The Bankruptcy Abuse and Consumer
Thomas J. Murphy
The Bankruptcy Abuse and Consumer Protection Act of 2005
What CPAs Need to Know
On October 17, 2005, the much-anticipated Bankruptcy Abuse and Consumer Protection Act of 2005 took effect. While much of the commentary on the new legislation has had a distinctly negative and bad-for-the-consumer tenor, CPAs and their clients will find it very beneficial in certain situations that they may encounter with some regularity. The vast majority of the bill has no appreciable impact on CPAs, but its impact will be significant where it does apply.
Is Bankruptcy a Concern to my Client?
The initial reaction of CPAs may be that the threat of bankruptcy is seldom faced by their clients. Maybe, but an important recent study suggests otherwise. In the February 2, 2005 edition of Health Affairs, a panel headed by several Harvard faculty members examined the effect of medical debts and illness upon bankruptcy filings. The study is apparently the first of its kind and does not paint a pretty picture. The study finds that, in 26.3 percent of bankruptcy filings, the primary cause was due to illness or injury, consisting mostly of debts incurred by medical treatment or of lost income due to the inability to work. Another 7.6 percent of bankruptcy filings were due to the death of a family member.
In other words, the primary causes in one-third of all bankruptcy filings are due to illness, injury or death – events that some CPAs may deal with frequently.
Bankruptcy issues can also have an important impact on estate planning, particularly for business owners who may suffer financial reversals or professionals with malpractice concerns. I often advise clients that it does not matter how much money you have — you are only one lawsuit away from poverty. Our advice to these clients becomes much more valuable if we can suggest methods to protect their assets if misfortune ever strikes. Knowing what assets are protected in bankruptcy is essential in rendering such advice in a worst-case scenario.
With this in mind, there are several important — and mostly favorable — developments in the new bankruptcy bill.
Increased Creditor Protection for Retirement Plan Assets.
For many years, I have strongly urged clients to consider maximizing contributions to retirement plans due to the creditor protection afforded by ERISA and several important decisions rendered in the 1990s by the United States Supreme Court, most notably Patterson v. Shumate, 504 US 753 (1992). The new bankruptcy bill greatly expands this creditor protection.
What is protected?
There is a new Section 522(b)(3)(C) of the Bankruptcy Code that dramatically increases the creditor protection afforded retirement plan assets. Sec 522(d) includes all assets “exempt from taxation” under IRC Sec. 401, 403 (school districts, churches and other tax-exempt entities), 408 (IRAs, SEPs and SIMPLEs), 408A (Roth IRAs), 414, 457 (deferred compensation) and 501 (tax-exempt entities). Prior to this, there seemed to be a distinction between ERISA assets (ie 401(k)s) and non-ERISA assets (IRAs, SEPs and Keoughs). This distinction is now gone — as long as the asset is exempt from taxation, it will come within the protection of the new Section 522.
How much is protected?
There is unlimited protection for IRAs containing funds rolled over from a qualified plan (typically a 401(k)). There is also unlimited protection for 403(b) and 457 plans as well as SEPs and SIMPLEs.
For all other retirement assets (primarily non-rollover IRAs), there is a $1 million exemption from creditors.
Note that these provisions largely override the holding in the recent case of Rousey v. Jacoway, 125 SCt 1561 (2005) that was decided less than two weeks before this bill was enacted. Rousey held that IRAs, which are non-ERISA assets, were afforded the same creditor protection as ERISA plans. The new Section 522 has made much of Rousey dead letter law but there are situations where the Rousey holding can still be used. Rousey held that an IRA was protected to the extent the funds were “reasonably necessary for the support of the debtor or his dependents.” In most situations, it is difficult to envision situations where the need for support would exceed the one million dollar exemption. But persons with disabilities or parents with disabled children could conceivably exceed this amount, so Rousey remains an important case for them.
