Berry Moorman

Asset Protection Planning

Asset Protection Planning

I. CHOICE OF ENTITY.

A. Corporation (C Corporation).

For many years, the C Corporation was the favored entity for conducting one’s business affairs because it provided the business owner protection from third-party claims against his or her personal assets. The procedure to form a C Corporation is simple, consisting of filing very abbreviated Articles of Incorporation with the State of Michigan for a nominal cost. Unlike the S Corporation (below), there are no limits on the number of shareholders, types of owners, nor limitations on the equity structure. Except under extraordinary circumstances, the shareholders’ liability is limited to their capital contribution.

B. S Corporation.

An S Corporation offers the benefit of limited liability to its shareholders while maintaining flow through taxation (similar to a partnership). However, there are substantial limitations upon an S Corporation that affect its desirability in certain instances. The S Corporation may only have seventy-five shareholders, may only issue one class of stock and only individuals, their estates or qualified trusts may serve as shareholders. Corporations and LLCs cannot own shares of an S Corporation. This inflexibility makes the S Corporation less desirable than other entities when doing Asset Protection Planning.

C. General Partnerships.

General partnerships do not offer any true degree of asset protection. Creditors of the partnership may hold each general partner individually liable if the partnership assets are insufficient to satisfy its debts. Each of the general partners is jointly and severally liable for damages from partnership torts and breaches of partnership contracts. Each general partner is jointly liable for the entire amount of the partnership’s other debts. In addition, the assignee may not be charged with the income tax of the general partner’s interest because the creditor does not acquire all of the dominion and control of the interest (this process is discussed below for limited partners). Rev. Rul. 770137.

D. Limited Partnerships.

1. General Partners. A general partner of a limited partnership (“LP”) is subject to same liabilities with respect to partnership debts as is a partner of a general partnership. Similar to creditors of a limited partner, creditors of the general partner may receive an assignment of the interest (more fully described below). Perhaps more importantly, the assignment of a general partner’s interest in an individual bankruptcy may adversely affect management of the partnership.

2. Limited Partners. Creditors of the partnership may not reach the limited partner’s separate assets unless the limited partner acts as a general partner by engaging in the management of the LP’s affairs. Judgement creditors of the limited partners, have no right to partnership property and are left with only one remedy — apply to the court for an order charging the debtor’s partnership interest with payment of the debt. In such a case, the judgment creditor has only the right of an assignee of the partnership interest. MCL§ 449.1703. The creditor will not have rights and powers of a partner. MCL§ 449.1702. Of critical importance, the creditor will not be able to examine partnership books. Because the general partner controls the amount and timing of the distributions, the creditor/assignee cannot compel any distributions and thus has received an asset that is of very little value. The charging order does not cover fees paid to the general partner for services rendered which are not disguised partnership distributions. It is less clear whether loans may be made to the limited partner/debtor outside of charging order.

Paradoxically, once the creditor/assignee has the charging order, the creditor may be deemed as the owner of that portion of the partnership interest for income tax purposes and thus will be taxed on the debtor/partner’s allocable share of income even if no distributions occur. Rev. Rul. 77-137. Thus, a creditor may end up paying income tax, even though he is not able to get his hands on any money. The phantom income to assignee/creditor may enhance the bargaining power of debtor to settle claims. Of course, when any distributions eventually come out, they will be subject to the charging order but the creditor’s position in the meantime is severely weakened.

Once again, care should be taken so that any contributions to the limited partnership will not be considered fraudulent conveyances and thus recoverable from the partnership. This is the creditor’s most efficient method of obtaining partnership contributions. In an LLC, all members automatically have limited liability. In a limited partnership, the general partner lacks limited liability. To ensure adequate protection in a limited partnership, it may be necessary to form an LLC or S corporation to act as the general partner. This additional step is not necessary if we use the LLC. Thus, unless other considerations dictate, an LLC is generally preferable to an LP.

