From the July 2005 issue of Investment Advisor • Subscribe!

July 1, 2005

THE GLUCK REPORT, Part I: The Bankruptcy Bill and You

Protecting your clients' assets

On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, hereafter referred to as the Act, which becomes effective for bankruptcy filings made after October 17 of this year. Why should you care? Because the Act changes how certain Bankruptcy Code rules apply to IRAs and revamps the rules on asset protection. While advisors usually focus only on accumulating wealth for their clients, protecting assets and managing them defensively can prevent a client from losing everything, and it can limit an advisor's exposure to legal liability difficulties. Any advisor working with high-net-worth individuals should be following this area closely. Attorney Gideon Rothschild, who provides estate planning advice with an asset protection twist to wealthy individuals, recently explained some key provisions in the new law to me and provided an update on some key estate planning areas. Rothschild is a partner at the New York law firm of Moses & Singer, is a CFP and a CPA, and is the former chair of the American Bar Association Committee on Asset Protection.

In your opinion, advisors who don't talk to their clients about how to protect their wealth from creditors are at risk. Right? Absolutely. Planners should be considering whether a client should place some portion of his assets in his wife's name, not only for estate planning but also for asset-protection planning. Planners should be talking with clients about the creditor protection afforded by pension plans, IRAs, life insurance, and annuities. Advisors should discuss with clients why they might want to set up trusts for the benefit of a spouse rather than giving assets outright. Advisors should be discussing why clients shouldn't be leaving assets outright to their children.

If an advisor doesn't talk to his clients about these things and the client afterward loses money to some unforeseen creditor, then the advisor could be deemed responsible. Asset protection is an integral part of financial planning.

I do estate planning with an asset protection lens. What that means is that with any planning I do, I'm always thinking about not only how does it affect the estate taxes and income taxes, but does the plan create additional exposure to creditors? Financial planners, in my opinion, need to be more alert to asset protection planning opportunities.

You say that as if they are not alert to asset protection. They aren't. And neither are most attorneys who do estate planning.

Where do they go wrong? Financial planners and attorneys are generally only looking at the tax angles and not through an asset protection lens. The best evidence of that is the number of wills I have seen where there is no effort to go beyond a credit shelter trust. As a result, spouses and children inherit assets outright instead of in a trust, which is often a big mistake. The planners fail to note the possibility that the children, after they receive this inheritance, could file bankruptcy. They could have judgments against them. Or maybe they will be subject to business failures. Maybe the heirs are professionals who might be subject to malpractice suits, or get divorced. It could come into play in the event of a lawsuit, a business liability, a real estate liability, a personal injury suit, an automobile accident, a malpractice suit, or if you default on a bank loan.

It is not a question of whether the child is a spendthrift. We cannot control or know which independent forces will come against that heir in the future to put the inherited assets at risk, and the safest way to avoid that is by keeping inheritances in trusts.

Are you saying it's a roll of the dice? Yes. But why roll the dice? Why not have the inheritance 100% protected by keeping those assets in trust? So many people come to me--doctors, young doctors--they are concerned that their assets may be taken by malpractice lawsuits. They come to me when they are already being sued. The first thing I tell them is that there is not much I can do about the assets they own outright that are already at risk from a malpractice judgment. Then I ask them about their parents' estate plan. Do their parents have significant assets? Point is, if you are going to lose most or all of your wealth because you are sued in a malpractice case, and then your parents are going to die and leave you $1 or $2 million, the last thing you want to do is lose that as well. Rather than leaving assets outright, parents could put money in a trust. Most parents figure that if their son or daughter is a doctor, he or she is capable of handling financial affairs. So they leave their assets outright to their children. But if a malpractice suit or divorce occurs, the assets are totally exposed.

But don't most wealthy individuals place their assets in a credit shelter trust? The credit shelter works when one spouse survives another. Once the second spouse dies, however, the credit shelter trust ends and the assets go to the children however the will provides. When the second parent dies, everything the second parent owned and everything that was in the credit shelter trust is distributed outright to the children.

So if all parents have done is create a credit shelter trust and a will that distributes assets outright to their children, then the estate is totally exposed in terms of asset protection. Right. And a financial planner should be saying, "Hey, you're a doctor, lawyer, or an accountant, and some day you might be sued or get divorced. And if assets you inherit get distributed to you outright, they are subject to claims of creditors."

I hope you're not saying that advisors have to become experts on asset protection. No. But advisors should know that there are certain assets that receive favorable treatment in bankruptcy or against judgment creditors. Advisors should encourage clients who might be at risk because of their business undertakings that they might want to maximize the use of exemptions on certain assets--whether it be life insurance, annuities, pensions, or IRAs. Also, if a client is asking about rolling over a pension into an IRA, and you advise the client to roll it over into an IRA, then at the end of the day the planner is going to be liable for not having considered the exposure to creditors when the creditor comes along and takes that IRA away--especially if it could have been avoided if it were a plan-to-plan transfer. In other words, given that ERISA plans are always totally exempt from claims by creditors and IRAs may not be, advisors need to be aware of these new rules when advising clients.

