Asset Protection
In the Aftermath of the Bankruptcy Abuse
Prevention and Consumer Protection Act of 2005
R. Glen Ayers, Jr.
Introduction
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,” was passed by the Congress this Spring and signed into law by President Bush April 20, 2005. The revisions to the Bankruptcy Code will have a draconian impact upon consumers and consumer bankruptcy practices. Many are now referring to the act at the “BARF” – an acronym composed with much regard to content of the statute but little regard for initials.
While there is much to criticize about the “BARF,” the purpose of this paper is to outline changes that will affect asset protection planning. Because those changes are limited and are in some large part justifiable, I will not be able to mount my soapbox and preach against the evil Congress and its masters, those banks and credit card companies who together created this punitive, anti-consumer, unworkable monster of a statute. And, if you really want to know how I feel about the statute, see the May 25th issue of THE TEXAS LAWYER.
The changes which will impact asset protection include changes in state law homestead rights when bankruptcy is filed, changes in the exemption scheme for IRA’s, and definitional changes which have the affect of removing education trust fund, education IRA accounts, and certain employee benefits from the bankruptcy estate.
However, you should know that all bankruptcy lawyers who represent consumers must now identify themselves as “debt relief agencies.” A “debt relief agency” is anyone who provides bankruptcy assistance. 11 U. S. C. §101(12)(A). At §101(4), bankruptcy assistance is defined as assistance in a bankruptcy case under title 11. Further, an “assisted person” under § 101(3) is a consumer debtor. Therefore, you do not have to disclose in your firm’s promotional materials or on its website that you are a “debt relief agency” unless you fit in these narrow categories. Because one of my partners has a large consumer practice, and because I do pro bono cases, my firm is now a “debt relief agency.” This is quite a shock to the two or three of my partners who represent banks.
By way of further introduction to the statute, and as an indication of some of the problems with the Act, new § 526 describes “restrictions on debt relief agencies.” One of the things that a debt relief agency (i.e., a bankruptcy lawyer) may not do is, at § 526(a)(4):
advise an assisted person or prospective assisted person to incur more debt in contemplation of such person filing a case under this title or to pay an attorney or bankruptcy petition preparer fee or charge for services performed as part of preparing for or representing a debtor in a case under this title.
A parsing of the sentence reveals that the provisions does not say that a lawyer cannot advise a debtor to borrow money to pay fees but rather that a debt relief agency may not advise a debtor to pay fees.
Effective Dates
The statute generally becomes effective on approximately October 17th or 180 days from the date the President signed the Act. However, some provisions of the Act will not become effective until rules are promulgated. See generally 11 U.S.C. §308. Some of the provisions of the Act dealing with the requirements that all consumer creditors have consumer credit counseling prior to the filing of a bankruptcy do not go into effect until there is a certification by the local United States Trustee that there are local agencies able to provide such consumer credit counseling pursuant to the terms of the Act. See new 11 U. S. C. §109(h).
However, the provisions of the Act dealing with the limitations on the homestead are effective now. The changes to §522 (n), (o) and (p) became effective when the President signed the statute. Also effective immediately are two of the amendments to the Bankruptcy Code Fraudulent Conveyances provisions; the scope of the provision has been extended and transfers made up to two years prior to the date of the filing of the petition are now within the reach of §548. See §548(a). The prior statute only reached transfers within one year. The second change to §548 which became effective April 20 is new subsection (e), which permits avoidance of self-settled trusts for up to ten (10) years.
EDUCATIONAL ACCOUNTS AND IRA’S
Educational Accounts
Rather than exempt education accounts, 11 U.S.C. § 541(a)(5)(b)(5) excludes from property of the estate funds placed in an “education individual retirement account” qualified under §530(b)(1) of the Internal Revenue Code and which have been in the account for at least 365 days.
The designated beneficiary must be “a child, step-child, or stepchild of the debtor) for the taxable year for which the funds were placed in the account . . .” Under new §541(e), “child” includes those children legally adopted or whose adoption is pending and foster children.
There are further limitations. The funds may not be pledged in connection with extensions and credit. Excess contributions do not qualify. Total funds contributed for the period between 720 days from the date of the bankruptcy petition and 365 days before the date of the bankruptcy petition may not exceed $5,000 per designated beneficiary. In other words, any contribution to a particular child which occurs after 720 days before the date of the petition and before 365 days before the date of the petition in excess of $5,000 is property of the estate. Further, any funds contributed within 365 days are property of the estate.
This certainly would not end an inquiry into whether the contributions made in excess of the $5,000 limit or within 365 days were recoverable for the benefit of creditors. The new statute merely provides a safe harbor for a limited amount of money.
