Pundits are warning that when the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPA) goes into effect this fall (Oct. 17 for most provisions), its clauses on homestead exemptions, pensions and self-settled asset protection trusts will seriously impede, maybe even kill, asset protection planning in this country.

Drivel and rot.

BAPA changes the rules a bit, but the game continues. In fact, the set up in some ways will get better for planners and their clients.

First, some perspective is needed. BAPA is a bankruptcy statute. Most clients won't file bankruptcy, and involuntary bankruptcies are rare for individuals. (See “The Involuntaries,” p. 60.) That means BAPA won't affect most asset-protection planning or related creditor attacks.

KEY CHANGES

When bankruptcies do occur, individuals may exempt certain assets from their bankruptcy estates; this is part of the “fresh start” ethos of our nation's bankruptcy policy.

Before BAPA, debtors could choose between state and federal exemptions, unless their home state legislatively opted out of the federal scheme, which would force debtors to invoke only state exemptions (plus any exemptions mandated by federal non-bankruptcy law). If state exemptions applied, whether by the debtor's choice or legislative decree, they usually did so whole hog, without any bankruptcy limitations or expansions of state exemptions.

BAPA changes these rules, and the change isn't uniformly bad for clients. But there is some unpleasant news that roils some experts: BAPA restricts access to state law exemptions — particularly for homesteads.

Amended Bankruptcy Code Section 522(b)(3)(A) (formerly Section 522(b)(2)) requires those filing for bankruptcy to live in-state for at least 730 days before they can use any of their home state's exemptions (previously it was just 180 days). Debtors who fail the 730-day test will usually be able to use exemptions allowed by their prior home state (but that's not much solace for those who've moved to debtor havens like Texas from, say, Michigan).

Under the new Bankruptcy Code Section 522(p) — which is effective immediately — debtors generally must live in-state for 1,215 days (roughly 40 months) before they can exempt more than $125,000 in homestead equity under that state's law. (A family farmer's principal residence isn't subject to the $125,000 limit.) Under new Section 522(q) — also effective immediately — certain felons and tortfeasors can't exempt more than $125,000 in homestead equity, unless more equity is reasonably necessary for the support of the debtor and his dependents (a change from prior law, which generally didn't condition exemptions on a debtor's conduct).

These changes certainly make homesteads less attractive in bankruptcy.

Yet there is some good news as well: BAPA makes tax-deferred pensions safer. New Bankruptcy Code Section 522(n) generally exempts from bankruptcy estates up to $1 million in both traditional individual retirement accounts (IRAs) and Roths; the courts can increase this limit in specific cases in “the interests of justice.” Under new Bankruptcy Code Sections 522(b)(3)(C) and 522(d)(12), there are unlimited exemptions for other tax-deferred plans, including simplified employee pensions (SEPs) under Internal Revenue Code Section 408(k) and SIMPLEs under IRC Section 408(p), as well as their rollovers. ERISA plans are better protected: sole-owner shops no longer need an employee to protect the business owners' ERISA interest. Moreover, these pension rules apply to all bankruptcies, even if the debtor lives in an “opt out” state that doesn't allow federal exemptions for other assets.

BAPA'S ABSURDITY

Some pundits also have expressed concern about the two, absurdly long 10-year fraudulent transfer limitations periods that BAPA creates. Creditors and bankruptcy trustees can object to exemptions claimed for any homestead equity that allegedly arose from transfers made to hinder, delay, or defraud creditors at any time during the decade before a debtor's bankruptcy. Bankruptcy trustees also may sue on similar grounds to avoid transfers made to self-settled asset protection trusts (APTs) in the 10 years pre-petition. These rules greatly extend the up-to-six-year limitations rule that applied to most fraudulent transfer suits in bankruptcy.

Certainly, the new limitations rules invite courtroom brawls over ancient transactions. The evidence problems are predictable: Over the course of a decade, memories fade, key witnesses die or move to points unknown, and relevant documents are lost or destroyed. None of this will necessarily deter plaintiffs. Indeed, some plaintiffs may prefer cases tried on partial truths. For planners, these new rules are among BAPA's uglier features.

But this 10-year open season also needs to be put into perspective. First, these are limitations rules; they don't change substantive fraudulent transfer law. Second, for most users of APTs, BAPA's 10-year-rule will probably be more bark than bite. Given the complex business and personal lives of typical APT settlors, any suits against them are likely to be equally complex and last many years. BAPA's 10-year APT limitations period will often lapse long before any post-judgment bankruptcy starts. Finally, as most homeowners build equity through routine mortgage payments and appreciation, not fraud, BAPA's homestead limitations period won't affect most cases.

