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.