizabeth, which had been part of the common law ever since its enactment. Virtually every state in the United States adopted these rules, making it impossible to create a valid self-settled, spendthrift trust in the United States. All past, present, and future creditors were entitled to disregard spendthrift language as to the settlor who was a beneficiary of that trust. As a result, creditors of the settlor/beneficiary had access to the trust assets even if the settlor had no such access himself. b. Permissible Spendthrift Protection. Many jurisdictions have allowed spendthrift protection for beneficiaries other than the settlor upon the theory that the settlor ought to be able to protect younger beneficiaries from wasting the trust assets by means of incompetence, imprudence, or misfortune. Furthermore, creditors can easily determine that such trust assets are not available for repayment. Even though the same arguments could at least in part be applied to justify spendthrift protection for the settlor of a trust, no such protection was traditionally allowed in any common law jurisdiction for equitable (if not moral) reasons. Should a debtor be able to escape liability for his debts and still have something available to support himself? Surely the debtor should have something left to live on, but aren’t bankruptcy laws and homestead or personal property exemptions sufficient? Why should a debtor be able to, in effect, set aside his own amount of exempt assets by simply establishing a trust? So the prevailing arguments went, at least until the 1980's when off shore jurisdictions began to rethink the issue. c. Off Shore Competition. In the 1980's, foreign jurisdictions modified their trust laws to remove the rule against self-settled, spendthrift trusts and provided for very short statutes of limitations regarding fraudulent conveyance claims. They began to require their courts to disregard the judgments of other jurisdictions with

respect to trusts settled within their own jurisdictions. Many such jurisdictions did away with the rule against perpetuities in order to make their trust laws even more appealing. All of this was done in an attempt to attract investment capital. d. Alaska and Delaware Fight Back. In 1997 both Alaska and Delaware adopted new trust statutes making self-settled, spendthrift trusts possible within United States, at least theoretically, for the first time. By effectively repealing the Statute of Elizabeth (as articulated under the Restatement (Second) of Trusts), Alaska and Delaware thus launched a new era in asset protection planning motivated by the competition for investment capital. A total of nine have all adopted similar domestic asset protection trust statutes, and more states are likely to follow. However, for various technical and practical reasons, Delaware and Alaska have remained the more attractive jurisdictions and are constantly in competition to expand protection under their statutes, and for these reasons, they alone will be discussed below. 2. U.S. Response to Off Shore Asset Protection Trusts. Generally, domestic asset protection trust laws work by providing a statute of limitations on fraudulent transfer actions or claims and by allowing spendthrift protection for the settlor. Specifically, all of the settlor’s creditors, including those existing at the time of the transfer, will have only four years from the date of the transfer to initiate an action to set aside the transfer as fraudulent. However, claims for torts occurring prior to the transfer or for child support or alimony are generally not subject to the spendthrift restrictions. 3. Characteristics of an Asset Protection Trust. What follows are the major provisions that must be included in any Delaware or Alaska domestic asset protection trust. a. Irrevocability. The trust must be irrevocable. AS 34.40.110(b)(2). 12 Del C. '3570(10)b. b. Identity of Trustee. The trust must have a qualified trustee, defined in Delaware as a natural person who resides in the state or a corporation subject to supervision by certain regulatory agencies with the state. 12 Del C. '3570(9). In Alaska, at least one trustee must be an Alaska resident or a trust company or bank possessing trust powers and having its principal place of business in Alaska. AS 13.36.035(c). c. Situs Requirements. The qualified trustee must materially participate in the administration of the trust


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(e.g., maintain trust records). At least a portion of the trust assets must be located within the state. 12 Del C. '3570(9); AS 13.36.035(c). d. Choice of Law. The trust instrument should state that the law of the situs jurisdiction governs the validity, construction, and administration of the trust. In Delaware, such provision is mandatory. 12 Del C. '3570(10)a. e. Spendthrift Clause. The trust must have a spendthrift clause. 12 Del C. '3570(10)c. f. Distributions to Settlor. The trustee may have the power to make distributions of principal or income in its sole discretion, and the settlor may retain a right to certain income interests, including certain annuity or unitrust payments, without losing spendthrift protection. AS 34.40.110(b)(3); 12 Del C. '3570(10)(b). 4. Other Important Statutory Provisions. Delaware and Alaska provide other rules that warrant mentioning. a. No Rule Against Perpetuities. Alaska has adopted a 1,000 year rule against perpetuities, essentially abolishing the rule for all practical purposes. AS 34.27.010, AS 34.27.050-100. Delaware has adopted a 110 year rule against perpetuities for real property and abolished the rule against perpetuities entirely for personal property. 25 Del C. '503(a)-(b). However, any interest in a corporation, limited liability company, partnership, business trust or other entity which holds real property is expressly excepted from the scope of the 110 year rule against perpetuities for real property. 25 Del C. '503(e). b. Partial Avoidance of Transfer. In Delaware, the transfer may be held void only to the extent necessary to satisfy the judgment debt. 12 Del C. '3574(a). c. Trust Advisor/Trust Protector. Non-residents may act as trust advisors or trust protectors. In Delaware, a trust advisor may have the authority to remove and appoint qualified trustees and/or direct, consent, or disapprove distributions from the trust. 12 Del C. '3570(9)(c). In Alaska, the trustee advisor serves only as an advisor (with no legal powers), though the trust protector may be given broad powers to modify the trust and/or remove or appoint a trustee. AS 13.36.370 and AS 13.36.375. d. Extensive Liability Protection. In Delaware, the trustee, trust advisor, and any person involved in the