Funds contributed in excess of the limits are (apparently) not automatically brought into the estate; rather, the right to recover those funds would be “property of the estate.,” The unprotected contribution would then be subject to avoidance as fraudulent conveyances under §548 of the Bankruptcy Code and Chapter 24 of the Texas Business & Commerce Code [incorporated into the Bankruptcy Code at §544(b)]. This must be correct. For example, IRC §530 “Coverdell Education Accounts” are trusts with a bank as trustee. Recovery from the trustee would require litigation for reasons to obvious to discuss.
In addition, the same exclusion from the property of the estate with the same exceptions apply to funds used to purchase tuition credits or certificates under Internal Revenue Code §529(b)(1)(A). The excess contributions would then be reviewed as possible fraudulent conveyances.
Employee Benefits
Also excluded from property of the estate are sums withheld by employers from employees under employee benefit plans or received by an employer from employees. See §541(a)(7) There appears to be no limit to the amounts involved as long as the sums withheld or contributed are for deposited into a retirement plan qualified under the Internal Revenue Code or a health plan is regulated by state law.
IRA Changes
For Texas residents, and residents of a limited number of other states, the IRA exemption rules have been changed to limit IRA exemptions to a total amount of $1.0 million but, given the poor wording of the amendments, this limit certainly appears to be “per debtor”– so, in a joint case, the limit would be $2.0 million. First, the limit is set out at new 11 U.S.C. §522 (n), which refers to “a case filed by a debtor who is an individual....”
Then, looking up one subsection, at 11 U.S.C. §522 (m), the statute states: “Subject to the limitation in subsection (b), this section shall apply separately with respect to each debtor in a joint case.”
The limitation in 11 U.S.C. §522 (b) refers to a provision of that subsection which prohibits husbands and wives, in joint cases from selecting the state exemption scheme for one and the Bankruptcy Code alternative exemption scheme, at 11 U.S.C. §522 (d), for the other spouse.
Given these provisions, almost certainly the cap is $1.0 million per debtor. Ownership of the IRA funds to title will be important, I think, and the exemption may be affected by whether the funds are community, separate, or owned by an entirety.
Finally, the IRA cap “may be increased if the interests of justice so require,” giving the bankruptcy court wide latitude to examine support needs and the like.
THE UNLIMITED HOMESTEAD EXEMPTION IS NOW LIMITED
Limitations in Unlimited Homestead States
New Sections 522(o), (p) and (q), which are now in effect, place limitations upon unlimited homesteads.
First, subsection (o) provides for a ten year look back at any transfers could be described as fraudulent conveyances. The new statute states that the value of the debtor’s interest in the homestead is reduced by any value of the homestead “attributable to” any non-exempt property “disposed of . . . with the intent to hinder, delay or defraud a creditor. . .” If non-exempt funds are invested in the homestead, and the value of the exemption increases as a result, that volume must somehow be recaptured where there was “intent to hinder, delay or defraud.”
This is a very significant provision because it implicates all long term planning decisions. For example, if a client in Texas is advised to transfer non-exempt cash into the homestead prior to engaging in a new business (increasing the value of the unlimited Texas homestead in a subsequent bankruptcy filed within ten years), the trustee must determine whether there was “intent to hinder, delay or defraud” a creditor.
However, given the structure of the sentence, if there is no creditor at the time of the transfer, the value of the homestead should not be reduced. And, unless the trustee can show “intent,” the transfer would not affect the value of the debtor’s interest in the homestead.
Because of the ten year period, I expect some litigation. How successful the plaintiffs will be, given the structure of the statute and the obvious proof problems, I cannot predict.
More importantly, I do not see any enforcement mechanism. Will courts orders sales of homesteads to enforce successful claims? Where will an impecunious debtor get the money without a sale? Will the statute force filing of chapter 11 or 13 cases?
New subsection (p) caps the value of the homestead at $125,000 if the homestead was purchased within three and one-half years of the date of the bankruptcy petition. The only exception is a same-state rollover of proceeds of one homestead into a new homestead. The homestead value is capped even if exempt savings, an exempt insurance annuity or some other exempt asset produced cash paid into the homestead. Also, the limitation of $125,000 applies if a homestead in an unlimited homestead state like Florida is sold, the debtor moves to Texas, and then invests those proceeds in a Texas homestead. Once again, note the lack of an enforcement mechanism.
Here we again have the question of whether the $125,000 gets doubled if the bankruptcy is a joint bankruptcy for a (married couple). The statute, at 11 U.S.C. §522(m), specifically says that the section applies “separately with respect to each debtor in a joint case.” Subsection (o) only discusses the singular “debtor,” and does not contain any reference to joint debtor cases or spouses or anything similar which might limit the impact of subsection (o). So, based upon the plain meaning of the statue, and without the need to refer to any legislative history, it would appear that the exemption amount gets doubled in joint cases unless, perhaps, the homestead was not owned jointly – e.g. was the separate property of one spouse.
