Hiding Assets in California

The vicissitudes of consumer fortune appear to have led to the “asset protection” industry. A cursory Internet search of the phrase, “asset protection” produces pages of advice for “protecting” assets from creditors and, ostensibly, from bankruptcy trustees. Often, asset protection advice is bereft of any discussion of California exemption statutes — which often provide the most efficient and safest asset protection — and fails to admonish the unwary of powerful creditor rights. Most asset protection discussion forums ignore the consequences of a Chapter 7 bankruptcy filing should asset protection counter-measures be deployed in response to a creditor's asset-hungry appetite. Ironically, some asset protection tools leave assets completely naked, and strip them of any protection afforded under exemption statutes.

As a preliminary matter, it may be useful to understand a common pitfall of most asset protection tools used in California. If a transfer of property of a debtor is actually or constructively fraudulent, it is recoverable by a bankruptcy trustee if made within two years of a bankruptcy filing pursuant to 11 U.S.C. § 548, or within four years of a bankruptcy filing under California Civil Code (Cal. Civ. Code) §§ 3439.04 or 3439.05. If, however, the debtor owes the IRS back taxes, the reach-back period for a bankruptcy trustee could be 10 years depending on the length of delinquency to the IRS. Mukamal v. Citibank NA (In re Kipnis), 16-1045 (Bankr. S.D. Fla. Aug. 31, 2016)

The real trouble for a debtor begins after property is recovered by a bankruptcy trustee. Under 11 U.S.C. § 522(g), if a transfer of property is avoided and the initial transfer was voluntarily made by the debtor, the return of the asset to the bankruptcy estate bars the debtor from exempting the recovered asset. 11 U.S.C. § 522(g). The asset, which may once have been protected by an exemption statute, is no longer protected after it is recovered and it is susceptible to liquidation by a bankruptcy trustee.

While there are a variety of asset protection tools, the three most common tools are discussed in this article. It is important to note, however, that nearly all asset protection tools fail because of the one-two combination of the right-hand jab of 11 U.S.C. § 548/Cal. Civ. Code §§ 3439.04/3439.05 and the left-hand upper-cut of § 522(g).

Trusts

A trust is defined as an equitable or beneficial right or title to land or other property, held for the beneficiary of the trust by another person, in whom resides the legal title or ownership, recognized and enforced by courts of chancery. See Black's Law Dictionary. Trusts can be revocable or irrevocable; the former permits a return of an asset to the trustor upon revocation of the trust, while the latter transfers ownership of trust assets to the trust.

Under California law, property of a revocable trust can be levied by creditors of the settlor. California Probate Code § 18200; In re Brooks-Hamilton, 348 B.R. 512, 519 (Bankr. N.D. Cal. 2006); In re Irwin, 338 B.R. 839, 854-53 (E.D. Cal. 2006). Similarly, property transferred to a revocable trust constitutes property of the settlor's bankruptcy estate. In re Cutter, 398 B.R. 6, 19 (9th Cir. BAP 2008), citing Askanase v. LivingWell, Inc., 45 F.3d 103, 106 (5th Cir. 1995). In short, revocable trusts offer no protection for assets in a bankruptcy case.

Irrevocable trusts, on the other hand, offer some asset protection because property of a trust is not generally considered bankruptcy estate property. United States v. Lawrence, 189 F.3d 838, 845 (9th Cir. 1999). That said, however, the powers a debtor may exercise under a trust for his or her own benefit do become property of the estate. Askanase at 106. Moreover, to the extent a debtor holds a beneficial interest in a trust, that beneficial interest becomes property of the bankruptcy estate. 11 U.S.C. § 541(a)(1) and (c)(2).

Notwithstanding the seemingly impenetrable wall of asset security an irrevocable trust appears to provide, assets of an irrevocable trust are not safe if the trust is self-settled. Assets held in a self-settled trust (a trust that designates the trustor as the beneficiary) are property of a bankruptcy estate because under California law, a settlor of a trust cannot also act as beneficiary of that trust. See California Probate Code § 15304(a). California law voids self-settled trusts to prevent individuals from placing their property beyond the reach of their creditors while at the same time still reaping the bounties of such property. See Nelson v. California Trust Co., 33 Cal. 2d 501, 202 P.2d 1021, 1021 (Cal. 1949). Where a trust is invalid, assets of the trust become property of a bankruptcy estate. Lawrence at 845.