counseling, drafting, preparation, execution, or funding of such trusts is protected. 12 Del C. '3572(d)-(e). e. Actual vs. Constructive Fraud. An advantage to Alaska law is that it requires proof of actual fraud and does not permit claims for constructive fraud as in other jurisdictions. AS 34.40.010. Delaware on the other hand follows the common law rule allowing proof of constructive fraud. 6 Del C. ''1304-1305. f. What is Barred. Delaware bars all actions with respect to the transfer including actions to enforce judgments of any jurisdiction. 12 Del C. S3572(a). Alaska bars only actions with respect to claims under its own fraudulent conveyances statute. AS 34.40.110(d). 5. Do They Really Work? Whether domestic asset protection trusts will work as intended remains uncertain since there have not yet been any reportable cases regarding their validity. What follows is a brief discussion highlighting the major legal hurdles that could threaten the viability of domestic asset protection trusts. a. Judgment Against the Settlor. A creditor could seek a judgment against the settlor in the settlor’s or the creditor’s own state. The creditor would have little or no problem with asserting jurisdiction for the matter. A court hostile to domestic asset protection trusts could refuse to apply the law of the trust situs on public policy grounds and deny the purported spendthrift protection. If the trust is drafted properly, the settlor would not have any legal right or control over the trust assets and thus could not use them to satisfy the creditor’s claims. The creditor would then have to seek enforcement of his judgment in the situs state, which could prove to be problematic (as discussed below). It should be noted that if the court believes the settlor does have the practical ability (even if not the legal ability) to receive distributions from the trust but does not produce such result, the court may hold the settlor in contempt of court and impose civil or criminal penalties if the settlor does not comply with an order to turn over the assets. See Federal Trade Commission v. Affordable Media, L.L.C., 179 F.3d 1228 (9th Cir. 1999); Goldberg v. Lawrence (In re Lawrence), 227 B.R. 907 (Bankr. S.D. Fla. 1998); In re Portnoy, 201 B.R. 685 (Bankr. S.D.N.Y. 1996). b. Judgment Against the Trustee. A creditor could seek a judgment against the trustee in a non-situs state. Jurisdiction over the trustee could be a significant problem if the trust assets are not located in the non-situs state and the trustee has not solicited or conducted business in the non-situs state. However, if jurisdiction over the trustee is valid and the creditor prevails, the


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trustee would face a serious dilemma. The trustee could ignore the order and face possible contempt charges in the non-situs state. Alternatively, the trustee could comply with the order and face a lawsuit by the settlor or other beneficiaries for violating its fiduciary duties under the laws of the trust situs. c. Choice of Law Provision. Very likely, a suit in the situs state would pose no choice of law issues. However, if suit is brought in a non-situs jurisdiction (e.g., settlor’s domicile), the creditor would likely argue that the choice of law clause in the trust instrument is invalid based on policy concerns. Specifically, a debtor should not be able to secure the benefits of a more debtor-friendly fraudulent conveyance statute or obtain spendthrift protection for himself simply by choosing another state’s laws when the legislature in his own domicile has clearly promulgated a strong policy on the issue. The law is sparse in this area, and modern courts tend to enforce forum law unless there is a strong reason for departing from it. Thus, it is highly likely that a creditor would prevail in any choice of law issue for a suit brought in a non-situs state. However, a creditor’s victory in a non-situs state may prove meaningless depending the outcome of other legal issues. d. Contract Clause. Some commentators have expressed concern over the Contract Clause contained in Article I, Section 10 of the U.S. Constitution. While the issue is unsettled, state legislatures enacting self-settled spendthrift trusts are drafting their statutes in way that most likely presents no Contracts Clause issue. The Contract Clause applies only to prevent modifications of existing contracts and not also to prevent prospective modifications to contracts. The Alaska and Delaware statutes do not purport to be effective for trusts created before enactment of such statutes and would only bar claims of existing creditors if they received notice of the transfer to such trusts. Accordingly, the only issue is whether the statutory baring of an existing creditor’s action or claim would be considered a modification of an existing contract between the settlor and the creditor. But, unless the contract between the settlor and the creditor stated that the creditor had a security interest in the settlor’s assets that were subsequently contributed to the trust, how could the statute providing spendthrift protection to such transfer be held to be a modification of an existing contract? Presumably, then, the Contract Clause analysis would greatly resemble the analysis of whether the transfer was fraudulent as to the creditor, since the statutory spendthrift protection would only be applicable if invoked by the settlor in such a way as to “modify” settlor’s existing contract with the creditor. Perhaps, the only utility of a Contract Clause argument would be to use it is as an end-around Alaska’s

