It is often possible to use carefully planned transfers to place your assets out of the reach of potential creditors. This can done in two ways: asset exemption planning and strategic funding practices within your business entity.
There are two major strategies business owners should use to protect assets from the reach of creditors. First, you must maximizing your use of your state's asset exemption laws. Second, because exemptions assist only individuals, you need to engage in strategic funding practices within a business entity.
Effective exemption planning can take many forms:
- using any of your available cash to purchase exempt assets;
- paying down mortgages on homes if your state provides an unlimited homestead exemption, or if the amount of the homestead exemption exceeds the value of your home;
- adding a mortgage to a home when the value of the home equity exceeds the amount of the homestead exemption; or
- converting secured debt into unsecured debt by, for example, using a credit card to make a mortgage payment.
A change of residence to a more debtor-friendly state is a more dramatic way to facilitate asset exemption planning, provided this is planned well in advance so that you will be able to claim the new state's exemptions should financial troubles arise.
Strategically funding your business. Strategically funding your business. Strategically funding your business entity means minimizing the amount of vulnerable capital within the business. You can accomplish this:
- by making leases and loans of assets to the business entity;
- by making a practice of regularly withdrawing funds from the entity as salary, lease and loan payments to yourself; and
- by encumbering the entity's assets with liens that run in favor of yourself, and that result from extensions of credit from you to the business.
Creditors have several methods challenge asset protection strategies
Even if you have followed sound asset planning techniques, it's still possible for creditors to challenge your asset transfers. Through proper planning, these challenges usually can be blocked effectively. The major avenues that creditors use to challenge asset transfers are the Bankruptcy Code, the Uniform Fraudulent Transfer Act (UFTA) and state laws regarding distributions of business assets to owners.
State laws may reach transfers of business assets
Provisions in many state limited liability company (LLC) and corporation statutes also restrict distributions from the business entity to an owner. If your business is a corporation or LLC, you'll need to consider the impact these laws may have on you.
While the UFTA and bankruptcy code apply to all types of transfers, the reach of these other statutes is limited to distributions made on account of the ownership interest. These distributions include dividends or other distributions of earnings, and ownership buy-outs such as stock redemptions. Ordinarily, these statutes will not apply to payments of salary, or for leases and loans, to the owner, because these distributions are not made to the owner simply because of ownership (i.e., they are made to you in your capacity as an employee, lessor or lender). This fundamental tenet of asset protection is addressed in our discussion of withdrawing funds from the business.
Note that when distributions of earnings and ownership redemptions are planned, the business owner must be aware of the separate rules (including the separate solvency tests) that will apply under these statutes.
Was there an asset transfer?
A challenge to an asset transfer can only succeed if there was actually a transfer of the ownership of an asset The courts have made a distinction between a transfer made by an individual to himself (or a married couple to themselves), on the one hand, and a transfer from a husband to a husband and wife, on the other.
The first situation does not involve a "transfer," as there is no change in ownership. Therefore, since there is no transfer, there can be no constructive fraud. In contrast, a transfer of the second type does involve a transfer, as there is a change in ownership.
Example
A married man inherited approximately $160,000 from his father. An inheritance is considered the sole property of the beneficiary, even if the beneficiary is married—unless the beneficiary takes action to convert the inheritance to marital property. Immediately after receiving this inheritance, he used it to completely pay off two mortgages on his home, which he owned in tenancy by the entirety with his spouse.
The husband also individually owed more than $100,000 in unsecured debt. About 1-1/2 years after he paid off the mortgages, he filed an individual bankruptcy action. His wife was not a party to this action.
Under the law, a creditor of only one spouse cannot reach property owned in tenancy by the entirety, when only the debtor spouse files in bankruptcy.
However, because of the timing of the transfer—within two years of the filing of the bankrupty petition—the bankruptcy court determined the mortgage payoff was fraudulent, and entered a judgment against the husband and the wife in the amount of the $160,000.
According to the court, there was a transfer from one entity (the husband) to a different entity (the husband and wife). Had the payment been from joint funds, rather than from the husband's inheritance, there would have been no “transfer,” and therefore no fraud.
As this example illustrates, one way to avoid a constructive fraud claim may be to ensure the transferor and transferee are one and the same. A payment on a mortgage secured by a jointly owned exempt home should come from joint funds, such as a joint checking account or a joint credit card.
Had the debtor in our example deposited the funds in the joint account, and left the funds in the account for a long period of time (the longer the better), so that the funds co-mingled with other joint funds in the account, it is possible that he would be considered to have converted the inheritance to joint funds. Thus, the transaction would not have been a "transfer" according to the definition of the term adopted by the court.
Wages versus inheritances. In contrast to an inheritance are wages, which are usually deposited by a couple into a joint account on a regular basis and used to pay joint bills. These wages are likely to be considered joint funds much more rapidly than, say, an inheritance. Thus, conversion of wages should not necessarily face the same outcome. However, it would be a mistake to pay down a mortgage on a jointly owned home from an account owned by only one spouse.
Match ownership of transfers to exempt assets
The small business owner should follow these rules in making asset exemption transfers:
- A solely owned nonexempt asset should be converted to a solely owned exempt asset.
- A jointly owned nonexempt assets should be converted to jointly owned exempt asset.
While not foolproof, this strategy helps to make the transfer resistant to challenge, on the grounds that it is not actually a "transfer" subject to the UFTA.
This strategy can be used to purchase an exempt asset (such as an exempt homestead), to pay down a mortgage when the exemption amount exceeds the home's value, or to encumber the home with another mortgage when the value of the home exceeds the homestead exemption.
In some cases, following this rule won't be practical. In the case of a newly married couple, for example, it would be expected that a residence owned by one spouse might by transferred into tenancy by the entirety. Here, to defeat a claim of constructive fraud, the transferor would need to ensure that he or she is not insolvent at the time of the transfer.
Note that, in cases involving fraud within one year of a bankruptcy filing, the court will not have to rely on the UFTA to invalidate a fraudulent act. In this situation, whether or not the fraud was in the form of a "transfer" will probably be irrelevant, because the transfer occurred within one year of filing a bankruptcy action. Where, however, the alleged fraud occurred before the one-year period, or the action is in state court, whether or not the fraud took the form of a transfer can affect the outcome.
The moral of the story is that caution must be exercised, especially in pre-bankruptcy exemption planning, because the debtor will usually be insolvent. In this situation, if you do not receive adequate consideration in return for the transfer, there is the possibility that the transfer will automatically be deemed fraudulent, regardless of intent, under the constructive fraud theory.
Warning
When a debtor is insolvent, a "gift" will always be deemed fraudulent under the constructive fraud theory. A gift is a transfer to another person or entity, where the transferor receives nothing (or something inadequate) in return.
The UFTA does not expressly define the term "adequate consideration." However, essentially the term means something of approximately equal value.