Which brings us to the new Bankruptcy Act and how it affects IRAs and high-net-worth individuals. The Act wasn't originally aimed at high-net-worth individuals. It was pushed through Congress by the banking lobby and credit card companies to make it more difficult for people to discharge debt after running up a lot of credit card bills. But at the last minute a number of provisions were added that will affect high-net-worth individuals. The intent of these last- minute additions was to prevent those crooks charged with securities fraud from getting away with discharging their debts--people like Bernie Ebbers and Ken Lay. But the statute was written very broadly and goes beyond corporate executives charged with financial crimes. The problem was the perception that some crooks abused loopholes in the law.

Loopholes like the homestead exemptions in states like Florida and Texas? Exactly. They defrauded investors and caused huge financial losses for them and their employees. Adding insult to injury, they filed for personal bankruptcy instead of making their investors whole. Before this Act was passed, they were able to move down to Florida and buy a nice big homestead. Using the homestead exemption, they have all their debts discharged but can still retain substantial wealth. Five states--Kansas, Florida, Iowa, South Dakota, and Texas--provide an unlimited homestead exemption, which basically means you can buy a home for $20 million or even a $100 million and then file for bankruptcy. Your creditors could not go after your very expensive primary personal residence.

Please tell me that this loophole has been plugged under the new Act. Yes, it is plugged. The new law also says that if you have been charged with a financial fraud, securities violations, any criminal act, or if you have a judgment arising out of a tort that caused serous physical injury or death, then your homestead exemption is limited to $125,000. But they made another change to the new statute that affects many more people than just those committing fraud, and advisors should be aware of this. Until now, you only needed to live in Florida for six months to take advantage of the homestead exemption in bankruptcy. Other states have similarly short waiting periods for their exemption to become effective. Now, however, the waiting period has been extended to 40 months. So although I think we could all agree that closing the loophole to prevent criminals and individuals who commit securities fraud from taking advantage of the homestead exemption is good, the new law goes much further than this by extending the time you must own your residence to 40 months to qualify for the homestead exemption. Advisors who have clients in professions or businesses where they are at high risk of being sued--doctors, accountants, landlords, attorneys, and other businesspeople--should be aware that a client's homestead exemption will take 40 months to become effective and that equity in a home can be attached by creditors during this period.

Please explain how the new bankruptcy Act affects IRA assets. Sure, but I need to start by first explaining a court decision that came down just before the bankruptcy Act became law. The case was Rousey vs. Jackoway. In that case, the Supreme Court determined that IRAs would be excludable from a bankruptcy estate but only to the extent that they are reasonably necessary for support of the IRA owner or his or her dependents. Under that ruling, the bankruptcy court must evaluate the amount in the IRA, how old [the owner is], how many more years [the owner is likely to live], and how much support he will need from the IRA. So if an IRA owner who is 70 years old declares bankruptcy, a $1 million IRA might be judged as more than adequate for reasonable support. The court might let part of that IRA be used to satisfy creditor claims. But someone who is 40 years old, disabled, and has a $2 million IRA or rollover might need it all in the court's eyes.

In addition to this court decision, though, the Act changes the way IRAs are treated in terms of creditor protection. Right? Yes. The new Act has done something good with IRAs. It exempts some IRAs totally and others partially from being attached by creditors after you file for bankruptcy.

For a rollover IRA, the exemption is unlimited. For a regular IRA where you simply make annual contributions, the exemption is limited to $1 million. So, for the first time, they have put IRAs on par with pension plans when it comes to creditor protection.

Does the new law take precedence over the Supreme Court decision? No. There is a difference between the exemption statute that exempts pension plans and this new law, which is an exclusionary statute. The new law says that if you have less than $1 million in an IRA, it cannot be attached by creditors. If it is a rollover IRA, then it is excluded no matter how large it is. However, if an IRA exceeds a debtor's need for support of himself and his dependents, it is not exempt. In other words, with this decision, the court is left to decide what is reasonably necessary. So while the new bankruptcy law says that creditor protection for regular IRAs is capped at $1 million, and rollovers are not capped, the Supreme Court said that there is a limit on the exemption of IRAs, and that it will be determined by the court and based on what is reasonably necessary to support the person who seeks bankruptcy protection.

So a creditor could go after that money if it is more than you need to sustain yourself. That's right--unless you live in a state that gives you unlimited exemption. Then, the state law will protect those IRA assets fully. The state law still applies and takes precedence over all of this.

So the net effect is that while IRAs have been given more protection from creditors, money that is in qualified plans is still more protected. Right? Yes. You are not going to get the same exemption on an IRA that you have with a pension plan. But since you brought up ERISA plans, I just want to address one significant change made with regard to the creditor protection provided to ERISA assets. The new Act says that to get any exemption in bankruptcy for ERISA plans, the plans must have an IRS determination letter. In the past, it didn't matter whether a qualified plan received a determination letter from the IRS. As long as the plan was qualified under ERISA rules, the assets qualified for the exemption and could not be attached by your creditors if you declared bankruptcy. Now, the plan must either have received a favorable ruling from the IRS that it is a qualified plan under IRS rules, or it must be maintained in accordance with IRS regulations--that is, if you have not contributed adequately for employees, failed discrimination tests, or contribute too much into the plan, then the plan could lose its exemption under bankruptcy. So it is very important that plans be maintained and administered in accordance with the IRS rules and regulations in order for the assets to avoid being attached in the event you file bankruptcy.