E. Limited Liability Company.

The Limited Liability Company (“LLC”) is a relatively new entity that shares many characteristics with a partnership while retaining the limited liability of a corporation. The LLC has become a popular tool for protecting assets. LLCs are similar to limited partnerships except that all of the owners (members) have limited liability. The operation and effect of a charging order (as described above for a limited partnership) also applies to a LLC. Like a limited partner, an interest in an LLC is assignable unless the operating agreement provides otherwise. Similar to a limited partnership, the assignment of a member’s interest only entitles the assignee to receive distributions. MCL 450.4504. For an assignee to become a member of an LLC, the consent of all of the other members is generally required. Thus, the significant creditor disincentives will normally apply to the LLC, as well. However, if the LLC is not centrally managed and the operating agreement provides for the continuation of the business of the LLC following the death termination, etc., of a member, then only the majority consent of the remaining members is necessary to admit a new member. MCL 450.4506. Because of its flexibility, a LLC may be preferable to the combination of a corporation acting as a general partner of a limited partnership under many circumstances.

F. Limited Liability Partnership.

An LLP operates almost identically to an LLC. A partner of a registered LLP is generally not liable (directly or indirectly) for the debts obligations or liabilities of the LLP arising from negligence, wrongful acts, omissions, misconduct or malpractice committed by another partner or an employee agent or representative of the LLP while the LLP is registered. However, a partner may be individually liable to the extent that the person who committed the negligence, wrongful act, omission, misconduct or malpractice was under the partner’s direct supervision and control. MCL 449.46.

G. Charging Orders.

a. Using the Limited Partnership (LP) or Limited Liability Company (LLC) may provide the partners or members with protection from creditors. Generally, a creditor of a partner of an LP or LLC member may obtain a “charging order” which entitles the creditor to receive all distributions of the LP to a partner or LLC membership interest. However, the charging order does not allow the creditor to become a substituted partner or member.

b. The Michigan Revised Uniform Limited Partnership Act and the Michigan Limited Liability Company Act differ slightly. The LLC Act explicitly provides that a member continues to function with all of the member’s rights including distributions except to the extent charged. The Uniform Limited Partnership Act lacks this explicit provision. However, both Acts provide that the creditor claiming under a charging order is only an assignee.

c. Keep in mind that a charging order may not be the exclusive remedy of a creditor. Several states permit a creditor to foreclose on a partner’s partnership interest, thereby making the creditor a full partner. Centurion Corn v. Crocker National Bank, 208 Cal App 3d (1989) (debtor/partner consented to the foreclosure); Hellman v. Anderson, 233 Cal App 3d 846 (1991) (foreclosure on partnership interest allowed where creditors would not be assuming management rights and. foreclosure would not unduly interfere with the partnership’s business). See also, Wills v. Wills, 750 SW 2d 567 (Mo, 1988); Bohonus v. Amerco, 602 P2d 469 (Ariz, 1979); Tupper v. Kroc, 494 P2d 1275 (Nev, 1972); Beckley v. Speaks, 240 NYS 2d 553 (NY, 1963); Birchwood Builders, 573 A2d 182 (NJ, 1990). No Michigan case has addressed the issue.

d. The debtor’s partnership interest will be part of the bankruptcy estate. Partnership assets are not generally recoverable by the bankruptcy trustee. However, in some cases, the trustee has been allowed to reach the partnership interest of the debtor despite restrictions in the partnership agreement. In re Cutler, 165 Bankr 275 (Ariz, 1994).

II. TITLING OF ASSETS.

The titling of assets will affect the owner’s rights in the property and thus will control which assets are exposed to various creditors of the owner. It is helpful to understand exactly how rights in ownership are determined to understand how much protection your assets currently enjoy. Depending on this analysis, further actions may be necessary to protect these holdings.

A. Joint Concurrent Ownership of Real Property.

Real property can be held in one of three (technically four) ways.

1. Tenancy In Common. There is a presumption that any grant or devise to at least two persons creates a tenancy in common, not a joint tenancy. MCL 554.44. Tenants in common hold title to real property with each having a divided interest except for the right of possession. Thus each co-tenant is entitled to a proportionate share of any rents and profits from the property and is entitled to convey that undivided interest in whole or in part. A tenant in common can mortgage his interest in the real estate and is entitled to partition. The interest of a tenant in common is susceptible to execution, levy and sale to satisfy a judgment creditor. However, to maintain an action for partition, the creditor must have a right of possession.