Irrevocable trusts may protect assets when the trust is not self-settled and a valid spendthrift clause exists. A spendthrift clause is a provision in a trust that prohibits the beneficiary of the trust from transferring his or her right to future payments of income or capital. California law recognizes the validity of spendthrift trusts. See In re Neuton, 922 F.2d 1379 (9th Cir. 1990) (citing California Probate Code §§ 15300 et seq.). Where a spendthrift trust is valid, most or all of the property of the trust is protected from creditors. The critical inquiry in determining whether a spendthrift trust is valid under California law is whether the trust's beneficiaries are able to exercise excessive control over the trust. See In re Witwer, 148 B.R. 930, 937 (Bankr. C.D. Cal. 1992). California law does not allow a participant with excessive control over a trust to shield that trust with an anti-alienation provision lacking true substance.

Recently, a significant blow was dealt to trust-lovers throughout California. On March 23, 2017, the California Supreme Court held that a bankruptcy trustee could seize property of an irrevocable trust, notwithstanding the existence of a valid spendthrift clause, once “principal” becomes due and payable to the beneficiary/debtor. Carmack v. Reynolds, 2017 Cal. LEXIS 2429 (2017). Consequently, trust property that becomes due and payable to a beneficiary may no longer be protected by a trust's spendthrift clause in California, and can be seized by creditors or a bankruptcy trustee.

Assuming a valid spendthrift clause exists and the property of the trust is not due and payable to the beneficiary/debtor, assets held in a trust may still be in jeopardy. This is because of the trustee's avoidance powers under 11 U.S.C. §§ 544, 548 and Cal. Civ. code §§ 3439.04 and 3439.05. See United States v. Carter, 2010 U.S. Dist. LEXIS 52732 (S.D. Cal. 2010). Most trusts are a one-way street; assets flow into the trust, but nothing is given back to the settlor. Because of this, most transfers of property to a trust are avoidable as actually or constructively fraudulent transfers.

Under the correct circumstances, assets placed in a trust are protected from liquidation. There are, however, a number of hurdles to establishing a bullet-proof trust. And should a transfer of property be avoidable, the return of an asset to the bankruptcy estate will bar the debtor from exempting the asset. See 11 U.S.C. § 522(g).

Business Entities

Entities such as corporations and limited liability companies are also popular asset protection tools. They are so popular that television and radio stations relentlessly trumpet the importance of incorporating for the purpose of protecting assets and loved ones. But are corporate coffers insulated from a bankruptcy trustee?

Stock owned by a debtor is property of a bankruptcy estate. See 11 U.S.C. §541(a); Milden v. Joseph (In re Milden), 1997 U.S. App. LEXIS 7726 (9th Cir. Cal. Apr. 16, 1997), an unpublished Ninth Circuit opinion citing In re Baker, 68 Bankr. 360, 363 (D. Or. 1986) (which found the corporation itself was property of the estate because it was wholly owned by the debtors); United States v. Ken Int'l. Ltd., 184 Bankr. 102, 107 (D. Nev. 1995); In re Deak & Co., 63 Bankr. 422, 427 (Bankr. S.D.N.Y. 1986); In re MacDonald, 114 Bankr. 326, 333-34 (D. Mass. 1990).

If a business entity has little or no debt, then a sale of stock of the entity will, in most cases, result in a sale price equal to the value of the assets held in the business entity. Although a debtor may assert an exemption to the stock of the entity, that exemption is limited. See California Code of Civil Procedure §§ 703 et seq. and 704 et seq. For example, if real estate is held in the name of a corporation, a debtor is not entitled to claim a homestead exemption of $75,000, $100,000 or $175,000 (which would ordinarily be the case if the property is held in the debtor's name). Instead, a debtor is limited to the “wildcard” exemption. Unlike the generous amounts provided under the California homestead exemption, the “wildcard” exemption caps out at $26,925. Further, the wildcard exemption only affixes to the stock of the entity and not the assets of the entity. In the context of a bankruptcy case, holding assets in a business entity may provide less protection than holding assets in the debtor's name.

Also, if allowed by corporate by-laws, a trustee may be able to vote himself or herself director of the entity and can control, without restriction, the entity's fate. For example, the trustee could file a bankruptcy petition to have the entity's assets liquidated by a fellow trustee, with the nominal debts of the entity paid and the resulting equity turned over to the individual debtor's bankruptcy trustee. A bankruptcy trustee could also file a complaint for involuntary dissolution of the entity, seek a receivership over the corporation's assets or assign the assets of the entity to a third party for the benefit of its creditors. And if that does not work, the trustee could seek substantive consolidation of the entity into the individual debtor's bankruptcy case and gain control over all of the entity's assets.

