BANKRUPTCY REFORM AFFECTS ASSET PROTECTION PLANNING

by Heather M. Forrest, R. Thomas Groves, Jr., Michael L. Kaufman

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.

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).

•   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.

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.

In Conclusion . The Act is filled with ambiguities and makes significant changes effecting 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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