requirement of actual fraud; the creditor might only need to prove facts equivalent to those necessary for proving a constructive fraud claim. e. Full Faith and Credit Clause. The Full Faith and Credit Clause of the U.S. Constitution requires each state to enforce the judgments of other states. Under this clause, a creditor would argue that a judgment in favor of the creditor in a non-situs jurisdiction must be enforced by any court in the situs jurisdiction. However, if a statute seeking to limit the enforcement of such claims is found to be a procedural rule, such argument will likely fail. Specifically, at least one court has held that statutes limiting the time in which an action to enforce a judgment may be brought are procedural and thus do not violate the Full Faith and Credit Clause. Matanuska Valley Lines, Inc. v. Molitor, (365 F.2d 358). The theory is that a state is not required to operate under multiple procedural systems, and thus a four-year statute of limitations on any actions (whether to enforce a judgment or bring an initial claim) provides merely a uniform procedural rule. Delaware law operates to bar any and all actions (procedural) and is thus arguably stronger on this issue than Alaska law which operates to bar fraudulent transfer claims brought under Alaska law (substantive). The Full Faith and Credit Clause could also operate to enhance creditor protection since each state must also respect the acts of other states (including their legislatures). Thus, a judgment in a non-situs state arguably would not necessarily trump the acts of the legislature in the situs state since they both should have equal sovereignty under the Full Faith and Credit Clause. Furthermore, the settlor or trustee could seek a judgment in the situs state, which should be considered equally valid with the non-situs judgment. If the issue is ultimately settled by a “which judgment was obtained first” analysis, the trustee or settlor could seek a declaratory judgment in the situs state prior to any litigation in a non-situs state. f. Bankruptcy Issues. Because of the addition of BC §548(e) by BAPCPA, it now appears clear that transfers to domestic asset protection trusts can be reached within ten (10) years after the transfer. On the one hand, the provisions significantly expand the “look back and recover” power of bankruptcy trustees. On the other hand, it gives at least tacit approval to domestic asset protection trusts as asset protection tools. See discussion at IV.J, supra. 6. Other Client Concerns. Clients will not only be concerned about whether domestic asset protection trusts actually work but will also want to know what kind of distributions they can receive if and when such trusts


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have withstood the attacks of their creditors. In other words, can the client get distributions at a time when he truly needs them (i.e. after all other assets are gone)? Additionally, the client will want to know whether he can combine domestic asset protection trust planning with the goal of excluding the trust assets from his estate. a. Distributions After Attack. If the spendthrift protection sought by the trust instrument is ultimately upheld, none of the trust assets will be accessible by settlor’s creditors, even after a judgment in the settlor’s own domicile, unless distributed to the settlor. Any distributions to the settlor become the property of the settlor and are thus subject to attachment by settlor’s creditors. AS 34.40.110(a) typifies the general rule with regard to any form of spendthrift protection. If the settlor has no right to distributions, the trustee will not make distributions to the settlor if such distributions would only end up going to the settlor’s creditors since the trustee could be liable for breaching its fiduciary duty under situs law to uphold the spendthrift protection clause as to the settlor. Because creditors know that the settlor will probably never get any distributions from the trust in such situation, the theory is they will likely be willing to settle their claims for a fraction of their stated value (“a bird in the hand is worth two in the bush”). Upon settling the claim, the settlor will be discharged by the creditor, and the trustee will be free under the trust instrument to make distributions to the settlor as he sees fit. Until the creditor settles the claim (or if the creditor is more concerned with principle than with business and thus decides to leave the judgment in tact rather than settle), then the trustee could make distributions to the settlor’s spouse or descendants (if a sprinkling power is given to the trustee in the trust instrument) who in turn could provide for the settlor’s support. In addition to a spray or sprinkle power, the more effective approach would be to include a strong facility of payment clause, allowing distributions for the beneficiary’s benefit without distributions actually being made to the beneficiary. b. Combining Tax Planning with Asset Protection: Pipe Dream or Reality? Some clients may be more inclined to make large lifetime gifts if they know the assets will be available for distribution to themselves if ever needed. If they can be assured that the assets will be excluded from their estates at death, however, most clients would have no doubt about such lifetime planning. Unfortunately, the there is some amount of uncertainty associated with whether such assets will be includable in the settlor’s estate. If creditors can reach the assets in the trust, the settlor has indirect dominion and control over the economic benefit of the trust assets by means of his own

powers. In other words, the settlor can incur debts and in effect relegate his creditors to the trust assets for repayment, thereby retaining the ability to fully enjoy the economic benefit of the assets for himself. Under I.R.C. '2036, the trust assets would thus be includable in the settlor’s estate because he has not given up sufficient dominion and control over the beneficial enjoyment of the assets. On the other hand, if self-settled spendthrift trusts prevent the settlor’s creditors from recovering against the trust, the trust assets should not be includable in the settlor’s estate (unless, of course, they are includable under another theory). Since 1999, it has been informally reported the IRS will not issue private letter rulings with respect to whether a transfer of assets to a self-settled spendthrift trust in such jurisdictions as Alaska and Delaware will be a completed gift, even though it has issued a few favorable PLR’s in the past. For example, PLR 9837007 held that a transfer to an Alaska self-settled spendthrift trust was a completed gift. Furthermore, the IRS has never issued a ruling on the issue of whether such assets are includable in the settlor’s estate and continues to decline to do so. The IRS is operating on the theory that the facts and circumstances necessary to make such a determination do not exist until the settlor’s death (or after substantial administration of the trust) because there could be an implied arrangement between the settlor and the trustee to make distributions to the settlor. Even assuming that the Delaware and Alaska statutes work as intended, the settlor may still have an impermissible ability to “borrow” from the trust assets for purposes of IRC '2036. Because children (child support), spouses (spousal support) and certain tort claimants are creditors who can attach the trust assets to satisfy claims against the settlor, the IRS could take the position that the settlor has not relinquished sufficient dominion and control of the trust assets to make the transfer a complete gift or to avoid estate tax inclusion. Whether such “access” to the trust assets ultimately proves to be fatal under IRC '2036 remains an open question, though it probably is not. It would be a far stretch of the English language to assert that the ability of the settlor to cause trust assets to go to his children or spouse for child or spousal support or to tort claimants is retention of an ability to enjoy the assets. Thus, while it appears that self-settled trusts can be effectively combined with estate planning, at least some doubt remains. c. Special Power of Appointment With Asset Protection Trusts. With off shore Asset Protection Trusts, the settlor usually retains a testamentary special power of appointment because he does not wish to make the transfer subject to gift tax. Such power of appointment is a retained power over beneficial