2. Joint Tenancy. Property may be held as joint tenancy if expressly so designated and all interests are created simultaneously. In Michigan, there are two types of joint tenancy and the rights of survivorship depend on which type is created. An instrument creating a joint tenancy that expressly includes a right of survivorship results in an indestructible right of survivorship, which cannot be severed (the strong variety). If the right of survivorship is not clearly set forth in the instrument, the weaker form of joint tenancy results and the right of survivorship is eliminated upon a transfer of the property. It is important to realize that, in Michigan, a mortgage upon one joint tenant’s interest in the property does not by itself sever the joint tenancy. The joint tenancy is effective until a creditor forecloses upon the property and an actual sale of the property occurs. Again, the right to convey the entire interest is dependent upon which type of joint tenancy is created. In the strong version, the joint tenant may only convey his lifetime interest in the property on the contingent survivorship rights. In the weak version, a tenant may convey his complete interest in the property because the joint tenancy is extinguished upon the transfer. The purchaser of a joint tenant’s interest of the weak variety becomes a tenant in common with the other former joint tenant.

3. Tenancy by the Entireties. Tenancy by the entirety offers the greatest protection from individual creditors and can only occur between husband and wife. A conveyance of real property to a husband and wife will create a tenancy by the entireties unless certain elements are lacking or if otherwise indicated. De Young v. Messler, 373 Mich 499 (1964). However, transferring a one-half interest in the property to his or her spouse will not create any tenancy by the entities. Similarly, if the title is vested in two persons who subsequently become married, the marriage standing alone does not convert the estate to one held by the entireties. Williams v. Dean, 356 Mich 426 (1959). If the title to real estate exists in one spouse prior to marriage, that spouse should quit claim the property to himself/herself and spouse as tenants by the entireties. However, care should be taken that the transfer is not considered a fraudulent conveyance (see discussion below). Once property is held in the entireties, neither individual can bind the property to any debt without the consent of the other. Rogers v. Rogers, 136 Mich App 125 (1984). As such, the primary advantage of tenancy by the entireties is that such property is not susceptible to creditors of an individual tenant. Muskegon Lumber and Fuel Co. v. Johnson, 338 Mich 655 (1954). Under MCL 557.101, the tenancy by the entireties may be terminated by a conveyance from one spouse to the other. Hearns v. Hearns, 333 Mich 423 (1952). In addition, the tenancy by the entireties is eliminated by the entry of a divorce decree. Under MCL 600.6018, a property is subject to a judgment creditor against both tenants.

B. Personal Property.

It is possible to establish a tenancy in common for personal property, but only if the instrument is very clear and specific. Generally, personal property is held between two or more persons as joint tenants with rights of survivorship (again, in the weaker form unless otherwise specified). The interest of a joint tenant in personal property may be severed to satisfy a creditor. Joint bank accounts are held as joint tenants and creditors of one tenant may garnish up to one-half of the joint account because it is presumed that each spouse contributed equally. However, upon a showing by the creditor that one spouse contributed all of the funds to the account, then all such funds are subject to the creditor’s claims. Sussex v. Snyder, 307 Mich 30 (1943).

C. It is possible that a joint bank account in the name of husband and wife might be entireties property under MCL 557.151. However, Michigan public policy generally disfavors finding tenancy by the entireties in personal property. Generally, only rents, income and profits derived from property held by the entireties will be considered as entireties property. MCL 557.71. Proceeds from the sale of entireties property that were deposited into a joint bank account has been held unreachable by creditors of the husband alone when the parties intended to reinvest the money in other entireties property. Muskegon Lumber, supra.

D. Stocks Bonds, Promissory Notes. Similarly, stocks, bonds, promissory notes and other instruments are treated in the same manner as real estate when held jointly by husband and wife. MCL 557.151.

E. Life Insurance Policies. During the life of the insured, the owner usually can cancel the policy without the beneficiary’s consent. Upon death of the insured, the right to payment becomes vested in the beneficiary. Generally, creditors of the owner of a life insurance policy or an annuity contract cannot reach the beneficiaries’ interest in the proceeds. MCL 500.2207. However, if the owner of the policy paid premiums in fraud of creditors, the proceeds are subject to creditors to that extent. It is not clear under Michigan law whether creditors of the owner may access the cash value of a policy. Most experts speculated that creditors could not reach the cash value, but in 1992 a federal court decided that the cash value was indeed accessible to a creditor. Chrysler First Business Credit Corporation v. Rotenberg v. John Hancock Mutual Life Insurance Company, 789 F Supp 870 (WD Mich 1992). While this decision is not binding upon Michigan courts until the issue is conclusively settled, federal courts deciding the issue are likely to follow the decision in Chrysler.

