Mortensen Case Holds that Self-Settled Trusts Don’t Work in Bankruptcy (but Our Trust Will)

Posted by McCullough

A self-settled trust is a trust in which the grantor is also included as a beneficiary. Historically, all fifty states did not allow asset protection for a self-settled trust.

In recent years, several states have passed laws allowing asset protection for a self-settled trust. These states include Alaska, Nevada, Delaware, Tennessee, Utah, Hawaii, Missouri, New Hampshire, Oklahoma, Rhode Island, Wyoming and South Dakota. Many have promoted self-settled trusts under the name of a “Domestic Asset Protection Trust,”an “Alaska Asset Protection Trust,” a “Nevada Asset Protection Trust,” etc. As more and more cases show that offshore trusts can be attacked through the use of a contempt order, these “Domestic Asset Protection Trusts have become quite popular.However, a recent bankrupcty case (Battley v. Mortensen, Adv. D. Alaska, No. A09-90036-DMD, May 26, 2011) shows that self-settled asset protection trusts are ineffective at protecting assets from bankruptcy. This is not a situation where bad facts make bad law. This is a case where the debtor settled the trust when he was not insolvent, and it was done four years before the debtor filed for bankruptcy.The reason the self-settled asset protection trust failed is because of a new bankruptcy law (Section 548(e)(1)) which specifically applies to a self-settled trust. This law allows the bankruptcy court to avoid any transfer made to a self-settled trust within ten years of the bankruptcy filing if the debtor made the transfer with actual intent to hinder, delay, or defraud any entity to which the debtor became indebted whether the debt occured before or after the transfer.It is important to note that the Mortensen case and Section 548(e)(1) have no affect on any trust in which the debtor is not a beneficiary; they only apply to self-settled trusts. Thus, our trust continues to be the best asset protection trust available in or out of the US because it is supported by the federal bankruptcy code (See Section 541(b)(1)), the Uniform Trust Code (See Section 505), the Restatements of the Law (See RESTATEMENT (SECOND) OF TRUSTS Section 156(2)), and many statutes and court cases throughout the country.Click HERE to read the case.

Asset Protection Test Case

Posted by McCullough

I had a client named Bill who was a wealthy physician. In 2003, he created a 541 Trust® for his wife Jenny and their four children.

He put $2,000,000 into the 541 Trust® where it was invested in income producing real estate. In 2005, Bill died. In 2007, Jenny married a successful real estate developer named Paul. Paul needed a loan for a large project and the bank required both Paul and Jenny to guarantee the loan. When the real estate market crashed in 2008 and 2009, the project failed. The bank sued Paul and Jenny on their personal guaranty. Paul and Jenny were both forced into bankruptcy. The bankruptcy court declared that the 541 Trust® was not includible in the bankruptcy estate and that the creditors have no claim on the 541 Trust®. The 541 Trust® is now Jenny’s only source of income. The income and principal of the 541 Trust® is available to Jenny, but protected from her creditors or from a divorce. When Jenny dies, the assets will be held for her children for life and they will receive the same asset protection.

Asset Protection for Doctors

Posted by McCullough

Doctors have several unique characteristics that require specialized asset protection planning. First, doctors cannot take advantage of the corporate shield that protects other business owners from the liabilities of their business. In all fifty states, doctors are personally liable for malpractice claims regardless of whether their practice is operated within a corporation. Second, malpractice insurance for many doctors is prohibitively expensive. Many doctors choose to underinsure or even go without malpractice insurance due to the outrageous expense. Third, a doctor’s most valuable assets often consist of accounts receivable and future earnings which are more difficult to protect than a current asset.

Because doctors have unique needs, they need a unique solution. The best solution for a doctor consists of the following entities: (1) a professional corporation (taxed as an S corporation) to operate the medical practice, (2) a 541 Trust® to remove assets from the doctor’s personal ownership, (3) a Delaware LLC that is owned by the 541 Trust to own cash and other investments, and (4) an effective equity stripping plan that allows the Delaware LLC to put an enforceable lien on the doctor’s home, accounts receivable and other assets which are personally held by the doctor. If you would like a diagram and detailed explanation of this plan, send me an email at lee@lsmlaw.net.

The purpose of the professional corporation is to save money on employment taxes and keep the employees and other non-malpractice liabilities separate from the doctor and his assets. The purpose of the 541 Trust is to remove assets from the doctor’s personal ownership so they cannot be discovered or attached in a lawsuit or other legal proceeding. The purpose of the Delaware LLC is to own and manage cash or other liquid assets. The purpose of the equity stripping plan is to ensure that the doctor’s home and accounts receivable cannot be attached by a third party.