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enjoyment of the trust, and thus the assets will be includable in the settlor’s estate. Do the new rules get around this issue? If the settlor is only interested in asset protection (and not also with combining tax planning), will a special power of appointment jeopardize asset protection? 7. Practice Pointers. a. Use Trust Advisors. Using direction and consent advisors rather than non-situs Co-Trustees will help prevent the application of non-situs law and weaken creditor attempts to obtain jurisdiction over the trust (i.e., over such Co-Trustee). b. Notify Creditors. Consider notifying existing creditors at the time of the transfer in order to ensure that the statute of limitations will begin running. If the transfer is not fraudulent and the settlor is in good standing with the creditor, the creditor will not have much incentive to spend its resources in an attempt to set aside the transfer, and the statute of limitations will begin to run. Furthermore, giving creditors notice of the unavailability of such assets diffuses any equitable argument that the creditor was misled by a secret trust arrangement. c. Wrap Assets in a Limited Partnership. Consider forming a limited partnership to hold the assets intended for transfer to the trust. In addition to providing an additional layer of creditor protection under the laws of the debtor’s own jurisdiction, the partnership could opt into Article 8 of the Uniform Commercial Code (which deals with investment securities) and obtain additional creditor protection. See U.C.C. '8-103(c), stating that a partnership interest is a “security” for purposes of Article 8 if, inter alia, the terms of the partnership agreement expressly provide that the partnership interests are securities governed by Article 8. All corporate securities (regardless of the terms of the corporate bylaws) fall within the scope of Article 8 of the Uniform Commercial Code, and thus a corporation could also be used to obtain the benefits of Article 8.

Although, Article 8 is not a jurisdictional statute, it does provide some degree of practical protection by limiting a creditor’s ability to attach the partnership interest to those procedures provided in Article 8. U.C.C. '8-112 describes the process by which a creditor may attach a security, providing for different mechanisms depending on whether the security is certificated, uncertificated, or issued under a “securities entitlement” system. The result is that a creditor will not be able to attach those assets under order of a court within a non-situs jurisdiction, thereby limiting the ability of such court enforce a judgment on behalf of the creditor. Hence, even if a non-situs court may have

jurisdiction over trust assets held in another state (and this is uncertain), Article 8 creates an enforcement problem for such court since attachment can only be by legal process within the situs jurisdiction. Even if opting into Article 8 would not ultimately prevent a creditor from being able to attach the trust assets, it will serve as a deterrent to litigation because of the enhanced legal hurdles creditors will face. d. Give Trustee a Sprinkling Power. Consider empowering the trustee to sprinkle income and/or principal over the settlor’s spouse and/or descendants. Any attempt by the settlor’s creditors to attach the trust assets will affect the rights of all the beneficiaries and not just those of the settlor, thereby diminishing the equitable argument that would otherwise exist if the settlor was the sole beneficiary. Additionally, if the settlor’s creditors would be entitled to attach any distributions actually made to the settlor, the settlor could still be supported by distributions made to the settlor’s spouse or descendants if they chose to support him. e. Give Trustee a Facility of Payment Clause. Allow the trustee to pay third parties directly so that the distributions are not made to the beneficiaries but to those person who provide necessaries to the beneficiaries. f. Limit Trustee’s Discretion. Limiting the trustee’s discretion over distributions might convince a court not to compel distributions on behalf of settlor’s creditors. The trustee’s discretion could be limited to the health, support, and maintenance of the settlor, thereby excluding distributions in satisfaction of a creditor’s claims. g. Maintain Sufficient Liquidity. Consider maintaining liability insurance or assets on hand that will be considered adequate for the settlor’s profession or business activities. As with corporations, a court is much less likely to uphold a claim for piercing the liability veil if the debtor has sufficient assets or is adequately insured. h. Charitable Planning. Delaware allows a settlor to retain the lead interest (i.e., annuity or unitrust) in a charitable remainder trust and still obtain spendthrift protection. As long as the transfer does not appear fraudulent, an attack by a creditor to attach the trust assets would force a court to consider the impact that granting the requested relief would have on charity. Even if the legal arguments are not strengthened in such a case, the court may be driven by a different equitable analysis and find it harder to compromise the interests of charity in favor of a creditor in such circumstances.


