Part Four | Asset Protection Planning from A-Z: 26 Things to Think About Before Jumping In

Prepared by Jeffrey Zaluda and Shannon B. Miloch

Insurance, IRAs, Annuities, and Other Exempt Assets

Each state’s statutes, as well as the Federal Bankruptcy Code, has a laundry list of property that is exempt from the reach of creditors. Typically, these include a portion of equity in a home, some minimal amount of liquid assets, a car, a bible, tools of the trade, and other minimal levels of assets required for basic support needs.

• In a number of states, including Illinois, a debtor may choose to have either the Federal bankruptcy exemption scheme or the state exemption scheme apply. He may not choose both in order to maximize his exempt property.
• Typically, state exemption schemes will protect at least a portion of the value of the homestead.

1. Most states have very limited homestead exemptions. For example, Illinois limits the exemption to a $15,000 interest in the primary personal residence. Texas, Florida and a few other states currently have virtually unlimited homestead exemptions (subject to certain limits in a bankruptcy). Accordingly, a potential debtor residing in one of those states may consider paying off a mortgage on the home.

• Most states, including Illinois, provide that life insurance policies payable to a spouse or dependent, including the policies’ cash value, are exempt from creditors. All states have some form of exemption for life insurance. Protection varies and depends on how the policy is written.

1. In most jurisdictions, the proceeds of a life insurance policy will be protected, provided they are not payable to the insured’s estate or to a trust that is obligated on the insured’s liabilities at death.
2. The exemption varies with respect to cash value, annuities or endowment policies during the insured’s or annuitant’s lifetime. Some states provide little to no protection. Others offer complete protection, provided the policy benefits the insured’s or annuitant’s spouse or dependents, even if the insured or annuitant has retained the right to change beneficiaries.
3. Under Federal bankruptcy exemptions, a limited amount of cash value may be exempted from creditor claims.
4. Care must be taken in purchasing life insurance policies to ensure they include any language specifically required by state statute in order to afford protection from creditors.

• Annuities are generally protected from attachment by the annuitant’s creditors if payable to a spouse, child, parent, or other dependent of the annuitant.

1. Most statutes do not distinguish between commercial and private annuities, or between annuities that are part of qualified plan payments or non-qualified deferred compensation payments (including Rabbi Trusts).
2. Deferred annuities may make sense for a professional planning to retire at a certain date. Payments could be deferred to a date a few years following retirement, thereby possibly getting past statutes of limitations for negligence or malpractice claims.

• For many professionals, retirement plans are among their largest assets. The good news is that retirement plans are generally protected from creditors, even in the case of bankruptcy.

1. In Patterson v. Shumate, 504 U.S. 753, the Supreme Court conclusively held that ERISA qualified plan accounts are outside the reach of a bankruptcy trustee or any other third-party creditor by virtue of the statutory anti-alienation provisions under ERISA. As clients get closer to retirement age or otherwise begin to roll their 401(k) accounts into IRAs, the protection afforded by state exemption statutes (and the Bankruptcy Code) becomes that much more important. Importantly, “ERISA-qualified” was not defined by the Supreme Court in Shumate and courts have since used various definitions of the same. A common three-part test has been used in the aftermath of Shumate, including a plan that must (i) be tax qualified under the IRC; (ii) include an anti-alienation provision; (iii) be subject to ERISA.
2. In Rousey v. Jacoway, 544 U.S. 320, the Supreme Court resolved an open question regarding the state law protection of IRA’s vis-a-vis bankruptcy law by holding that an IRA account would receive creditor protection in a bankruptcy proceeding, subject to the protection caps under the Bankruptcy Act.
3. Illinois, along with many other states such as California, Texas, and New York, have traditionally provided protection to IRA’s in any event, and Rousey was a validation of that position. Still, it is important to note each state provides a different level of protection; for example, in some states, the protection afforded by ERISA may be lost once the IRA rollover is accomplished. Yet other states only provide protection for some types of retirement plans, such as teacher retirement plans and police pensions, or extends protection only to the extent necessary to support the debtor and the debtor’s dependents during retirement. For example, Nevada exempts IRA funds up to $500,000, Montana does not exempt contributions from the year prior to the bankruptcy filing, and other states include vague language capping exemption at an amount necessary for support.
4. The conversion of non-exempt assets into exempt assets, such as the contribution of funds to an IRA shortly prior to filing bankruptcy, may be deemed a fraudulent conveyance, and a planner should be careful in advising such a step (and in certain circumstances such a step could even preclude the ability to obtain the protection of the bankruptcy courts). Worse yet, if the bankruptcy trustee is successful in unwinding a last-minute contribution to an IRA, the distribution back out of the IRA could result in an additional 10% penalty for early withdrawal.
5. Whether a plan distribution, once made, is protected from the distributee’s creditors depends primarily on state law. ERISA anti-alienation protection terminates immediately upon distribution of the funds to the plan participant. The general rule is that distributions are not protected from attachment once in the hands of a beneficiary except to the extent specifically protected by state law.
6. In Auto Owners Insurance v. Berkshire, 225 Ill. App.3d 695, the Illinois appellate court found that distributions from a tax-qualified retirement plan would be exempt only if the debtor held the distributed funds in a "cash equivalent account," such as a checking account, and the funds were necessary for the current support of the debtor and his family. In In re Schnabel, 153 B.R. 809, an Illinois bankruptcy case decided about the same time as Auto Owners Insurance, the bankruptcy court provided substantially greater protection for the debtor. In that case, the bankruptcy court looked to the history of the current Illinois exemption statute and determined that the exemption for pension plan payments was no longer limited to the amounts necessary for the debtor’s support but would, in fact, apply to any distributions from a qualified plan. This issue remains largely unresolved in Illinois, but the safe course is to assume that Auto Owners is applicable.
7. The 5th Circuit, on the other hand, looked to federal statutes to provide protection for the debtor. In In re Ragos, 700 F.3d 220, the 5th Circuit, relying on Bankruptcy Code section 1325(b)(2) and Social Security Act sections 407(a) and (b), held that social security income should not be included in a Chapter 13 debtor’s projected disposable income and may be excluded from the debtor’s payment plan. The Ragos court held that the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) explicitly excluded social security benefits from the definition of calculating a debtor’s “projected disposable income,” and the exclusion of this kind of income should be read as intentional exemption of these assets.