F. Retirement Benefits. In non-bankruptcy instances, federal and state anti-alienation provisions will provide protection for most forms of tax-qualified retirement plans. However, non-qualified plans are not subject to the same anti-alienation provisions and may not offer protection.

In bankruptcy cases, the issue is somewhat more complicated. Title I of the Employee Retirement Income Security Act of 1974 (“ERISA”) requires that qualified employee benefit plans contain an enforceable spendthrift restraint. This requirement was interpreted by the Supreme Court as a restriction on transfer enforceable under “applicable nonbankruptcy law” for purposes of the Bankruptcy Code and thus can be excluded from the bankruptcy estate. Patterson v. Shumate, 112 S Ct 2242 (1992). Therefore, generally covered retirement plans are given full protection from creditors. However, there are certain items that are not automatically excluded from the bankruptcy estate. These items may still be protected if the debtor elects the qualified plan assets under the section 522 federal or state exemptions. For example, the federal exemptions offer limited protection for Keogh plans. Under Michigan law, eligible IRAs are fully protected. MCL 600.6023.

III. STATUTORY EXEMPTIONS.

A. If an individual debtor files bankruptcy in Michigan, the debtor must elect either the federal exemptions or the state exemptions. 11 USC § 522. If the individual elects the state exemptions, the debtor is also entitled to any other federal exemptions not listed in Section 522(d).

B. The debtor must choose between the federal or state exemptions in their entirety. The debtor cannot select a federal exemption for one item and the state exemption for another. Spouses filing joint bankruptcy cases must elect the same system. Any property exempted under Section 522 is not liable during or after the bankruptcy case for any pre-petition debt, except for alimony or child support indebtedness, tax indebtedness, certain liens including tax liabilities and certain debts from fraud, embezzlement, etc.

C. The State of Michigan exemptions are set forth primarily in MCL 600.6023.

D. MCL 565.49 and 11 USC § 522(b)(2)(B) exempt property held by the individual debtor. As a general rule, the creditors of one individual spouse cannot attach property held as tenants by the entireties. Michigan National Bank v. Chrystler, 14 Bankr 85, 89 (WD Mich, 1981); Grosslight, 757 F2d 73 (6th Cir, 1985). The exemption under Michigan law is unlimited (i.e., debtor may have unlimited equity in real property and exempt the entire amount). Personal property may be held as tenants by entireties. MCL 557.1512. Debtors must keep in mind that the enhancement of bankruptcy exemptions during a period of insolvency may be set aside as a fraudulent conveyance pursuant to the Michigan Fraudulent Conveyance Act. MCL 556.11, Glazer v. Beer, 343 Mich 495 (1955); Doe v. Ewing, 205 Mich App 605, 606 (1994). A creditor may either have the fraudulent conveyance set aside “to the extent necessary to satisfy his claim,” or may disregard the conveyance and levy on the conveyed property. MCL § 566.19. If the conveyance is set aside “to the extent necessary” it is not entirely voided. The creditor is basically given an equitable lien upon the conveyed property. Brownell Realty. Inc. v. Kelly, 103 Mich App 690 (1981). The creditor’s lien will be junior to outstanding mortgages, the other spouse’s claim for payments made from that spouse’s individual property that would give rise to a senior lien by subrogation, and to a claim for exemption. Innocent participants do not relieve a transaction from the taint of fraud.

Effective use of the tenancy by the entireties exemption is strictly limited to situations in which a creditor’s claim is asserted against only one of the two joint tenants. If a creditor’s claim is maintained against both the husband and wife, the entireties exemption will not apply. However, any proceeds derived from the administration of jointly held property will only be disbursed to creditors having joint claims. Creditors with claims against either the husband or the wife may not be entitled to share in the proceeds. In Re Oberlies, 94 Bankr 916 (ED Mich, 1988).