This plan is simple to implement, easy to maintain, and impervious to attack if it is implemented in advance of a problem. However, individual circumstances require individual plan design and this site should not be construed to create an attorney-client relationship or provide legal advice for any particular situation. If you would like to discuss your situation, please give me a call.

Update of Recent Asset Protection Cases

Posted by McCullough

This is a summary of important findings from recent asset protection cases:

1. In re Baldwin, 593 F.3d 1155 (10th Cir Ct. App. 2010). Bankruptcy trustee can avoid restrictions imposed by state law charging order statutes if a partnership agreement is not an executory contract. Also see In re Ehmann 2005 WL 78921 (Bankr.D.Ariz. 01/13/2005) which had similar facts and a similar holding.

From these cases we learn the following: (1) Partnership agreements and LLC operating agreements should be carefully designed to ensure that they constitute executory contracts, (2) Personal use assets should not be held by business entities (except for valid lease arrangements), (3) Entities should be structured for valid business purposes, (4) If possible, entities should include legitimate partners other than the debtors (and unrelated to the debtors if possible).

2. Shaun Olmstead vs. Federal Trade Commission, No. SC08-1009, June 24, 2010. The Supreme Court of Florida held that Florida law permits a court to order a judgment debtor to surrender all right, title, and interest in the debtor‘s single-member limited liability company to satisfy an outstanding judgment. A charging order is not the sole remedy authorized by law.

From this case we learn the following: (1) Some states provide much better asset protection than others for LLCs and limited partnerships. Many states, including Florida, mention a charging order as one remedy but remain silent as to whether it is the sole remedy of a creditor. This case shows that this language is insufficient to ensure “charging order protection.” (2) As we have learned from previous cases, including In re Albright, 291 B.R. 538, 540 (D. Colo. 2003), you cannot rely on a single member LLC to provide charging order protection. This does NOT mean that a single member LLC cannot provide asset protection to the members against the inside liabilities of the LLC.

3. Miller v. Kresser, 2010 Fla. App Lexis 6152 (Fla. 4th DCA 2010); Wachovia Bank, NA v. Levin, 419 B.R. 297 (E.D.N.C. 2009) and In re: Coumbe, 304 B.R. 378 (2004). From these cases we learn that the good old fashioned asset protection provided by a spendthrift trust continues to be upheld by the courts. This protection is even greater when the trust is designed as a discretionary trust (see Wilson v. U.S., 140 B.R. 400 (N.D. Tex. 1992). Once again, this protection is even greater when supported by a state statute that provides that a beneficial interest is not a property right and that the discretion of a trustee is “absolute.”

4. Sweeney, Cohn, Stahl & Vaccaro v. Kane, No. 2002-04052 (N.Y. App.Div. 03/08/2004). A New York resident attempted to protect a residence by placing it in a Florida corporation whose shares were owned as tenants by the entirety under Florida law. The Supreme Court of the State of New York- Appellate Division, found that Florida law applied because the state of incorporation has the greatest interest in determining whether the corporate veil may be pierced. The court allowed the creditor to attach the residence under a theory of “reverse-veil piercing.”

This case affirms the fact that the internal affairs of a corporation, including a potential piercing of the corporate veil, are governed by the laws of the state where the corporation is filed, regardless of the fact that the plaintiffs, the defendants, and the cause of action in the case, were all located in another state. The case also reminds us not to put personal use assets in a corporate entity without a lease or other business purpose to justify such an arrangement.

Historic Opportunity

Posted by McCullough

In Revenue Ruling 2010-18, the IRS published the applicable federal interest rates for July, 2010. These are some of the lowest rates in the past thirty years, and as far as I can see,some of the lowest rates in modern history. For example, you can sell assets in July in exchange for a promissory note with athree year termand an interest rate of 0.61%. Or, you can sell assets in July in exchange for a promissory note with a nine year term and an interest rate of 2.33%. Or, if you have previously sold assets to a trust for estate planning purposes, you could re-finance the note at these historically low interest rates. These low rates allow more of your assets to grow outside of your estate and pass to thenext generation free of estate taxes.

At least three factors create an ideal environment for entering into an estate planning transaction:

(1) low interest rates, (2) relatively low values in real estate, stock, and other markets, and (3) the likelihood of future inflation. I believe that all three of these factors are in place at the present time, making this possibly the best time ever to enter into an estate planning transfer.

It is true that the estate tax laws are in a state of uncertainty. At the present time, no one knows whether theestate tax exemption will be $1,000,000 per person or $5,000,000 per person in 2011. In my opinion, if you have an estate in excess of $2,000,000, the best course is to planto avoid the estate tax even if the exemption is only $1,000,000 per person, and make your plans flexible enoughso that you can adapt toany changes in the law.