• The Supreme Court held in Clark v. Rameker in 2015 (134 S.Ct. 2242) that inherited IRAs are not retirement funds for the purposes of bankruptcy exemption. The Court reasoned that the purpose of the exemption for IRAs in bankruptcy is to allow debtors to meet their basic needs in retirement, but that the nature of traditional and Roth IRA guidelines prevent a debtor from experiencing a windfall – the debtor can’t withdraw until a set age. In contract, inherited IRAs can be used immediately as a windfall or a ‘free pass,’ contravening the goals of exemptions in the Bankruptcy Code.
• In many states, a certain amount of wages earned by the Head of Household will not be subject to creditor claims and may be invested in other exempt assets without being considered a fraudulent transfer.

Jurisdiction

Twenty-one states - Alabama, Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming - have all adopted domestic asset protection trust statutes, sometimes referred to as “DAPTs.” State laws vary and should be taken into account when choosing the situs of a DAPT.

The selection of the trust situs for a DAPT is not merely ink on paper, but a Grantor who opts for a DAPT under another state’s DAPT laws should consider ways to strengthen their contacts with the situs state:

1. Depositing trust assets into an account in the designated state or otherwise using property located in the designated state.
2. Appointing a local trust company, attorney, or other third-party as Trustee, and documenting he Trustee’s active involvement in the DAPT, such as through filing tax returns.
3. Give the Trustee sole discretion over distributions to the Grantor.

Asset protection measures like DAPTs should be considered well in advance of possible creditor concerns, but it is not always possible to see into the future. Be prepared and flexible to take alternative or additional actions if creditor concerns arise, or if your client’s particular needs (professional liability risk, asset picture, etc.) require. For example:

• Many clients do not wish to give up control and place their assets in an asset protection trust (onshore or offshore) when they do not foresee an immediate risk of a creditor claim. But, it may be wise to include language in a trust or operating agreement that allows a change of jurisdictions at any time. This may be accomplished in any number of ways, including:

1. Allowing the existing trustee or manager, or trust protector, to name a substitute trustee or manager (temporary or permanent, irrevocable or revocable). Note that some states, like Wyoming, will allow the Grantor to change these fiduciaries.
2. Allowing for a change in the jurisdiction of the asset custodian.
3. Providing a trusted party with a limited power of appointment that includes the power to appoint to offshore or other hard-to-pierce entities.

• As storm clouds begin to form, it may be helpful to substitute one asset that may be of greater long-term interest to the client (e.g., a closely held business interest) with another that may be more expendable (e.g., cash). But, it is important that any such substitution be of equivalent value in order to avoid any appearance of fraudulent conveyance. Note that some states, including Alabama, Alaska, and Mississippi, require the Grantor of a DAPT to execute an affidavit of solvency before funding a trust, and substituting trust assets should be carefully considered within the applicable state law.
• As storm clouds begin to form, it may be helpful to substitute one asset that may be of greater long-term interest to the client (e.g., a closely held business interest) with another that may be more expendable (e.g., cash). But, it is important that any such substitution be of equivalent value in order to avoid any appearance of fraudulent conveyance. Note that some states, including Alabama, Alaska, and Mississippi, require the Grantor of a DAPT to execute an affidavit of solvency before funding a trust, and substituting trust assets should be carefully considered within the applicable state law.
• Include language in a trust that allows for disclaimer and specifies what happens to disclaimed trust interests.

1. This may include directing that disclaimed assets be poured over to a particular trust.
2. This may also include a limitation on the disclaimer to a lifetime interest, while retaining a testamentary limited power of appointment.
3. Note that a disclaimer of this nature may not be qualified under IRC Section 2518, which could result in a taxable gift depending on the nature of the disclaimer.

Protection is often not comprehensive. For example, persons entitled to spousal or child support can generally pierce a self-settled trust to the extent of the debt owed. Also, persons who suffer wrongful death, personal injury or property damage at the hands of the grantor on or before the date of the transfer of assets to the trust may also be able to gain access to those assets. The Alaska Trust Act, which became effective in 1997, is illustrative. The statute recognizes the effectiveness of self-settled trusts with four important exceptions: (i) creditors may generally pursue fraudulent transfers into these trusts that are made within four years of the creation of the trust; (ii) the trust will not defeat the claims of a creditor if the grantor may revoke or terminate all or part of the trust against the wishes of a beneficiary or if the trust requires that all or part of the trust's income and/or principal must be distributed to the grantor; and (iii) the transfer of assets to a trust will not be upheld if the grantor is thirty or more days late in making a child support payment.

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