In addition to the problems mentioned above, corporate assets are subject to a bankruptcy trustee's strong-arm powers provided under 11 U.S.C. § 548 and Cal. Civ. Code §§ 3439.04 and 3439.05. Entities designed to hold assets typically accept assets in the form of capital contributions. But capital contributions made without any value in return are nothing more than transfers that are avoidable. If the transfer of property is avoided, a business entity designed to protect assets provided no protection for the assets.

Marital Agreements

In California, assets of spouses can be divided during marriage by agreement. But assets transferred in California under a martial agreement are subject to avoidance under 11 U.S.C. § 548 and Cal. Civ. Code §§ 3439.04 and 3439.05. Mejia v. Reed, 31 Cal. 4th 657 (2003), (holding that property voluntarily transferred under a marital settlement agreement is subject to avoidance under Cal. Civ. Code §§ 3439.04 and 3439.05).

Moreover, a release of child or spousal support is no longer adequate consideration for a transfer of an interest in property. Carbaat, 357 B.R. 553 (Bankr. N.D. Cal 2006) (noting the definition of “value” under 11 U.S.C. § 548(d)(2)(A) and Cal. Civ. Code § 3439.03 excludes an unperformed promise to provide future support to the debtor or to another person); Hahn v. Leong (In re Llamas), 2011 Bankr. LEXIS 4779 [*40] (Bankr. C.D. Cal. Dec. 12, 2011) (holding the transfer of property in exchange for a release from an obligation to pay support was is not adequate consideration for purposes of satisfying “value” required under 3439.04 and 3439.05).

As a result of the holdings in Carbaat and Llamas, property transferred to a spouse can be recovered by a bankruptcy trustee if a waiver of spousal support is the “value” provided. And if the property is recovered because a transfer was avoided, it cannot be exempted. 11 U.S.C. § 522(g).

Conclusion

Asset protection can be foolish and costly. To properly protect an asset in California, it's generally best to understand and maximize exemptions. Most “asset protection” advice is free. You often get what you pay for. Sometimes less.

*****
David Goodrich is a member at SulmeyerKupetz, a business, financial restructuring and litigation firm; he also serves as a Chapter 7 trustee. He can be reached at [email protected] or 213-617-5297.

The vicissitudes of consumer fortune appear to have led to the “asset protection” industry. A cursory Internet search of the phrase, “asset protection” produces pages of advice for “protecting” assets from creditors and, ostensibly, from bankruptcy trustees. Often, asset protection advice is bereft of any discussion of California exemption statutes — which often provide the most efficient and safest asset protection — and fails to admonish the unwary of powerful creditor rights. Most asset protection discussion forums ignore the consequences of a Chapter 7 bankruptcy filing should asset protection counter-measures be deployed in response to a creditor's asset-hungry appetite. Ironically, some asset protection tools leave assets completely naked, and strip them of any protection afforded under exemption statutes.

As a preliminary matter, it may be useful to understand a common pitfall of most asset protection tools used in California. If a transfer of property of a debtor is actually or constructively fraudulent, it is recoverable by a bankruptcy trustee if made within two years of a bankruptcy filing pursuant to 11 U.S.C. § 548, or within four years of a bankruptcy filing under California Civil Code (Cal. Civ. Code) §§ 3439.04 or 3439.05. If, however, the debtor owes the IRS back taxes, the reach-back period for a bankruptcy trustee could be 10 years depending on the length of delinquency to the IRS. Mukamal v. Citibank NA (In re Kipnis), 16-1045 (Bankr. S.D. Fla. Aug. 31, 2016)

The real trouble for a debtor begins after property is recovered by a bankruptcy trustee. Under 11 U.S.C. § 522(g), if a transfer of property is avoided and the initial transfer was voluntarily made by the debtor, the return of the asset to the bankruptcy estate bars the debtor from exempting the recovered asset. 11 U.S.C. § 522(g). The asset, which may once have been protected by an exemption statute, is no longer protected after it is recovered and it is susceptible to liquidation by a bankruptcy trustee.

While there are a variety of asset protection tools, the three most common tools are discussed in this article. It is important to note, however, that nearly all asset protection tools fail because of the one-two combination of the right-hand jab of 11 U.S.C. § 548/Cal. Civ. Code §§ 3439.04/3439.05 and the left-hand upper-cut of § 522(g).

