All of the books I've read about asset protection emphasize the importance of solvency in being able to make transfers of assets to exempt forms or to entities that remove the assets from the reach of future creditors. 

None of these books really get into the meat of the question, 

"How Do You Compute Solvency or Insolvency?"

The more I read, the more obvious it became that a person could be totally solvent under traditional methods of computing assets, liabilities and net worth, while being seriously insolvent after eliminating all exempt assets and after including all contingent debts. 

It seems to me that this seems to be a seriously undefined issue in the context of asset protection planning. So, I'm "rushing in where wise men fear to tread" and I've attempted to provide an explanation of how to adjust traditional financial data for a solvency analysis. 

Asset protection planning, estate planning and even some family income tax planning methods usually involve the transfer of ownership of various assets to other family members by gift. If you want to be sure that your transfers will protect those assets from the claims of your creditors in the event that you might be sued, then you need be sure that you are solvent at the time you make the transfers. Where asset protection is your primary concern, your lawyer or financial planner is likely to insist that he or she conduct an insolvency analysis for you. Many of the articles about asset protection in professional journals are now warning legal and financial advisors that they could be held accountable for helping a client to commit a fraud against the client's creditors. 

If you make transfers that render you insolvent or unable to meet your obligations, then the courts may give your creditors the right to recover any property from the transferee where there is a lack of fair value given in exchange for the property. 
 

If you make transfers to an offshore trust, it might be more difficult for the creditors to get to that money, but then the courts might not be willing to grant you any relief in bankruptcy if you should be sued. The claim would then be hanging over your head for many years to come and if the assets were brought back, they would be available to satisfy the claims of any waiting creditors. 
 

1. Insolvency, or
2. unreasonably small capital, or
3. an intent to incur debts that could not be paid.

The business must also be left with sufficient capital to meet its obligations as they become due and the debtor must be reasonably able to foresee that a lack of working capital could result in not being able to meet any claims that might become due. In addition, this element gives standing to future creditors, where the solvency element doesn't. As a practical matter, if the debtor is solvent and can demonstrate a reasonable belief that existing resources and future cash flow would permit the debtor to meet all known or foreseeable obligations, then it should be very difficult for a creditor to prevail on a claim of insufficient capital. 

As for the element of intentionally incurring debts beyond the ability of the debtor to pay those debts, this element goes back to the difficulty of proving intent. So long as the transferor can show that he attempted to retain sufficient assets to meet his obligations, it should be extremely difficult for a creditor to prevail on this element of constructive fraud. 

Thus, the measure of solvency becomes a critical element in any asset protection plan. It also needs to be considered in connection with any estate planning or family income tax planning. So long as you are solvent, as defined below, and so long as you can show that you have a reasonable basis to believe that you can fulfill your future obligations, then your asset protection or estate planning transfers should hold up to a challenge 

However, the "normal" definition has only a slight relationship to the concept of solvency in relation to the bankruptcy laws or the state laws that define creditors rights. 

For example, the definition of solvency given in "Barron's Dictionary of Legal Terms" is that the debtor has the "ability to pay all debts and just claims as they come due." Thus, in some cases, solvency may need to be measured in terms of income and cash flow in relation to future debt obligations. 

In Asset Protection: Legal Planning and Strategies (Warren Gorham & Lamont), Peter Spero states that, 

"In computing the amount of a transferor's assets, the following can be taken into account.

• Reasonably foreseeable cash flow,
• Loans,
• Contributions to equity,
• Reasonably foreseeable sources of capital,
• Assets pledged and personal guarantees,
• Capital contributions,
• Small Business Administration loans,
• Annual income (and)
• Contingent assets."

"However, the following are excluded from the computation of total assets.

• Exempt property ... such as tenancies by the entireties that cannot be severed;
• Property that is transferred, concealed or moved to defraud creditors;
• Property that is not subject to the jurisdiction of the court, such as property transferred to an offshore trust; and
• Property transferred to a partnership or other closely held entity, if the valuation discounts applied to the retained interest significantly reduces the debtor's assets."