Similarly, However, a bank account holding the proceeds from the sale of the entireties property is exempt as long as it is maintained to acquire entireties property in the future. Muskegon Lumber & Fuel Co. v. Johnson, 338 Mich 755 (1954).

Federal Bankruptcy Law. The federal bankruptcy exemptions are set forth in 11 USC § 552(d). The amount of the exemptions is doubled in jointly administered cases. Generally the debtor may exempt: $15,000 in real property used as the debtor’s principal resident; up to $2,400 of equity in motor vehicle; household goods and furnishings with a value of up to $8,000, although no individual item may exceed $400 in value; jewelry up to $1,000; a general exemption for virtually any type of property in the amount of $800, plus any unused portion of the homestead exemption up to a maximum of $7,500; up to $1,500 in tools used in the trade of the debtor; unmatured life insurance policies and up to $8,000 in the form of accrued dividends or interest, or loan value; and professionally prescribed health aids for the debtor or a dependent.

In addition, 11 USC § 522(d)(10) allows the debtor to exempt social security benefits, veterans’ benefits; disability, illness or unemployment benefits; alimony, support, or maintenance to the extent reasonably necessary for the support of the debtor or any dependent; payments under stock bonus, pension, profit sharing, annuity or similar plans or contracts on account of illness, disability, death, age or length of service, to the extent reasonably necessary to the support of the debtor or any dependent of the debtor. This provision is subject to certain limitations. In Re Rector, 134 Bankr 611 (WD Mich, 1991).

11 USC § 522 (d)(11): allows the debtor to exempt certain types of payments resulting from personal injury recoveries, reparation awards, and proceeds and other funds received of a like nature. Many of the provisions under this section are limited to those funds that are reasonably necessary for the support of the debtor and any dependent of the debtor.

A common objection to exemptions is that the debtor converted nonexempt property into exempt property in anticipation of bankruptcy. This is often the case with entireties property (see discussion on fraudulent conveyances below).

The conversion of non-exempt into exempt assets is risky. See In Re Saunders, 37 Bankr 766 (ND Ohio, 1984). Sometimes conversion as part of pre-bankruptcy planning is permissible as long as it is not done to avoid a particular collection action. In Re Swecker, 157 Bankr 694 (MD Fla, 1993).

Upon the sale of a homestead the owner was entitled to claim the proceeds as exempt up to the amount of the allowable exemption. See In Re Zohner, 156 Bankr 288 (D Nev, 1993).

B. IRAs. Under MCL 600.6023, individual retirement accounts or annuities and any payments or distributions therefrom are generally exempted from levy and sale by creditors. These items also qualify as an exemption under § 522(b)(2) of the Bankruptcy Code. However, the IRAs and distributions therefrom are subject to divorce decrees and judgments, child support payments and tax liens. To the extent that any contributions occur within 120 days before the filing of bankruptcy, such contributions will be considered as fraudulent conveyances or preferences and thus recoverable by the bankruptcy trustee.

C. Qualified plans and any payments or distributions therefrom are exempted from levy and sale by creditors under § 522(b)(2) of the Bankruptcy Code. However, ERISA plan distributions are subject to divorce decrees and judgments, child support and tax liens. To the extent that any contributions occur within 120 days before the filing of bankruptcy, such contributions will be considered as fraudulent conveyances or preferences and thus recoverable by the bankruptcy trustee.

D. MCL 500.2207 exempts proceeds of life insurance payable to a spouse or child or trust for their benefit in the absence of a fraudulent conveyance. As indicated earlier, the law is not clear whether the cash value of the policy while debtor is alive is exempt from creditors.

IV. OFFSHORE TRUSTS

Generally, the primary motivation for establishing an offshore asset protection trust (“Offshore Trusts”) is to shield the transferred assets from claims of future creditors. It must be stressed that the increasing use of these Offshore Trusts is, generally, not based upon achieving favorable tax consequences. In most instances, the tax advantages of the Offshore Trusts are minimal for U.S. citizens, i.e., Offshore Trusts are usually tax neutral. There are some ways in which tax advantages may be realized, but the normal reason for the Offshore Trust is a creditor protection device.