Trusts

A trust is defined as an equitable or beneficial right or title to land or other property, held for the beneficiary of the trust by another person, in whom resides the legal title or ownership, recognized and enforced by courts of chancery. See Black's Law Dictionary. Trusts can be revocable or irrevocable; the former permits a return of an asset to the trustor upon revocation of the trust, while the latter transfers ownership of trust assets to the trust.

Under California law, property of a revocable trust can be levied by creditors of the settlor. California Probate Code § 18200; In re Brooks-Hamilton, 348 B.R. 512, 519 (Bankr. N.D. Cal. 2006); In re Irwin, 338 B.R. 839, 854-53 (E.D. Cal. 2006). Similarly, property transferred to a revocable trust constitutes property of the settlor's bankruptcy estate. In re Cutter, 398 B.R. 6, 19 (9th Cir. BAP 2008), citing Askanase v. LivingWell, Inc. , 45 F.3d 103, 106 (5th Cir. 1995). In short, revocable trusts offer no protection for assets in a bankruptcy case.

Irrevocable trusts, on the other hand, offer some asset protection because property of a trust is not generally considered bankruptcy estate property. United States v. Lawrence , 189 F.3d 838, 845 (9th Cir. 1999). That said, however, the powers a debtor may exercise under a trust for his or her own benefit do become property of the estate. Askanase at 106. Moreover, to the extent a debtor holds a beneficial interest in a trust, that beneficial interest becomes property of the bankruptcy estate. 11 U.S.C. § 541(a)(1) and (c)(2).

Notwithstanding the seemingly impenetrable wall of asset security an irrevocable trust appears to provide, assets of an irrevocable trust are not safe if the trust is self-settled. Assets held in a self-settled trust (a trust that designates the trustor as the beneficiary) are property of a bankruptcy estate because under California law, a settlor of a trust cannot also act as beneficiary of that trust. See California Probate Code § 15304(a). California law voids self-settled trusts to prevent individuals from placing their property beyond the reach of their creditors while at the same time still reaping the bounties of such property. See Nelson v. California Trust Co. , 33 Cal. 2d 501, 202 P.2d 1021, 1021 (Cal. 1949). Where a trust is invalid, assets of the trust become property of a bankruptcy estate. Lawrence at 845.

Irrevocable trusts may protect assets when the trust is not self-settled and a valid spendthrift clause exists. A spendthrift clause is a provision in a trust that prohibits the beneficiary of the trust from transferring his or her right to future payments of income or capital. California law recognizes the validity of spendthrift trusts. See In re Neuton, 922 F.2d 1379 (9th Cir. 1990) (citing California Probate Code §§ 15300 et seq.). Where a spendthrift trust is valid, most or all of the property of the trust is protected from creditors. The critical inquiry in determining whether a spendthrift trust is valid under California law is whether the trust's beneficiaries are able to exercise excessive control over the trust. See In re Witwer, 148 B.R. 930, 937 (Bankr. C.D. Cal. 1992). California law does not allow a participant with excessive control over a trust to shield that trust with an anti-alienation provision lacking true substance.

Recently, a significant blow was dealt to trust-lovers throughout California. On March 23, 2017, the California Supreme Court held that a bankruptcy trustee could seize property of an irrevocable trust, notwithstanding the existence of a valid spendthrift clause, once “principal” becomes due and payable to the beneficiary/debtor. Carmack v. Reynolds, 2017 Cal. LEXIS 2429 (2017). Consequently, trust property that becomes due and payable to a beneficiary may no longer be protected by a trust's spendthrift clause in California, and can be seized by creditors or a bankruptcy trustee.

Assuming a valid spendthrift clause exists and the property of the trust is not due and payable to the beneficiary/debtor, assets held in a trust may still be in jeopardy. This is because of the trustee's avoidance powers under 11 U.S.C. §§ 544, 548 and Cal. Civ. code §§ 3439.04 and 3439.05. See United States v. Carter, 2010 U.S. Dist. LEXIS 52732 (S.D. Cal. 2010). Most trusts are a one-way street; assets flow into the trust, but nothing is given back to the settlor. Because of this, most transfers of property to a trust are avoidable as actually or constructively fraudulent transfers.

Under the correct circumstances, assets placed in a trust are protected from liquidation. There are, however, a number of hurdles to establishing a bullet-proof trust. And should a transfer of property be avoidable, the return of an asset to the bankruptcy estate will bar the debtor from exempting the asset. See 11 U.S.C. § 522(g).

Business Entities

Entities such as corporations and limited liability companies are also popular asset protection tools. They are so popular that television and radio stations relentlessly trumpet the importance of incorporating for the purpose of protecting assets and loved ones. But are corporate coffers insulated from a bankruptcy trustee?