The legislation also overrules the controversial Supreme Court holding in Yates v. Hendon, 541 US 1 (2004) that held that there is no creditor protection for retirement assets where the only participants were the business owner and family members. This meant that sole proprietors and other one-person or husband-and-wife businesses lost this protection. The new Section 522 ignores this distinction and places these businesses on equal footing with all other qualified plans
Who is protected?
Clearly, plan participants come within the protections outlined above. But what about surviving spouses and other people who inherit an IRA or other qualified plan assets? This is not specifically addressed in the legislation but it would appear that these situations will be afforded protection since these assets would continue to come within the definition of an asset exempt from taxation under IRC 401. All of the commentators I have read, including Natalie Choate, agree about this.
Protection for 529 Plans and Coverdell Education Accounts.
Another favorable development is the amendments to Sections 541(b) & (c) that protect IRC Section 529 college savings plans and Coverdell education accounts. Any of these accounts that name a child, grandchild, stepchild or stepgrandchild as a beneficiary will be protected. Any contributions made prior to two years of a bankruptcy filing are protected as long as they did not exceed the amounts that are tax-qualified under the IRC. This will be in the $250,000 range for most 529 plans and, for Coverdell accounts, will be the accumulation of the $3,000 maximum annual contributions. For contributions made within one to two years of filing, only $5,000 per account will be protected. Contributions made within one year of filing will not be protected in any amount.
Homestead Exemption
There are two important provisions in the new Section 522(q) regarding homesteads.
First, there is the provision that eliminates the “move to Florida” tactic often employed by high-level CEOs in trouble. This is done to take advantage of Florida’s unlimited homestead exemption, which also exists in Iowa, Kansas, South Dakota, Texas and the District of Columbia. The new bill prohibits the use of the homestead exemption in any amount if the debtor has engaged in the violation of securities or RICO laws or, within five years of filing, has committed a criminal or tortious act resulting in physical injury. The bill goes further by providing a 10-year look-back period if the purchase of the home was done with the actual intent to hinder, defraud or delay a creditor.
Second, in the more common scenario, the homestead exemption can only be asserted if the debtor has lived in the home for 1215 days (3 years and 4 months) prior to filing. There is a $125,000 federal homestead exemption. State law may provide for a higher exemption. If a debtor has lived in the homestead for less than 1215 days, the new law gets murky and the commentators are not in agreement in interpreting the new Section 522(p). My interpretation is that, in most circumstances, the debtor will be able to claim the exemption if the debtor has lived in the house for at least six months. Living in the home for less than that time may preclude the use of any homestead exemption although, again, there is disagreement on this.
New Fraudulent Conveyance Rules and Domestic Asset Protection Trusts
There is a new Section 548(e) of the Bankruptcy Code that imposes a two-year look-back period from the date of filing for any fraudulent conveyance. Under this section, a transfer of property is deemed fraudulent if the transfer was made with actual intent to hinder, delay, or defraud any pre-existing or subsequent creditor. Or, the transaction will be deemed fraudulent if the debtor received less than a reasonably equivalent value in exchange for such transfer and (a) was insolvent or became insolvent as a result of such transfer or (b) after the transfer, the debtor had remaining an “unreasonably small” amount of capital
There is a 10-year look-back period for transactions involving self-settled trusts where the grantor/debtor is a beneficiary. This rule applies to trusts “or similar devices” which is not defined. This section was drafted with the express purpose of limiting the effectiveness of the domestic asset protection trusts that are now available in Alaska, Delaware, Nevada, Oklahoma and Rhode Island and, to a lesser extent, in Missouri, South Dakota and Utah.
Forum Shopping
The new bill has confusing language that limits forum shopping by amending Section 522(b)(3)(A). If the debtor has moved, the basic requirement is that the court will look to the most recent location where the debtor had lived for six months.
Thomas J. Murphy is an attorney practicing in the Ahwatukee area of Phoenix. His practice emphasizes estate planning, elder law and all probate matters. He can be reached at (480) 838-4838 or www.murphy lawaz.com.
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