By taking advantage of today’s low interest rates and low market values, you will have greater peaceof mind,you will have more optionsto allow you to adjust to future conditions, and you will potentially save millions in estate taxes.

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Miller v. Kresser

Posted by McCullough

In the recent case, Miller v. Kresser, 2010 Fla. App Lexis 6152 (Fla. 4th DCA 2010), a Florida Appeals court overturned the ruling of a lower court which allowed a creditor to reach the assets of a trust.

The lower court allowed the creditor to reach the assets of the trust because the beneficiary exerted significant control over the trust, the trustee was related to the beneficiary, and the trustee basically failed to perform the administrative duties expected of a trustee. The appeals court overturned that ruling and upheld the asset protection provided by the trust despite the fact that the trustee was not fulfilling his duties.

Lessons learned from this case:

1. Courts continue to uphold the asset protection provided by a spendthrift trust, even in cases where the operation of the trust is imperfect.

2. You can improve your chances of protecting trust assets by appointing an independent professional as the trustee instead of appointing a family member.

3. If you must appoint a family member as a trustee, appoint an independent professional as a co-trustee in order to add legitimacy to the trust.

4. A trustee who does very little administration and allows the beneficiary too much control over the trust will jeopardize the asset protection provided by the trust. The trustee should keep books and records, participate in regular meetings, make investment decisions, sign tax returns, and take part in the administration of the trust.

5. Distribution of income and principal should not be mandatory at any time, but should be left to the unfettered discretion of the trustee.

6. The trust should be located in a jurisdiction that supports the asset protection provided by an irrevocable spendthrift trust.

Death Hollow Done Right

Posted by McCullough

As a sequel to my previous blog entry, I wanted to provide a report of our recent trip to Death Hollow.

The first day entails a 13 mile hike in soft desert sand without any water. Last time we did this hike we almost died of dehydration. This time we left at 3am and used headlamps to light our way. Not only did we enjoy the adventure of hiking through the desert at night, we arrived at our destination early, with plenty of water remaining in our packs. The decision to leave early and hike at night was right – dead right.

hh5 hh4 hh3

The second day requires swimming through icy water. This can be scary with shoes and a backpack. We threw ropes back to the younger boys so they could grab on if they got in trouble. This turned out to be unnecessary, but it was the right decision – dead right.

Late on the second day we found ourselves in the narrows when it started to rain. We decided to run down river and get to high ground to avoid a flash flood. No flood came on this day, but the decision to play it safe was right – dead right.

That night we slept in a cave that was sheltered from the storm outside. After we set up camp we found bear scat all over the place. We moved all the food away from our sleeping area, built a fire at the entrance to keep the bears away, and dried tons of wet firewood over the fire to give us extra fuel for a bonfire. Twice during the night we heard a large animal splashing in the river outside and we stoked up the fire really quick. The decision to prepare tons of firewood and keep the fire raging was right – dead right.

The next morning we were anxious to press on in order to get home on time, but it was raining and we decided it would be wise to wait out the storm. We witnessed a deluge of rain for five hours. Huge waterfalls poured off the canyon walls. The river rose and we watched the flash flood from the safety of our bear cave. The decision to wait out the storm was right – dead right.

hh2 hh1

The storm passed and we finally started hiking at noon. We hiked as fast as we could to try to make it out before dark. When darkness came we pressed on with our headlamps walking down a river in the dark for four hours. We really wanted to make it to the end of the hike so we could call and let our families know we were safe, but we got lost in the darkness. We knew we were close to the parking lot but we couldn’t tell if we had passed it in the darkness, and we didn’t know which way to go. We really wanted to keep looking for the parking lot but we knew it was best to stay where we were until the morning so we didn’t get lost any further out of our way. That was the right decision – in fact, it was dead right. In the morning, we found the way and realized we never would have found it in the dark.

Death Hollow was a great adventure, one that we will never forget. I am grateful for the friends that made the trip so much fun, and for the wisdom, experience, and inspiration that helped us to make the right decisions and bring everyone home safely.

Selecting A Trustee

Posted by McCullough

If you are choosing a trustee for a dynasty trust, an asset protection trust, or a trust used to establish residency in a certain jurisdiction, then you better pick a corporate trustee or a professional trustee. Even if they don’t provide a lot of services, their fees are justified by their credibility if the trust is attacked, by their independent approval of related party transactions, and by the cost of their malpractice insurance. The IRS and the courts have busted many a trust by proving that the trustee was a straw man and the trust was a sham. (See Sparkman v. Commissioner, 509 F. 3d 1149 (C.A. 9, Dec. 10, 2007)).