This same argument can, of course, be made as to subsection (q), discussed below.
Subsection (q) limits the homestead exemption to $125,000 where a debtor is convicted of a felony where “circumstances demonstrate that the filing of the case was an abuse” or where the debtor owes debts arising from violation of the security laws, state or federal laws or regulation. There is some discretion with the application of this statute. Subsection (q) does not apply “to the extent the amount is reasonably necessary for the support of the debtor and any dependent of the debtor.”
Other Caps on State Exemptions
In addition to 11 U.S.C. §522 (q) discussed above, which limits all state exemptions to $125,000 in certain securities fraud cases, new 11 U.S.C. §522 (b)(3)(A) also caps state exemptions.
The debtor cannot elect state exemptions unless his or her domicile has been located in the state whose exemptions are to be used for 730 days immediately preceding the date of the filing of the petition or if the debtor’s domicile has not been located at a single State for such 730 day period, the place in which the debtor’s domicile was located for 180 days immediately preceding the 730-day period or for a longer portion of such 180-day period than in any other place. 11 U.S.C. §522 (b)(3)(A).
The debtor will be forced to use exemptions of the state of residence before he or she moved to Texas or Florida unless the debtor has been a resident for 730 days or 2 years.
Domestic Support Obligations and Exemptions
If an individual owes a financial obligation to an ex-spouse or child, that debt will be important in any asset protection plan. To understand this statement, an analysis of several new statutory provisions is necessary.
The revisions create a new category of obligation called “domestic support obligations,” defined at 11 U.S.C. § 101(14A):
[A] debt that accrues before, on, or after the date of the order for relief . . . including interest . . .
(A) owed to or recoverable by –
(i) a spouse, former child, or child of the debtor – or such child’s parent,
. . . guardian, . . . relative, or
(ii) a governmental unit;
(B) in the nature of alimony, maintenance or support . . . without regard to whether such debt is expressly so designated;
(C) established . . . before, on or after the
. . . order for relief
. . . [in a] –
(i) separation agreement, divorce decree, or property settlement; (ii) in an order of a court of record; or (iii) a determination . . . in accordance with applicable non-bankruptcy law . . . . by a governmental unit; and,
(D) not assigned to a non-governmental entity, unless assigned . . . [for the purpose of collecting the debt].
Domestic support obligations are now a first priority administrative claim under 11 U.S.C. §507. This means that the assets of the debtor not subject to liens will be distributed first in satisfaction of those unsecured claims (prior to other expenses of the case, except those related to the collection and liquidation of assets necessary to pay the domestic support obligation).
In addition to being a first priority, domestic support obligations are non-dischargeable under 11 U.S.C. §523(5).
Because priority claims must be paid in full in chapter 11, 12, and 13, and because those chapters cannot generate a discharge greater than is generated in a chapter 7, a plan in chapter 11, 12, or 13 must provide for the payment of all such obligations.
And, the problems continue. Under the exemptions provisions of 11 U.S.C. §522(c), by filing bankruptcy, a debtor waives state law exemptions and non-bankruptcy law federal exemptions to the extent necessary to pay all of the “domestic support obligations” governed by 11 U.S.C. §523(a)(5).
While almost any financial obligation created in a divorce decree or related court order may well fall into the categories of “alimony” or “support,” if a financial obligation is not within those categories, the obligation remains non-dischargeable under 11 U.S.C. §523(a)(15). Section 523(a)15 also applies in all chapters, including chapter 13. So, even in chapters 11, 12, and 13, any financial obligation created in a divorce decree will either be paid or will pass through bankruptcy.
Obviously, it is the waiver of exemptions provision of §522(c) that is most relevant to asset planning. Only the “non-bankruptcy law” exceptions are waived. This does leave the bankruptcy exemptions at §522(d). But, those exemptions are of limited value, particularly if the Debtor owns a homestead. Planning “around” this problem seems all but impossible. I suspect many ex-spouses will now need to avoid bankruptcy. These provisions will not be effective until October, 2005.
Self-Settled Trusts
Although there were many comments that the early versions of the statute did not attack the self-settled trust protection schemes available in Alaska and certain other states, new 11 U.S.C. §548 (e)(1) seems crystal clear. Transfers into self-settled trusts for the ten years prior the date of the petition, where the transfer was by the debtor and the debtor is a beneficiary, may be attacked if the trustee can show “actual intent to hinder, delay or defraud any entity to which the debtor was or became, after the date such transfer was made, indebted.” Note that this provision applies to present and future creditors.