Stock owned by a debtor is property of a bankruptcy estate. See 11 U.S.C. §541(a); Milden v. Joseph (In re Milden), 1997 U.S. App. LEXIS 7726 (9th Cir. Cal. Apr. 16, 1997), an unpublished Ninth Circuit opinion citing In re Baker, 68 Bankr. 360, 363 (D. Or. 1986) (which found the corporation itself was property of the estate because it was wholly owned by the debtors); United States v. Ken Int'l. Ltd. , 184 Bankr. 102, 107 (D. Nev. 1995); In re Deak & Co., 63 Bankr. 422, 427 (Bankr. S.D.N.Y. 1986); In re MacDonald, 114 Bankr. 326, 333-34 (D. Mass. 1990).

If a business entity has little or no debt, then a sale of stock of the entity will, in most cases, result in a sale price equal to the value of the assets held in the business entity. Although a debtor may assert an exemption to the stock of the entity, that exemption is limited. See California Code of Civil Procedure §§ 703 et seq. and 704 et seq. For example, if real estate is held in the name of a corporation, a debtor is not entitled to claim a homestead exemption of $75,000, $100,000 or $175,000 (which would ordinarily be the case if the property is held in the debtor's name). Instead, a debtor is limited to the “wildcard” exemption. Unlike the generous amounts provided under the California homestead exemption, the “wildcard” exemption caps out at $26,925. Further, the wildcard exemption only affixes to the stock of the entity and not the assets of the entity. In the context of a bankruptcy case, holding assets in a business entity may provide less protection than holding assets in the debtor's name.

Also, if allowed by corporate by-laws, a trustee may be able to vote himself or herself director of the entity and can control, without restriction, the entity's fate. For example, the trustee could file a bankruptcy petition to have the entity's assets liquidated by a fellow trustee, with the nominal debts of the entity paid and the resulting equity turned over to the individual debtor's bankruptcy trustee. A bankruptcy trustee could also file a complaint for involuntary dissolution of the entity, seek a receivership over the corporation's assets or assign the assets of the entity to a third party for the benefit of its creditors. And if that does not work, the trustee could seek substantive consolidation of the entity into the individual debtor's bankruptcy case and gain control over all of the entity's assets.

In addition to the problems mentioned above, corporate assets are subject to a bankruptcy trustee's strong-arm powers provided under 11 U.S.C. § 548 and Cal. Civ. Code §§ 3439.04 and 3439.05. Entities designed to hold assets typically accept assets in the form of capital contributions. But capital contributions made without any value in return are nothing more than transfers that are avoidable. If the transfer of property is avoided, a business entity designed to protect assets provided no protection for the assets.

Marital Agreements

In California, assets of spouses can be divided during marriage by agreement. But assets transferred in California under a martial agreement are subject to avoidance under 11 U.S.C. § 548 and Cal. Civ. Code §§ 3439.04 and 3439.05. Mejia v. Reed , 31 Cal. 4th 657 (2003), (holding that property voluntarily transferred under a marital settlement agreement is subject to avoidance under Cal. Civ. Code §§ 3439.04 and 3439.05).

Moreover, a release of child or spousal support is no longer adequate consideration for a transfer of an interest in property. Carbaat, 357 B.R. 553 (Bankr. N.D. Cal 2006) (noting the definition of “value” under 11 U.S.C. § 548(d)(2)(A) and Cal. Civ. Code § 3439.03 excludes an unperformed promise to provide future support to the debtor or to another person); Hahn v. Leong (In re Llamas), 2011 Bankr. LEXIS 4779 [*40] (Bankr. C.D. Cal. Dec. 12, 2011) (holding the transfer of property in exchange for a release from an obligation to pay support was is not adequate consideration for purposes of satisfying “value” required under 3439.04 and 3439.05).

As a result of the holdings in Carbaat and Llamas, property transferred to a spouse can be recovered by a bankruptcy trustee if a waiver of spousal support is the “value” provided. And if the property is recovered because a transfer was avoided, it cannot be exempted. 11 U.S.C. § 522(g).

Conclusion

Asset protection can be foolish and costly. To properly protect an asset in California, it's generally best to understand and maximize exemptions. Most “asset protection” advice is free. You often get what you pay for. Sometimes less.

*****
David Goodrich is a member at SulmeyerKupetz, a business, financial restructuring and litigation firm; he also serves as a Chapter 7 trustee. He can be reached at [email protected] or 213-617-5297.