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i. Consider a Pre-emptive Strike by Trustee. Consider obtaining a trustee who will seek a declaratory judgment in the situs jurisdiction to the effect that the trustee is not obligated to make payments from the trust to any of settlor’s creditors. The court would be obligated to grant the judgment under local law, and the Full Faith and Credit Clause of the U.S. Constitution would require other states to uphold the judgment as to property held within the situs. Of course, the settlor’s creditors (who would have to be given notice) could foreclose any such litigation by initiating an involuntary bankruptcy proceeding against the debtor; but the same facts and circumstances justifying such an action would also likely render the transfer to the trust void under situs law. 8. Coordination With Grantor Trust Rules. The grantor trust rules do not impose any unique issues with respect to domestic asset protection trusts. The use of certain trust powers granted to a non-adverse trust advisor (e.g., a power exercisable in a non-fiduciary capacity to reacquire assets by substituting assets of an equivalent value under I.R.C. ' 675(4)(C)) are perhaps the best way to achieve grantor trust status without running afoul of either the asset protection rules discussed above or the gift and estate tax rules for removing the trust assets from the settlor’s estate. Likewise, if non-grantor status is desired for the trust, both the Alaska and Delaware statutes provide ample drafting room to secure that result concurrently with the achievement of self-settled spendthrift protection. 9. Conclusion. Domestic asset protection trusts appear to work, although some doubt still remains. As with any attempt to radically alter the law, the movement of certain state legislatures to validate domestic asset protection trusts will be tested in the courts since so much is at stake and certain aspects of existing law remain uncertain. The most conservative clients will likely wait a few years to see if the movement picks up momentum or begins to flag and whether their own jurisdictions will adopt similar asset protection laws. The client only stands to lose the transaction costs of establishing such a trust (including whatever litigation costs the client later decides to pursue in defense of the trust, if any); although if estate planning is combined with asset protection planning, the client may also be giving up other opportunities for estate planning. Thus, while a clear path is not laid out before the client, the prudent estate planning practitioner will at least become familiar with domestic asset protection trusts and be prepared to discuss them with his clients. If domestic asset protection trusts work, and if they can be combined with gift, estate, and GST tax planning, the estate planning practitioner would be remiss for not at

least discussing them with virtually all of his wealthy clients. VII. INTRODUCING THE JONES FAMILY. Having discussed the legal rules, available techniques, and preliminary planning considerations, it is now time to see how they apply to a realistic factual scenario. A. Example C The Jones Family. 1. Basic Facts. John Jones, age 40, is a prominent corporate securities lawyer in Dallas, Texas. He is married to Jane Jones, age 38. John and Jane have three children, James (age 12), Jared (age 10) and Jennifer (age 1). John is a partner in Money, Money & Moremoney, L.L.P. (“MM&M”). John’s projected partnership draw for the current year is $500,000.00 with an expected special distribution of $250,000.00 (to be paid next January). After taxes and living expenses, John and Jane have a surplus of $300,000 per year. John is confident that he can expect the same compensation and surplus for the next 20 years (and we will assume the same for purposes of this example). John’s and Jane’s financial statement, as of the date of this speech, is described in Column 1 of Exhibit A (attached). 2. No Interest in Estate Planning. Despite repeated suggestions from friends and professional advisors, John has no interest in estate planning. He and Jane currently have simple “all to spouse” wills which provide contingent testamentary trusts for their children. John is content with this arrangement especially since the unlimited marital deduction will result in no federal estate tax upon the death of the first spouse to die. John has also read about the so-called “Kiddie Tax” and high tax rates imposed on trust income so he sees no point in establishing any trusts for his children since the income tax savings seem to be minimal. 3. Eighteen Years Later – Personal Bankruptcy. Eighteen years after achieving considerable prominence in his profession, and after accumulating substantial wealth, John and Jane file for personal bankruptcy under Chapter 7 of the Bankruptcy Code. The Jones’ financial statement fifteen years later and three years before the bankruptcy filing is described at Column 2 of Exhibit A. Note that it is assumed John and Jane’s cash reserve stayed at $1.0 million, their securities (including surplus cash, which they invested in securities) grew at 8%, and their real estate grew at 3%. This financial catastrophe is the result of a malpractice lawsuit brought nearly three years before the bankruptcy. Despite serious and major flaws in the


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plaintiff’s case, a jury returned a verdict against John in the amount of $25.0 million, only $1.0 million of which was covered by malpractice insurance. Despite optimism by John’s attorney, the Texas Court of Appeals and Texas Supreme Court affirmed the trial court’s judgment. As a result of the bankruptcy, nearly all of John’s and Jane’s nonexempt assets were seized to satisfy the plaintiff’s judgment. This includes the Jones Family Farm which has been in John’s family since before the Civil War. The assets left for the Joneses after the bankruptcy are shown at Column 3 of Exhibit A. Because of this financial downturn, Jennifer, a sophomore at Stanford University, must transfer to a state school. Jared, after a three-year hiatus, may not be able to start at Harvard Law School in the fall. The Jones’ have also decided to sell their house since the monthly mortgage payment of $3,500 is unrealistic in light of John’s current income level, which has declined substantially because of the publicity surrounding the trial. If things are not bad enough, John’s father, Jacob, dies of a heart attack three months after John files for bankruptcy. The $500,000 John inherits from his father is also seized by the trustee in bankruptcy to pay John’s debts. B. Could John and Jane Have Averted Financial Disaster? What could John and Jane have done differently to avoid this financial disaster? Should they have sent their liquid assets “off shore” to an exotic South Pacific island? Should they have formed a “mega” family limited partnership? Or should they have consulted with an estate planning advisor with experience in “Preservation Planning” for a thoughtful analysis of their estate and preservation planning options? Let’s assume John and Jane have consulted with I.M. Planner, Esq., a well respected estate planning lawyer. During the initial meeting, Mr. Planner reviews John’s and Jane’s family and financial situation and explores their objectives. He then shares with John and Jane two guiding principals to a successful preservation plan. These principles are as follows: 1. As Yogi Berra Might Have Said Regarding Preservation Planning, “You Need to Do It Before You Need to Do It!” Designing and implementing a comprehensive preservation plan on the eve of bankruptcy or other financial disaster is likely to be too much too late. Waiting for the “ax to fall” is too late. Planning must be done before you know or should have known the ax exits. 2. Less is More. As they say in Texas, “Pigs get fat and hogs get slaughtered.” The same principle applies to preservation planning. Leave some money on the table