• "Under the Uniform Fraudulent Conveyance Act (UFCA), a person is insolvent when the present fair salable value of his or her assets is less than the amount that will be required to pay his probable liability on the existing debts as they become absolute and matured. Under the Uniform Fraudulent Transfers Act (UFTA), a person is insolvent if the sum of his or her debts is greater than the assets at a fair valuation."

• "Every conveyance made by a person who is or will thereby be rendered insolvent ... is fraudulent ... if the conveyance is made ... without adequate consideration." Stated in the opposite form, "A conveyance is not fraudulent, even when made without fair consideration if it does not render the debtor insolvent and there is no intent to hinder, delay or defraud future creditors."

According to Spero, the Federal Bankruptcy Code and the UFCA basically use a balance sheet test of solvency but only the assets available to satisfy creditor's claims (as listed above) can be taken into account. Spero points out that "... the valuation of assets under the UFCA is generally stricter than under the UFTA and Bankruptcy Code. The UFCA uses the term 'present' salable value which does not allow time for marketing the asset and may require a single sale of all assets."

The UFCA states include Delaware, Maryland, Masochists, Michigan, Montana, New York, Pennsylvania, Tennessee and Wyoming. 
 

1. List all of your assets and debts as of a date as near as possible to the date of a transfer by gift. 

2. Adjust the value of the assets to equal market values based on either fair market value in UFTA states or liquidation values in UFCA states. Without getting into an extensive discussion of valuation theories and principles, here are some of the ways to determine value for different personal assets. 

• Cash would be valued at face value.
• Listed securities would be valued at the quoted price on an auction market.
• Investment partnerships could be valued based on secondary market quotes or on what the partnership would offer to repurchase the interest. If there is no market for the interests, the value is zero.
• Valuable art, antiques, jewels or collectibles might require an appraisal if the amount is significant. Otherwise, the simple approach is to just value these items at zero where the appraisal cost would be prohibitive compared to the value of these assets.
• The value of uncollected installment notes would be based on the discounted present value of the future payments unless state law would exempt such payments as an annuity.
• Residential real estate would need to be appraised or based on an estimate that is very conservative. However, if the home equity is protected by homestead laws or by tenancy by the entireties, then the value is zero for solvency purposes.
• Any investment real estate would need to be appraised. However, a conservative value based on estimates by real estate agents might be adequate for this purpose.
• Life insurance cash values and cash values in a deferred annuity would be valued at the amount available to the transferor for a liquidation of the contract. However, in those states where such values are exempt from the claims of creditors, the value would be zero.
• Funds in a qualified retirement plan would be valued at zero if they are not available to satisfy the claims of creditors. Otherwise, the specific assets would be valued as described for personally owned assets.
• A closely held business would be the most difficult asset to value. When making a transfer of a large amount, an appraisal is required if only to establish the value for gift tax and estate tax purposes. For purposes of a solvency analysis, only the amount retained by the transferor would be included. Any discounts for lack of marketability or minority interests should be taken off in the solvency analysis. In the UFCA states, the value would be based on the liquidation value of the assets without any value associated with a going concern.
• In all but three states (Georgia, Louisiana and New York), a partner's interest in specific partnership property is fully exempt from the claims of creditors. Thus, if the partnership interest is not transferable, it should be valued at zero for solvency purposes.
• Property held in trust would be included if the trust is revocable and the assets can be reached by creditors. Otherwise, those assets would have a zero value for solvency purposes.
• If the income interest from a charitable trust or annuity will be available to creditors, then the present (discounted) value of the annuity payments would be included as an asset In a solvency analysis. Where the trust allows for the deferral of any payments to be made up at a future date, the conservative approach is to value those future payments at zero.
• Where the transferor has made a transfer in exchange for an annuity payment, the discounted present value of the expected future payments would be included as an asset so long as the annuity payments are not exempt by state law. In most cases, the value of future payments from an intra-family private annuity would be excluded because of the relationship to the transferor.
• Any assets held in any entity that can't be reached by creditors would have no value for a solvency analysis. This would include any amounts that are held in Swiss annuities or life insurance contracts or held in an offshore trust or even in a closely held corporation where the transferor has no power to control the corporation.
• Exclude any other exempt assets under state law, based on the amount of the exemption permitted by the applicable state, such as (but not limited to) state and local retirement plans, burial plots, apparel, furniture & appliances, tools and auto used in business or work, liquor permits, a personal motor vehicle and wedding or engagement rings.
• Include the value of all assets where the transferor is a joint owner with the right of survivorship, even though the joint ownership applies to the assets of a spouse, parent, child or other relative. To the extent that the assets can be taken by any creditor, they are part of the estate for solvency purposes.
• Any assets that have been given away within the statute of limitations under the state fraudulent conveyance law can be recovered and should be listed as an asset.
• Include the value of any assets transferred to others where the transferor has retained any use or possession of the property.
• Where there are pending or potential claims arising from liability to others, the amount of any liability insurance available to pay any part of those claims can be treated as an asset or deducted from the amount of the claim.
• Deduct the value of any assets that you are planning to transfer for asset protection or for estate planning purposes. This would include any planned conversions of non-exempt assets (like listed securities) into exempt assets - like an interest in a partnership.

