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BANKRUPTCY
REFORM AFFECTS ASSET PROTECTION PLANNING
By
Heather
Forrest, R.
Thomas Groves, Jr., Michael
L. Kaufman
As
a result of the significant risks of professional
liability that are part and parcel of the
practice of medicine, many physicians have
examined and adopted (or should examine and
adopt) plans for protecting personal assets
from claims that may arise from their practices.
On April 20, 2005, President Bush signed the
Bankruptcy Abuse, Prevention and Consumer
Protection Act of 2005 (the “Act”). The Act
makes the most sweeping changes to the Bankruptcy
Code (“Code”) since its enactment in 1978,
and includes Code changes that will significantly
impact asset protection planning. Generally,
as a result of the changes made by the Act
(and the resulting ambiguities and uncertainties
regarding some of the changes), the focus
of asset protection planning will, in most
cases, shift from planning with a view towards
a potential bankruptcy to planning with a
view to avoid bankruptcy. Many Act provisions
take effect on October 17, 2005, but some
became effective immediately. Unless otherwise
indicated, all changes discussed in this article
become effective on October 17, 2005.
Among
other provisions of the Act that impact asset
protection planning are the following, discussed
below.
•
A new “means test” that
must be met in order for debtors to
qualify for Chapter 7 bankruptcy proceedings
involving primarily consumer debt.
•
Limitations on homestead
exemptions that can take precedence
over state-law homestead exemptions
(of particular interest in Texas ).
•
Limitations (based on residency
requirements) on a debtor's ability
to elect to have state exemptions apply
in bankruptcy.
•
Revisions to the treatment
of qualified retirement plans and IRAs
in bankruptcy.
• Provisions
regarding “asset protection trusts.”
Means
Test .
The controversial new means test restricts
who is eligible for Chapter 7 liquidation
relief. It requires dismissal of a Chapter
7 case for debtors who have primarily
consumer debts and the ability
to pay those debts, or alternatively forces
them into a Chapter 13 or Chapter 11 proceeding
(which generally requires payment of debts
over a period of years).
•
The Act now provides that
the means test will apply if a debtor's
net current monthly income exceeds the
determined state median income level.
The Texas monthly median income level
is around $3,950.00.
•
If the means test applies,
a debtor reduces monthly gross income
only by expenses described in the Act
to compute the debtor's “excess income.”
•
If the debtor's monthly
excess income is greater than $166.67,
the case will be dismissed or converted
to a Chapter 13 or 11 proceeding.
•
If the debtor's monthly
excess income ranges between $100 and
$166.67, the case must be dismissed
or converted to Chapter 13 or Chapter
11 if the debtor has sufficient income
to pay 25 percent of nonpriority unsecured
claims.
• Remember
that the means test applies only in
cases where the debtor has primarily
consumer debts. If a debtor files bankruptcy
due to a significant non-consumer debt
related judgment (e.g. a medical malpractice
claim), Chapter 7 relief may still be
available subject to a court's ability
to dismiss the case after finding the
grant of chapter 7 relief would be an
abuse of the bankruptcy process .
By
requiring a debtor to proceed under a Chapter
11 or Chapter 13 proceeding, (and paying
off debts over a period of 5 years), debtors
who have successfully engaged in asset protection
so as to remove assets from claims of creditors
may find that, at least indirectly, creditors
will nevertheless benefit from the protected
assets. For example, a debtor's current
income and other available current resources
may be substantially used to make payments
to creditors, requiring the debtor to resort
to protected assets in order to maintain
his or her standard of living and that of
his or her family.
Limits
on Homestead Exemptions .
Under prior law, a debtor in a bankruptcy
proceeding could elect to claim a homestead
exemption based on the homestead exemption
available under the laws of the state of his
or her residence. In Texas , there is an unlimited
homestead exemption (as to value). Effective
for bankruptcy filings occurring on or after
April 20, 2005, however, the Act places limits
on the homestead exemption under certain circumstances.
•
There is now a ten year
“look back” period for the portion of
the value of the homestead that is attributable
to transfers made with the intent to
hinder, delay or defraud creditors.
Accordingly, if a debtor, intending
to hinder, delay or defraud creditors,
invests non-exempt funds into the homestead
resulting in an increase in the value
of the homestead, and if the debtor
files for bankruptcy within 10 years
after that investment, the part of the
homestead value attributable to that
investment is not exempt and becomes
part of the debtor's estate available
for satisfaction of creditor claims.
•
If a homestead is purchased
within three years and four months prior
to the date of the bankruptcy filing,
the Act places an additional cap on
the amount of the available bankruptcy
homestead exemption regardless of whether
the state law exemption exceeds that
cap. For homesteads acquired within
1215 days preceding the date of the
bankruptcy filing, the bankruptcy homestead
exemption cap is $125,000.