What else should advisors know about the new bankruptcy law? Asset protection trusts, whether they are onshore or offshore, have been dealt a blow. Basically, a provision was inserted into the Act at the last minute with the aim, again, of precluding crooks from using asset protection trusts. For instance, if you know the SEC is going to go after you or that your company was going to go under or be sued in a class action. The perception was that you could use self-settled trust laws in eight states--Delaware, Alaska, Nevada, Rhode Island, Missouri, Oklahoma, Utah, and South Dakota--to squirrel away your wealth, and then declare bankruptcy and avoid making good on any such claims against you. The fact of the matter is that there is no evidence that self-settled trusts have been abused this way.

Explain why you disagree with the limits placed on asset protection trusts by the new law. People setting up self-settled trusts--offshore or domestic--are worried about the litigation environment. If they are directors of publicly held companies, they know they can get sued someday. If they are officers of public companies, then they have a real risk of being sued under Sarbanes-Oxley. Let's face it, these days you can get sued over almost anything. Judges are result-oriented and juries are often unfair. Say I'm a doctor that just got out of medical school and I inherited $5 million. Should that $5 million be at risk during my 40-year career? If I make a mistake and a jury awards $10 million because of a mistake I make, why should my inheritance be exposed?

Okay, I see your point. But it sounds like Congress did not. After The New York Times came out with an editorial shaming Congress for leaving this big loophole, and claiming the Bankruptcy Act only affects the little guy with credit card debt and does nothing to prevent fraudsters from filing bankruptcy and shielding their assets, the homestead exemption provision and this asset protection trust provision were inserted into the Act at the last minute.

Exactly how does it affect asset protection trusts? A new fraudulent transfer provision was added. With respect to self-settled trusts--that is one where you make yourself a beneficiary--if you transfer assets to the trust, then the transfer--if it was made with the intent to hinder, delay, or defraud creditors, even future creditors--is deemed fraudulent if you file for bankruptcy within 10 years. Previously the statute of limitations was four years in 42 states, while the other states had slightly different periods.

What if it is an offshore trust? Doesn't matter. If you're named the beneficiary of that trust, whether you are the sole beneficiary or you and your spouse are both beneficiaries, and you file bankruptcy within ten years, the transfer may be deemed fraudulent and is put back into the bankruptcy estate and is available to your creditors. Ironically, Congress has been concerned about people using offshore trusts, but this will tempt more people to go offshore.

How so? Let's say I set up a trust in Delaware naming myself as beneficiary. Then I get sued and have to file bankruptcy within 10 years or someone puts me into an involuntary bankruptcy. This statute says that because you transferred the money into the trust within 10 years with the actual intent to hinder your creditors, the bankruptcy court has jurisdiction over those assets and over the trustee in Delaware. You very well could lose those assets. If you set up an offshore trust, however, and the bankruptcy court determines it was done with fraudulent intent and the 10-year statute applies, what power does the bankruptcy court really have over an offshore trust?

For financial advisors who have clients that have asset protection trusts or that should have asset protection trusts, what's the bottom line? Advisors must be aware now that there is a new 10-year statute, and that there is no grandfathering. If you have a domestic asset protection trust that was created within the last 10 years and your client is forced into bankruptcy, that trust may not be protected. And if you have clients who should have an asset protection trust in place, they may want to now go offshore. There is also a silver lining with this legislation. The fact that the new Act discusses self-settled domestic asset protection trusts means they are being recognized under law as a viable way to protect assets. Once the 10 years have passed, they are now likely to be respected. So advisors may simply want to work with the 10-year statute and encourage clients to set up these trusts early.

Any other estate planning or asset protection ideas advisors should be aware of? If you have any clients in family limited partnerships or are contemplating using them, be aware that the IRS has been quite successful lately in attacking these. It is of utmost importance to have them reviewed, especially if you have an old partnership. The IRS has been most successful in challenging them on the death of the transferor, when either the transferor did not administer them properly or kept too much control.

Any other hot spots? Dynasty trusts. The Joint Committee on Taxation several months ago recommended modifying the estate and gift tax rules to raise revenues and plug loopholes, and one of the things they recommended was to limit the dynasty trust. The concern is that many states have repealed the rule against perpetuities, which means you can maintain assets in trust forever. So what they are proposing is that these dynasty trusts should not allow assets to remain exempt for more than one generation. If you want to benefit future generations without any term limit, then you should use your estate tax exemption now and set up the trust in a state that respected the rule against perpetuities. Trusts created prior to any legislation will likely be grandfathered.

Editor-at-Large Andrew Gluck, a veteran personal finance reporter, is president of Advisor Products Inc. (www.advisorproducts.com), which creates client newsletters and Web sites for advisors. Advisor Products may compete or do business with companies mentioned in this column. He can be reached at agluck@advisorproducts.com.

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