ASSET PROTECTION

So how should planners respond to changes wrought by BAPA? Simple: Continue traditional asset protection planning — although perhaps with a few new wrinkles. For instance:

  • Homesteads — Clients should still use homestead exemptions. As a matter of contingency planning, equity should perhaps be kept under $125,000 until after day 1,215 of residency, and prospective moves to homestead-friendly states should be made sooner rather than later to earlier satisfy BAPA's 730-day rule.

  • Tenancy-by-the-Entireties (TBEs) — BAPA doesn't affect TBEs, a form of joint ownership available to spouses in some states. TBE assets generally can't be attached to satisfy debts owed by just one spouse. Because BAPA leaves TBE intact, normal TBE planning should continue.

  • Spendthrift Trusts for Others — Clients still can make non-fraudulent gifts into spendthrift trusts that benefit other persons.

  • APTs — They're still viable. Because BAPA didn't change substantive fraudulent transfer law, any APT that was defensible before BAPA is defensible after BAPA.

Some clients also can use BAPA's pension rules as a tripwire to help deter involuntary bankruptcies. In many states, non-ERISA pensions are subject to exemptions that have low dollar caps or that require debtors to establish need. Clients in these states should still maximize tax-deductible non-ERISA pension contributions. Not only is this good tax planning, it creates a potential cost for creditors considering an involuntary. While an involuntary might give creditors more time to attack alleged fraudulent transfers to APTs or homesteads, or cap a debtor's homestead exemption at $125,000, such gains would be offset by the loss created when pension funds that might be attachable under state law are wholly exempted in bankruptcy.

BAPA also puts a premium on proactive advance planning, which can create fine results. For example, a client may have significant homestead equity that is exempt under state law, is more than 1,215 days old and arose from normal appreciation and mortgage payments. The client's APT may have been settled and funded more than a decade ago (it may even be a foreign APT beyond the reach of U.S. courts in any event). The client also may have significant pension dollars that would be attachable under state law but exempt under BAPA. For this client, bankruptcy under BAPA might result in a Chapter 13 partial repayment plan (a whole separate issue), but it won't cause a loss of accumulated assets that satisfy BAPA's new rules. Ergo, BAPA isn't necessarily a problem, but may instead be a welcome solution.

So planners, fear not. BAPA won't put us out of business; it merely changes some of our strategies and tactics.

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THE INVOLUNTARIES

Very few will be dragged by creditors into BAPA's clutches

Yes, people are sometimes forced into involuntary bankruptcy. But these “involuntaries” happen rarely. According to the U.S. Courts website, only 602 involuntaries were filed in 2004 compared to 1,618,987 total bankruptcy filings that year. That's a tiny 0.0003718 percent of the overall number.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which amended the Bankruptcy Code, will make involuntaries rarer still.

It's still true that under Bankruptcy Code Section 303, three creditors who are owed a combined amount of $12,300 or more can commence an involuntary; one creditor who is owed $12,300 or more can file an involuntary if there are less than 12 creditors overall.1

Even before BAPA, only solid claims or debts counted toward the $12,300 threshold: contingent claims didn't count toward the $12,300, nor did claims subject to a bona fide dispute as to liability. BAPA amended Section 303, so now claims subject to a bona fide dispute as to the amount are also excluded from the tally. Debtors who can colorably contest claims can stave off an involuntary bankruptcy, perhaps for years, by merely disputing how much is owed.

Even $12,300 of fully adjudicated judgments may not suffice to force an involuntary bankruptcy. BAPA says a debtor must be “generally” in default of his obligations. Clients fighting a few of their creditors, even over big debts, may not satisfy the “generally” criterion if they routinely pay other creditors representing a significant percentage of their overall debt.

Involuntaries are further deterred by other rules that apply both before and after BAPA. Among others: Debtors can contest an involuntary filing, and creditors who lose such a fight are subject to claims for attorney fees and damages. Even if creditors win the right to file an involuntary petition, somebody must then prepare the debtor's schedules and statement of financial affairs. If the debtor refuses, this burden is apt to fall upon petitioning creditors. The cost of preparing these documents is theoretically reimbursable out of a debtor's estate — but that's scant comfort if the estate lacks easily attachable assets.

Moreover, BAPA's new credit counseling rules may have unwittingly outlawed most involuntaries. Bankruptcy Code Section 303 says an involuntary can be filed only against someone who “may be a debtor under the chapter under which such a [involuntary] case is commenced,” while new Bankruptcy Code Section 109(h) generally makes debtors ineligible to file unless they've attended credit counseling in the 180 days before filing. It's unclear if the credit-counseling criterion applies to involuntaries. If it does, most targets of an involuntary won't satisfy this requirement, particularly wealthy individuals who probably wouldn't be caught dead in a credit counselor's office.

So much for the masses being pushed into involuntary bankruptcy and BAPA hell.
John E. Sullivan III

Endnote

  1. The figure $12,300 arises from automatically indexing the original statutory figure of $10,000.