•
An exception to
the 1215 day requirement described above
applies to a same-state rollover
of homestead sale proceeds. If
a debtor uses funds received from the
sale of an exempt homestead to purchase
a new homestead located in the same
state, then as long as the aggregate
period of ownership for the old and
new homesteads exceeds 1215 days, the
cap should not apply. This rollover
exception will not apply to amounts
invested in the homestead that were
acquired from other previously exempt
assets, such as life insurance or annuity
proceeds.
• Finally,
the $125,000 cap applies, without regard
to the amount of time the debtor owns
the homestead, if: (1) the debtor has
been convicted of a felony under circumstances
that demonstrate to the court the filing
of the bankruptcy was an abuse of the
bankruptcy process; or (2) the debtor
owes debts that arose from (A) the
violation of federal or state securities
laws or regulations, (B) fraud, deceit
or manipulation in a fiduciary capacity
or related to a securities offering,
(C) civil remedies under RICO;
or (D) a criminal act, intentional tort
or willful or reckless misconduct causing
serious injury or death within the 5
years preceding the filing. Courts will
have some discretion when applying this
limitation and can increase the amount
of the exemption to the extent it is
reasonably necessary to provide support
for the debtor and any of his or her
dependents.
Limits
on Other State-Law Exemptions .
In determining which assets of a debtor
are exempt for purposes of a bankruptcy
proceeding, the debtor may generally elect
to claim exemptions provided under federal
law, or exemptions provided under the
law of the state of his or her residence.
Under the Act, however, a debtor cannot
elect exemptions of a state unless the
debtor has been a resident of that state
for 730 days (i.e., 2 years) immediately
preceding the filing of a bankruptcy petition.
If the debtor was not a resident of one
state for that period of time, he or she
may elect the state exemptions for the
state in which the debtor's domicile was
located for the 180 days immediately preceding
that 730-day period, or if there is none,
the state in which the debtor was resident
for longer than any other place during
that same 180 day period.
Retirement
Plans and IRAs .
The Act also changes the treatment afforded
qualified retirement plans and IRAs.
•
The Act includes a new provision
providing that any sums withheld by
an employer from an employee's wages
for contribution into a qualified employee
benefit plan, deferred compensation
plan, or tax-deferred annuity is not
property of the debtor/employee's bankruptcy
estate. The Act does not limit the sums
that can be contributed to these plans
or the amounts held in these plans that
are excluded from the employee/debtor's
bankruptcy estate.
• There
is now a $1 million limit on the amount
a debtor may claim as exemptions for
IRAs, notwithstanding the fact that
state law may provide unlimited or higher
exemptions for IRAs (for example, in
Texas, the state law creditor exemption
for IRAs is unlimited). However, the
$1 million limit does not apply to IRA
assets attributable to “rollover” distributions
from qualified retirement plans, and
the earnings on those rollover amounts.
The Act is unclear and poorly worded
with respect to this $1 million IRA
exemption limit - this exemption could
be interpreted to apply to each debtor.
Therefore, in a joint case (husband
and wife) in a community property state,
such as Texas , the limit could possibly
be as high as $2 million.
Asset
Protection Trusts .
The Act adds a new provision regarding
so-called “asset protection trusts.” These
are trusts established under the laws
of certain foreign countries or certain
states in the United States that permit
an individual to establish a trust and
retain certain economic or beneficial
interests in the trust property, but remove
the trust property from claims of creditors
of that individual.
•
Under the Act transfers
into these “self-settled trusts” and
into any “similar devices” are now subject
to a ten year look back period. If the
transfer to the trust was made by the
debtor within 10 years prior to the
filing of the bankruptcy petition, the
debtor is a beneficiary of the trust,
and the trustee can show that the transfer
was made with an actual intent to hinder,
delay or defraud any entity to which
the debtor was at the time or later
became indebted, the transfer into the
trust can be avoided and the property
brought back into the debtor's bankruptcy
estate.
• Prior
to the Act, at least in the more egregious
situations, bankruptcy judges ignored
these types of trusts on the basis that
they were essentially under the informal
control of the individual establishing
them and therefore, they were shams;
however, because the Act specifically
mentions these types of self-settled
trusts, it now appears that they can
be effective tools for asset protection
if created in a foreign country or U.S.
state which protects assets included
in these types of trusts. However, even
if the trust is not a sham, and therefore
not subject to being disregarded in
a bankruptcy proceeding on that basis,
the effectiveness of the trusts could
be substantially diminished by the ten
year look back period.
In
Conclusion .
The Act is filled with ambiguities and
makes significant changes affecting how
JW clients should approach asset protection
planning. Because the Act is unclear,
the most prudent course of action is to
plan with a view to avoiding bankruptcy,
until these uncertainties are resolved
by the courts or future amendments to
the Act. We will be actively involved
in the legal and practical applications
of the Act and its effect on asset protection
planning. If you have any questions about
the Act or its application to your asset
protection planning, please contact Tom
Groves at (214) 953-5813, or Michael
Kaufman at (214) 953-5734.
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