for those unforeseen creditors. In the long run, you will likely preserve more. C. Recommended Preservation Plan For the Jones Family – Sensible and Conservative Steps to Financial Security. After a detailed analysis of John’s and Jane’s situation, Mr. Planner makes the following recommendations: 1. Step 1 – Prepare a Detailed Solvency Balance Sheet. Many of the techniques described below involve the transfer of assets. In order for these techniques to successfully protect assets, it is important for John and Jane to demonstrate they are “solvent” both before and after the transfers described below. This will go a long way in overcoming allegations of actual or constructive fraud. Accordingly, Mr. Planner insists that John and Jane develop a detailed current balance sheet demonstrating their solvency at all relevant times. a. What is “Solvency” in the Asset Protection Context? In order to be considered “solvent”, John and Jane must prove the aggregate value of their non-exempt assets exceeds the aggregate value of their debts immediately before and immediately after implementation of the techniques described below. This means value of their home equity, $60,000 of certain personal effects, life insurance cash values, and other exempt assets cannot be considered. b. The Term “Debts” Includes the Value of “Contingent” Claims. Further, the term “debts” is much more broad than used in the traditional sense. It includes not only contractual debts and debts that have been reduced to judgment but also the value of contingent claims and liabilities. For example, if at the time of the planning, John had already received a demand letter from a potential claimant, John would need to estimate the possibility of recovery and assign a value to the claim. The value of this claim would therefore be considered a “debt” in determining whether John and Jane are solvent. 2. Step 2 – Evaluate and Increase Liability Coverage if Necessary. If possible, John should increase [or convince his firm to increase] his malpractice insurance. Further, John and Jane should consider adding an umbrella “all risks” liability coverage to his existing homeowner’s insurance coverage. The incremental cost of increasing liability coverage from $1 million to $5 million is surprisingly inexpensive. 3. Step 3 – Do New Wills. John makes a new will. John makes a gift of his “applicable exclusion amount” to a credit shelter trust for Jane and the children with the


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residue of John’s estate passing into a qualified terminable interest marital deduction trust for Jane. Distributions of income and principal to Jane and the children from the credit shelter trust will be limited to distributions for health, education, maintenance and support. Distributions of principal to Jane from the marital deduction trust will likewise be limited to distributions for Jane’s health, support, and maintenance. After Jane’s death, the assets will be held in three trusts, one for each child. Each child’s trust shall provide as follows:

i. The Trustee(s) may distribute income and

principal to the child and the child’s descendants for health, education, maintenance, and support.

ii. The trust will last for the child’s lifetime. iii. The child will be given a testamentary limited

power of appointment in favor of John’s and Jane’s descendants, the child’s spouse (in trust only), and/or charities. The child will also be given a contingent general power of appointment over the trust to avoid the generation-skipping tax at the child’s death if the estate tax rate is lower than the GST rate.

Jane’s will is a mirror of John’s will. The same plan could also be accomplished through the use of pour over wills and a revocable living trust. 4. Step 4 – Buy Cash Value Life Insurance. a. Purchase. John and Jane purchase a $2.0 million whole life policy on each spouse’s life ($4.0 million total insurance). The premium on John’s policy is $29,680. The premium on Jane’s policy is $21,780. b. Accumulations. Fifteen years later, the net cash surrender value of John’s policy is $568,960, and the net cash value of Jane’s policy is $415,800. The total cash value for both policies is $984,760. 5. Step 5 – Buy Annuities. a. Purchase. In January of each of the next fifteen years, John uses $100,000 of his year end bonus to pay the premiums on a variable annuity with a track record of earning at least 8% each year. b. Accumulations. Fifteen years later, the annuity is worth $2,932,428. 6. Step 6 – Establish a Pension and/or Profit

Sharing Plan. a. Description of Plan. At John’s urging, MM&M adopts a 401(k) and profit sharing plan for all eligible full-time employees. Under the plan, John is credited