According to Peter Spero, 

• "... the determination of liabilities is dependent on applicable laws. The creditor oriented UFCA results in a total that is inflated when compared with the UFTA and the Bankruptcy Code. Under the UFCA, existing debts include 'all claims whether matured or unmatured, liquidated or unliquidated, absolute, fixed or contingent'. Guarantees and other contingent liabilities are generally taken into account at their face value". Under the UFCA, loan guarantees are apparently treated as debts based on the amount that the transferor might have to pay.

5. Where you are concerned about a potential claim that has not reached the point where a judgment has been obtained, the most conservative approach is to estimate the amount that might be due (less any insurance that might be available for that claim) and to deduct that from your assets as an obligation. The opinion of your attorney as to the probability of successful litigation by the plaintiff and the amount of a potential award might be the only way to get a number to use in your solvency analysis. 

6. The total of the adjusted value of your assets less the adjusted total value of your debts as discussed above would determine if you are solvent with respect to the claims of any creditors. If you have an excess of assets over your debts based on this kind of analysis, then your asset protection and/or estate planning transfers should be safe from future claims by distraught creditors who are trying to get at those assets. 
 

The cash flow projections also require adjustments to exclude any projected cash income that is exempt under state law. For example, in some states, up to 100% of your earnings or wages are exempt. Many states will also exempt amounts received from pension plans. 
 

Where the solvency analysis includes an unincorporated business, the value of any business assets not discussed above would need to be estimated. Accounts receivable should be discounted to reflect any potential bad debts. Inventory should be valued at the price that could be realized by selling it back to the vendors or by selling it to competitors. Business equipment and fixtures should be valued at estimated auction values in UFCA states and at a going concern value in other states. In non UFCA states, you should be able to include the value of intangible assets such as going concern, licenses, favorable leases, patents, copyrights, locations, trade secrets, etc. 

The cash flow projections would be even more critical for a business if it is to be continued. 
 

From what I've read, any attorney who offers to do bankruptcy work should also be prepared to make a detailed solvency analysis as part of that service. 

Some attorneys may have developed arrangements with some accountants who will "crunch the numbers". As an accountant, I do have some bias about using an accountant to do number crunching, but in this case, I think you should be sure that the accountant is really informed about the special rules for computing solvency in your state. 

There is an association of attorneys and accountants who do bankruptcy related work, and I would presume their members should be able to make a competent solvency analysis. The association is the American Institute of Bankruptcy and their phone number is (703) 739-0800. 
 

The UFTA gives creditors up to four years to recover property after the time it was transferred or up to one year after the claimant discovers, or reasonably could have discovered, the transfer - whichever is later. Therefore, if the transfer was not disclosed so that a claimant can reasonably be able to discover it, then there is virtually no statute of limitations. 

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.  He  sponsors and moderates a free discussion group on asset protection and offshore topics.  His email address is vkj@rpifs.com.  He can be reached by phone or fax at (913) 362-9667.

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