Substantial Abuse and Chapter 7: “Means Testing for the Affluent”
Much of the discussion about the new statute has focused upon the “means test” for consumer debtors, with opponents arguing that consumer debtors with little or no ability to pay will be forced into chapter 13 repayment plans for five years. This is all true. The Procrustean bed called a means test is based upon IRS budgets and requires those individuals whose debts are primarily consumer debts to undergo a stringent analysis of budget, income and ability to repay before being permitted to continue in a chapter 7 liquidation case. See generally 11 U.S.C. §707(b).
However, the means test applies to all consumer debtors, even those not eligible for chapter 13. Chapter 13 is open to human beings and their spouses who owe less than approximately $308,000 in unsecured debt and less than approximately $923,000 in secured debt. The means tests clearly supplies to consumer debts eligible for chapter 13, but it can be used to force conversion from chapter 7 to chapter 11 for those consumers.
So, if a person with a great deal of consumer debt (e.g., Dr. Jones, M.D.) wishes to discharge debt, he will be forced to file a chapter 11 case or do without. If Dr. Jones owes a lot for the toys and the good life, and he makes more than the median family income as determined by reference to reports from the Bureau of the Census [see 11 U. S. C. §101(39A)], and if he can pay $6,000 to unsecured creditors over five years on a budget taken from the IRS, his only choice is chapter 11.
How future income would factor into this equation is unclear. If Dr. Jones, M.D. is just graduating from medical school, and she does not have much income yet, or if Dr. Jones does not have consumer debt but only has malpractice claims, the trustee or creditors should be limited to 11 U. S. C. §707(a), which permits dismissal for cause.
Significant Changes in the Treatment of Taxes
For those who deal with taxes owed to the federal and state governments, several changes are worth noting. First, the chapter 13 “super discharge” for certain taxes and other claims is gone. 11 U. S. C. §1328(a).
In chapter 11 cases, 11 U. S. C. §1129(a)(9) has been amended to provide for a five year – as opposed to six year – period for repayment, but the five years begins on the date of the order for relief. The six year period began on the date of assessment. The repayment must be in regular installment payments on terms not less favorable than those of “the most favored non-priority unsecured claim” (with an exception for what are called “convenience class” claims, which are small claims paid in a lump sum for ease of administration).
Involuntary Bankruptcies
11 U.S.C. §303 permits creditors to file involuntary bankruptcies against debtors under chapters 7 and 11. If the debtor has less than 12 secured creditors, only one petitioning creditor is necessary; otherwise, there must be three. The one or three (or more) must hold unsecured, undisputed claims aggregating at least $12,300.
What if petitioning creditors file an involuntary petition at a time when a debtor cannot take advantage of state law exemptions in the state of residence – e.g., an involuntary is filed against someone who has just moved to Texas and purchased, for cash, a $1.0 million house? At state law, the house is “safe.” In bankruptcy, the exemption is limited to $125,000 (or $250,000 if doubled). Is it constitutional to force a waiver of the exemption in this fashion? I think not. I think it constitutional to force the debtor to elect between a limited homestead exemption and bankruptcy protection. If the debtor wants to file bankruptcy, and take advantage of the discharge, he or she may have to pay a price. I do not think it constitutional to allow creditors to force the debtor into bankruptcy in order to take away a state law given right, such as a homestead.
Soapbox
Earlier, I stated that much of what Congress did in the context of asset protection was justified. Even though confusing and poorly thought out, most of the changes and limitations are responses to real problems. All of the homestead and exemption limitations seem to reflect notorious Florida bankruptcies, where debtors fled to Florida one step ahead of creditors or the SEC, bought or built mansions, and pulled up the drawbridge.
Many of the other changes are generally beneficial, including the education trust/IRA and benefits exclusion. The cap on IRA’s, except in a few states like Texas, is actually neutral or beneficial.
The truly punitive portions of the statute, which are not explored, impact poor consumers. Those are people who barely know the meaning of the word “asset” and who think that “asset protection planning” involves purchasing burglar bars.
Conclusion
With the new restrictions on exemptions, including the homestead, asset protection plans must now adopt a very long range approach, assuming that the full protections of careful planning may not be fully realized until from two to ten years have passed.
R. Glen Ayers, Jr. is a Shareholder with the firm of Langley & Banack, Incorporated in San Antonio, Texas. He received his J.D. from University of South Carolina in 1975 and his LL.M. from Harvard Law School in 1979. He is admitted to practice in Texas and the District of Columbia. Mr. Ayers is a member of the American Bankruptcy Institute, State Bar of Texas, District of Columbia, Maryland and San Antonio Bar Associations. He is a Fellow with the American College of Bankruptcy, a Life Fellow with the Texas Bar Foundation, a Member and Research Fellow with the Center for American and International Law, and a Research Editor with the South Carolina Law Review.
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