If you are selecting a trustee to administer your family living trust, the analysis is different. You have the option of picking a family member, friend, CPA, or a professional trustee. I usually recommend a professional trustee because they are qualified, experienced, capable, unbiased, and they have the time and energy to get the work done. But most people ignore my advice and appoint a family member who has no qualifications, no experience, no independence, no time, and no desire to serve in that capacity. Most people pick a family member in order to save money, failing to factor in the cost of probate litigation, restraining orders, and strategic warfare among their heirs when the estate is administered by a family member.

Being chosen as an executor or trustee is a lot like being asked to referee a church basketball game. You have little to gain, and no matter how hard you try, you will probably be disliked, accused of being unfair and incompetent, and you will probably find yourself in the middle of a melee. I have personally played in a game that involved six technical fouls, two ejections, and a chipped tooth. The referees were atrocious, but, most importantly, we won the game.

These are some factors to consider in selecting a trustee:

Someone who is honest and trustworthy. If they have deep pockets, you have greater assurance they won’t steal or your money and leave you without recourse.
Someone who is qualified and capable. It helps if they have accounting skills, investment experience, and some business savvy.
Someone who is organized, responsible, and capable of decent record keeping.
Someone who is fair, unbiased, and a good communicator.
Someone in your geographic vicinity.

The Case for Specialization (and deep powder)

Posted by McCullough

Last Saturday I went snowcat skiing with my dad and my brother. We had a marvelous time. But the most impressive part of the day was watching the guides who led us to the steepest and deepest powder runs while avoiding the dangers all around us. The guides have years of experience on the same mountains and they know exactly where the best powder is found and how to avoid the avalanches and other dangers which were apparent all around us. All day the snowcat climbed up ridges no wider than the snowcat itself with thousand foot drops on both sides. We skied along narrow ridges where the guides insisted that we stay directly on their tracks to avoid collapsing the rims on either side. In one large bowl thousands of yards across, the guides showed us how there was avalanche danger on the right, icy crusty snow on the left, and one perfect powder run down the middle. They had us ski between the tracks of one guide on the right and the tracks of another on the left so we could take advantage of the lightest and deepest powder the mountain had to offer.

asset protection ski — Powder skiing photography by John Dougall

These guides did not rely on generalized weather reports or general backcountry experience. They were focused on the specific conditions of each particular hillside at each specific moment in time. They knew which slopes got the most sun, which got most wind, which got the most snow, and how this would affect the safety and enjoyment of the skiers at any particular time. Because of their specific knowledge, they were able to provide a safer and better experience than we could ever do for ourselves.

This same principal applies equally well in many fields. I keep a specialist file in my office with the name and contact information of people who are the very best in their field of specialization. So if you ever need an expert in municipal bonds, or the taxation of stock options, or mediation, or bankruptcy (hopefully not), let me refer you to a specialist. By focusing on one specific area, a specialist can stay up on the latest developments, dangers, strategies and ideas. Just like the ski guides, we can show you where the dangers are, and where the good stuff can be found.

Living on the Edge

Posted by McCullough

Gooseberry Mesa is the greatest mountain bike trail on earth The trail involves sweet single track, endless slick rock playground, and breathtaking views. If you look east, you see the imposing cliffs of Zion National Park If you ride along the south or north edges of the mesa, the trail skirts sheer cliffs dropping hundreds if not thousands of feet to the valley floor At the end of the mesa is a narrow neck of rock, forty feet wide with a trail down the middle and cliffs on both sides Finally, the rock ends with sheer cliffs dropping off in front of you and on both sides A trip to Gooseberry Mesa is exhilarating, and refreshing to the soul.

The trail keeps you close enough to enjoy the view, but never puts you in danger of falling off the edge This is a good analogy for those of you who like to live on the edge I have many clients who get involved in aggressive tax planning, speculative investments, or high risk businesses Some push the limits too far and get burned; others live to play another day Sometimes it is luck that makes the difference; other times, a person is protected by taking precautionary measures that limit their exposure I recommend the following precautionary measures:

First, “Where no counsel is, the people fall: but in the multitude of counsellors there is safety” (Proverbs 11:14) A really good CPA not only helps you take advantage of every opportunity, but he also knows where to draw the line and when to push back when you get too greedy Before taking the plunge on a risky deal, I suggest you get several independent opinions from well qualified counselors.

Second, “He that maketh haste to be rich shall not be innocent” (Proverbs 28:20) If it sounds too good to be true, it probably is If it is that good, it is worth taking the time for some advance planning and due diligence.

Third, “He that walketh with wise men shall be wise: but a companion of fools shall be destroyed” (Proverbs 13:20) More important than any legal documents, tax opinions, or pro forma projections, is the character of the promoters.

Remember, a fine day at Gooseberry Mesa is made better by the fact that you are likely to survive, to do it again.