with $34,000.00 of salary reduction and profit sharing contribution each year. b. Accumulations in Plan. The plan earns 8% each year. Fifteen years later, John’s vested account balance is $997,026. 7. Step 7 – Pay Off Homestead. John and Jane decide to pay off their mortgage balance using some of their cash. At the end of the fifteen year period, the homestead residence has no mortgage and is worth nearly $1.2 million. 8. Step 8 – Make Gifts in Trust for Children. a. Description of Program. John and Jane establish three irrevocable gift trusts, one for the benefit of each of their children. The principal purpose of each trust is to provide for each child’s college education. Each of the trusts provides for Crummey withdrawal rights, so John and Jane can make an annual gift of $26,000 of their community property to each trust ($78,000 total gifts). A trust company affiliated with a large brokerage company is the trustee of each trust. The trust assets consist of a low expense “total market” index fund. If John and Jane limit their gifts to the annual exclusion amount, no gift tax returns are required to be filed and the gifted assets should forever be removed from John’s and Jane’s gross estates for federal estate tax purposes. Similarly, net income of the trusts will likewise be removed from John’s and Jane’s estates for federal estate tax purposes. b. Accumulations in Trusts. John and Jane continue these annual gifts for fifteen years. The assets in the trusts grow at a net rate of return of 8%, compounded annually. Fifteen years later, the trusts have a collective value of $2,287,294. 9. Step 9 – Enter Into an Agreement to Partition Community Property. a. Description of Partition. John and Jane own $3.6 million of community property cash and publicly-traded common stocks. In recognition of Jane’s support, John wants Jane to have some of her own separate property, in addition to the $200,000 of publicly traded bonds she inherited from her father (as indicated on Exhibit A). Accordingly, John and Jane enter into a written agreement to partition the $3.6 million of jointly owned cash and securities into two $1.8 million shares, one for John, as his sole and separate property, and one for Jane, as her sole and separate property.

The partition agreement also provides that the income earned on each spouse’s separate property (including income from the $200,000 of publicly traded


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bonds Jane inherited) will be that spouse’s separate property.

After the partition, $1,800,000 of cash and publicly traded stocks are transferred solely into John’s name as his separate property and $1,800,000 of cash and publicly traded stocks are transferred solely into Jane’s name as her sole and separate property. b. Jane’s Accumulations. Jane does a good job investing her $1,800,000 share of the partitioned assets and the $200,000 of bonds she inherited. Fifteen years later, Jane’s $2,000,000 has grown to $6,344,338. 10. Step 10 – Form a Family Limited Partnership. a. Description. Shortly after this speech, John transfers the Jones Family Farm to a family limited partnership called Jones Farm, Ltd. (“JFL”). The 1% general partner is a limited liability company called J&J, LLC. (“J&J”). Each of John and Jane owns a 50% membership interest of J&J. Initially the sole limited partner is John (99%). Shortly after forming JFL, John gives a 49.5% limited partnership interest to Jane. That gift is intended to include the income generated from the gifted partnership interest. Over the next several years John and Jane begin making gifts of the LLC membership interests and limited partnership interests to the children’s trusts described earlier. b. 15 Years Later. Fifteen years later, JFL is worth approximately $778,984 and ownership is as follows:

J&J = 1% GP interest (LLC membership interests owned equally by John, Jane and each of the children’s trusts) John = 27% LP interest Jane = 27% LP interest James’ Trust = 15% LP interest Jared’s Trust = 15% LP interest Jennifer’s Trust = 15% LP interest

11. Step 11 – Spousal Credit Shelter Trust (& Spousal QTIP Trust). After the partition agreement described at Step 9 above, John creates a “credit shelter trust” for the benefit of Jane and the children with $1.0 million of his newly created separate property (i.e., using up his $1.0 million applicable gift tax exclusion amount). The terms of the credit shelter trust will generally be as follows:

i. The Trustee(s) may distribute income and

principal to Jane for her health, support, and maintenance. Jane is the primary beneficiary.

ii. The Trustee(s) may also distribute income and principal to the Children (more remote descendants) for health, education, maintenance, and support.

iii. Jane is granted a testamentary special power of appointment to distribute the assets remaining at her death outright or in trust to or for the benefit of any one (1) or more of John, the Children (and more remote descendants), and charities.

iv. If Jane does not exercise the testamentary special power of appointment, the assets remaining at her death pass into separate trusts for the Children identical to those described at Step 3 above.

Note: John and Jane could also form a second family limited partnership (“JFL II”) with $1.0 million of John’s and $1.0 million of Jane’s separate property. The 1% general partner could be J&J, LLC (described above), and each of John and Jane would own a 49.5% limited partnership interest. Sometime after forming JFL II, John could give his entire 49.5% limited partnership interest to the credit shelter trust. In addition to an additional layer of likely creditor protection and an ability to pool investment assets together (i.e., Jane’s $1.0 million with John’s $1.0 million), the transfer of the limited partnership interest may be entitled to lack of control and lack of marketability discounts. However, it is assumed that John and Jane do not form this second partnership. 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. 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. 14. Step 14 – Urge Estate Planning for Parents and Other Relatives From Whom You Expect to Inherit. One month before John files his bankruptcy petition, John convinces his father to establish a testamentary trust under his will properly designated as a spendthrift trust. Under that trust, John’s brother, Jerry, is trustee with absolute discretion to distribute income and/or principal to John, Jane and their children for any reason. Jerry is also empowered to terminate the trust at any time if he believes to do so would be in the best interest of the beneficiaries. Upon termination, the trustee is required to distribute the property to John. John has no right to force a termination.


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15. Comparison. For purposes of comparing the “no planning” scenario with the “preservation planning” scenario, it is important to note that $263,460 of John and Jane’s $300,000 surplus was used to purchase and/or fund certain exempt assets (see immediately below) and that it is assumed such purchases and funding were not in defraud of creditors and not otherwise reachable in bankruptcy.

