The Debtor's Last Resort 

Federal and State Exemptions

Other Changes in The Federal Bankruptcy Law

Bankruptcy Law and Fraudulent Conveyances

Bankruptcy is often the only method of asset protection for those who are unprepared for future lawsuits. For those who do plan ahead to avoid being wiped out by a lawsuit, the threat of bankruptcy is a significant weapon in negotiating with a creditor. 

This article is a summary of the key changes to the bankruptcy code resulting from the 1994 bankruptcy law and how the process of asset protection relates to the rules and procedures of bankruptcy. This discussion isn't limited to the use of bankruptcy as a protection for taxpayers, but there are some special situations when taxes can be discharged in bankruptcy. The November, 1994 issue of Pilla Talks Taxes includes an excellent summary of the new bankruptcy law in the context of taxes owed by taxpayers. For information on obtaining a copy of that issue, call (612) 484-8144.

The federal bankruptcy laws are included in Title 11 of the U.S. Code. Chapters 1 through 5 and 9 of the Bankruptcy Code address general provisions, case administration and other matters. 

Chapter 7 covers the liquidation of assets and a complete settlement of all dischargeable debts of the debtor. 

Chapter 11 (of Title 11) is primarily for business reorganizations in which the business continues to operate while paying off a portion of its debts. This section includes all forms of businesses, including a sole proprietorship. Family farms are reorganized under Chapter 12. 

Chapter 13 is generally known as the "Wage earners" bankruptcy, where the debtor can pay all or a portion of his or her debts out of future income.

(1) Unmatured life insurance contracts owned by a debtor, 
(2) social security and unemployment benefits, 
3) veteran's benefits, 
(4) disability or illness benefits, 
(5) alimony or separate maintenance payments, 
(6) most payments under pension, profit sharing or annuity contracts by reason of age, illness, disability or length of service and 
(7) compensation for loss of future earnings. 

However, each of the states has its own schedule of exemptions. In 15 states, the debtor can choose between the federal exemptions or the state exemptions. In the other states, the debtor must use the state exemptions - which are usually more generous. 

For example, six states (Florida, Iowa, Kansas, Oklahoma, South Dakota and Texas) provide an unlimited exemption for the value of a homestead, but the laws limit the amount of urban and rural acreage that is exempt. 

The rules for exempting pension, profit sharing, 401(k) or IRA assets are very different from state to state. In most cases, the pension or profit sharing assets are protected while the IRA, SEP or 401(k) assets are not. 

In many states, the proceeds of life insurance policies payable to a spouse or child are exempt and the cash value of a policy owned by the debtor is exempt - but the rules vary greatly from state to state. The exempt status of amounts in an annuity contract are far more diverse and far more ambiguous.

One of the more significant changes in the 1994 law is the ability to sue government agencies. According to Dan Pilla, this change "corrects a long standing problem with the bankruptcy law. ... Under the Doctrine of Sovereign Immunity, the United States Government (can't) be sued unless it consents to the suit. ... When a discharge is questioned by a creditor, the proper procedure is for the debtor to file suit to ... ask the (bankruptcy) court to declare the debt discharged. ... But ... if the government (can't) be sued, a debtor cannot quiet the claim against him. ... The new law gives the bankruptcy court the authority to 'issue against a government unit an order ... or judgment'". (Pilla Talks Taxes, November, 1994) 

Another change in the law provides greater protection for former spouses and children by giving them a higher priority among various creditors, providing for ongoing payments during bankruptcy proceedings (by providing relief from the automatic stay) and providing for non dischargeability of alimony and child support debts. 

In addition, the new law grants to bankruptcy courts the authority to conduct jury trials in civil proceedings. This is of particular benefit to taxpayers where the IRS is asserting that the taxpayer has committed fraud - which prevents a discharge of debts, thus creating a "Catch-22". With a jury trial, the taxpayer has a chance to argue the question of whether fraud was committed. 

As long as you rely on U.S. laws to protect your assets, those laws can be changed at any time when some judge decides that a creditor has been unjustly deprived by your use of the U.S. laws. Even if you could prevail in an appeal, your assets could be tied up for an extended time or the legal fees could wipe you out. 

However, if you are not able to get a judgment creditor to agree to a settlement, the threat of bankruptcy may be the only way you can force the claimant to settle the dispute. Perhaps you have taken steps (well in advance of a lawsuit) to transfer substantial assets to a family limited partnership, to an offshore trust, a charitable trust or a corporation controlled by other family members. Then the person who has won a judgment against you refuses to settle and insists on getting paid in full. If you can convince a bankruptcy judge that your prior transfers were not made to defraud any of your creditors, bankruptcy can help you to settle this claim. 

According to Gideon Rothschild, "If asset protection planning is done far enough in advance, a bankruptcy judge should allow the prior transfers if a creditor forces you into bankruptcy."

The term "fraud" for this purpose is not the same as a fraud committed to secure money or property in a criminal sense. The concept of a fraudulent transfer is not a criminal issue except in some extreme circumstances where it can be shown there was a willful intention to commit a fraudulent transfer of assets after secure funds from a creditor. In the context of this discussion, the most common situation involves a person who has incurred an obligation already, and then takes steps to "hinder, delay or defraud" an existing or reasonably anticipated future creditor. 

While the Federal bankruptcy laws have provisions about fraudulent transfers (Section 548), the two uniform fraudulent conveyance laws applicable in different states are effective without regard to bankruptcy. Where transfers have been made to "hinder, delay or defraud" any creditor, the courts can recover the property from the person or entity to whom it was transferred. If the creditors can convince the court that the transfer was based on an "actual intent" to defraud the creditors, the property can generally be recovered from the person to whom it was transferred. 

Since actual fraud is difficult to prove, creditors usually try to prove constructive fraud. In that case, if a transfer is made for "adequate consideration", it won't usually be considered a fraudulent transfer - subject to the facts presented to the court. In addition, if you can show you were still solvent and able to meet your obligations after the transfer, it should not be considered a fraudulent transfer and won't be recoverable. 

Even so, as Gideon Rothschild pointed out, "since a bankruptcy court is a court of equity, the judges have wide discretion to obtain the results desired and therefore it is much more advisable to not be subject to such proceedings in the first instance." In other words, use an offshore trust if you want to avoid the broad discretions available to bankruptcy judges. 

Further details about protecting your assets from future lawsuits  are available in our subscriber's web site. Changes in the tax laws and various federal and state laws affecting various asset protection devices are provided in our monthly newsletter on Asset Protection Strategies. 

NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified  professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article. 

About the author: 

Vernon Jacobs is a CPA/CLU who works as a tax author and consultant.