Annual Amount John’s Insurance Premiums $ 29,680 Jane’s Insurance Premiums $ 21,780 Purchase of Annuities $ 100,000 401k and Profit Sharing $ 34,000 Annual Exclusion Gifts to Children’s Trusts $ 78,000

Total $ 263,460 D. What’s Left After Bankruptcy Under the Recommended Planning For the Jones Family. 1. Selection of State Exemptions. In the early stages of the federal bankruptcy proceeding, John is given a choice regarding the exemption of property from unsecured creditor claims. He may either claim federal exemptions under the Bankruptcy Code or he may claim the exemptions given to him under Texas law. Texas is a community property state. John wisely elects to claim his state law exemptions thereby protecting $60,000 of eligible personal property, all of his homestead, most (if not all) of his vested interest in the profit sharing plan, most (if not all) of his and Jane’s life insurance cash values, and most (if not all) of his annuity. These exemptions and other protected assets will be described more fully below. 2. Life Insurance and Annuities. a. Life Insurance Cash Values. Article 1108.051 of the Texas Insurance Code will insulate the life insurance cash values and death benefits to the extent those cash values and benefits are not attributable to premiums paid in fraud of creditors. b. Value of Annuities. Article 1108.051 of the Texas Insurance Code will likewise insulate the value of the annuities to the extent those values are not attributable to premiums paid in fraud of creditors. 3. Profit Sharing Plan. It is clear John’s vested profit sharing account balance will be insulated from John’s judgment creditor (and therefore available to John upon retirement). Any doubt about this result was settled by the United States Supreme Court in Shumate v. Patterson. 504 U.S. 753 (1992).

4. Homestead. Since John elected his state law exemptions in lieu of the federal list of exemptions, and since the Federal Bankruptcy law limiting the homestead exemption will clearly not apply, it is clear that his nearly $1.2 million homestead will be exempt from the claims of creditors. Therefore, the only debts for which John’s homestead would be liable would include purchase money debts (i.e., one has to pay back the loan used to acquire the homestead), valid liens on the homestead for home improvements, ad valorem taxes, and federal tax liabilities. 5. Gifts to Children’s Trusts. In order to recover the gifts, the trustee in bankruptcy would need to prove that they were fraudulent conveyances. To do so, it would be necessary to prove that John was insolvent immediately before or after the gifts or that the gifts were made with an actual intent to hinder, delay, or defraud John’s creditors. Under Texas and federal bankruptcy law, an individual is considered “insolvent” when the sum of that person’s debts exceeds the sum of that person’s nonexempt assets, at fair value. Thus, at the time of each gift John appears to have met the test of solvency. Furthermore, although the gifts are for the benefit of family members (generally a badge of fraud), the gifts were clearly motivated by valid estate planning objectives and none of the other so-called badges of fraud seem to exist. Nearly all of the assets of the children’s trusts should be beyond the reach of the trustee in bankruptcy and therefore insulated from John’s judgment creditor. 6. Jane’s Separate Property (Acquired by Inheritance and Partition). The bonds Jane inherited from her father are clearly her sole and separate property. In addition, Jane’s $1.8 million share of the partition of community property, cash and stocks, the income earned from those assets, Jane’s inheritance, and the income from that inheritance, are, by agreement, her sole and separate property. Under Texas law, Jane’s separate property is not generally subject to John’s liabilities unless she has agreed to be liable (which she has not). All of Jane’s separate property should therefore be insulated from John’s judgment creditor. The only chance that the trustee in bankruptcy would have to reach some of Jane’s property would be to show that the partition agreement was void as a fraudulent conveyance. Even if such a fraudulent conveyance could be proven, an arguable two-year statute of limitations with respect to interspousal transfers would appear to preclude recovery by the trustee.


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7. Family Limited Partnership. John’s interest in J&J and JFL are certainly reachable by creditors. However, they are not very attractive assets C both are minority interests in a family business. The trustee in bankruptcy is likely to sell at pennies on the dollar to other family members. 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

and protect a client’s assets from judgment creditors. Hopefully this outline has demonstrated that a comprehensive estate plan can not only achieve traditional estate planning objectives but can also provide substantial asset protection benefits B and all this can be achieved without a passport.


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EXHIBIT “A”

JOHN & JANE JONES C FINANCIAL CONDITION

Description

1

Today

2

15 Years Later

3

Assets Left

for Family

After

Bankruptcy

Discharge/

No Planning

Cash (community property (“C.P.”))

$ 1,000,000

$ 1,000,000

$-0-

Marketable Sec.

Bonds (Jane’s separate property

(“S.P.”))

Stocks (Public) (C.P.)

200,000

3,000,000

634,434

18,313,792

634,434

-0-

Real Estate

Homestead (: acre lot) (C.P.)

Jones Family Farm

(John’s S.P.)

750,000

500,000

1,168,476

778,984

1,168,476

-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

($3,500/mo./30 year loan)

(500,000)

$ -0-

-0-

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

Homestead

Jane’s Separate Property

Trust for John Created by Father

Cash Value of Life Insurance

Jane’s 27% limited partnership interest in Jones

Family Partnership (undiscounted)

Value of Deferred Annuities

Total for John and/or Jane with Preservation Planning

$ 997,026 (no exposure)

1,168,476 (no exposure)

6,344,338 (very little or no exposure)

500,000 (no exposure)

984,760 (very little or no exposure)

210,326 (no exposure)

2,932,428 (very little or no exposure)

$ 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

45% limited partnership interest in Jones Family

Partnership (undiscounted) in Children’s Trusts

Total Assets for Children

Total for Jones Family with Preservation Planning

$ 2,287,294 (very little or no exposure)

350,543 (very little or no exposure)

$ 2,637,837

$ 18,947,359

Documents

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