Offshore Trusts are created under the laws of foreign jurisdictions having favorable legislation. Many countries such as the Bahamas, Cayman Islands and the Turks & Caicos Islands have established and developed laws that allow the settlor to shield the assets from foreign creditors while maintaining some degree of control over the transferred assets. To avoid being within the control of the settlor, the trusts are irrevocable. The trustee is a foreign trust company or financial institution and is granted absolute discretion over any distributions. However, the trusts may terminate at a specified time period or they may be tied to the lives of the settlor or beneficiaries, typically the spouse or the children. The settlor normally may retain a reversionary interest in the assets. In addition, the settlor usually maintains a limited degree of lifetime control over the assets by providing the foreign trustee with a non-binding “letter of wishes” describing the settlor’s preferences regarding distributions of trust property. The settlor may also serve as a member of an advisory committee or may be designated as a protector of the trust, thus given the power to remove and appoint a substitute trustee.

The Protection Scenario

After time-consuming and costly litigation in the U.S. courts, a creditor must try to recover the assets of the settlor. When the creditor tries to levy upon the settlor’s assets, the creditor discovers that the assets are held by an offshore trust. The creditor is now faced with unfamiliar and complex foreign laws that do not recognize foreign judgments. The only obvious course of action is to retry the case in the designated jurisdiction. Aside from the cost of another lawsuit and the burdens of travel, these countries have laws that are far more protective of settlors. A creditor typically bears a greater burden of persuasion in the designated jurisdiction than that under U.S. law. Therefore, it becomes very difficult to obtain a judgment in the foreign jurisdiction and, given the prohibitive costs, it is usually seen as a waste of time and money.

Burden of Proving a Fraudulent Conveyance is Higher

Generally, the laws of the offshore jurisdiction respect the spendthrift provisions of the trust. Thus even if a creditor obtains a favorable foreign judgment, the creditor still must prove that the transfer into the trust was fraudulent. In these jurisdictions, this is a formidable task. These jurisdictions have their own fraudulent conveyance laws that normally require proof of actual intent to defraud; this standard is almost impossible to meet. The badges of fraud applied by American courts to prove fraudulent intent circumstantially have no bearing on the fraudulent conveyance proceedings. As long as the settlor-debtor has legitimate grounds for setting up the trust, such as estate planning objectives, it is difficult for a creditor to prove actual intent to defraud. The standard of proof is notably severe; the plaintiff must prove his pleadings beyond a reasonable doubt, instead of the preponderance of the evidence standard adopted in U.S. civil proceedings. Arguably, a court may, under its conflict of laws rules, decide to apply U.S. fraudulent conveyance laws rather than the laws of the foreign jurisdiction depending on the surrounding circumstances.

Offshore Trusts Allow for Stronger Settlor Controls

Offshore jurisdictions allow settlors to maintain a degree of control far beyond that tolerated in domestic trusts. For example, the settlor may be a beneficiary, a “protector” or an “advisor” and may include a “letter of wishes” with the trust giving non-binding instructions to the trustee. Properly chosen, a trust-friendly offshore jurisdiction will honor spendthrift clauses in self-settled trusts wherein the settlor is a beneficiary. Although a settlor may frame a trust for his own benefit, he is nonetheless shielded from his creditors. For this reason, jurisdictions such as the Bahamas, Cayman Islands and the Cook Islands are some of the most popular for Offshore Trusts.

Location of Assets

According to general trust law, the assets can be located locally (in the U.S.) even if the trust is established and administered in the foreign jurisdiction. Many settlors feel more comfortable knowing their assets are close by. In addition, there may be a slight decrease in financial benefit management fee if the assets are held locally. There is, however, an degree of risk if the assets are not moved offshore. Courts in the United States are quite hostile to offshore trusts and might be more inclined to use any method to assert jurisdiction over local assets on behalf of an aggrieved creditor, especially a tort victim.

Possible Tax Benefits

The IRS will tax an offshore trust formed by a citizen of the U.S. person having one or more U.S. citizens as beneficiaries as a grantor trust. The settlor will continue to pay tax on any income received from the trust. Under IRC section 6048, the transfer of any property into an Offshore Trust is a reportable event. In addition, if the U.S. beneficiary receives any distributions from the foreign trust, the amounts and adequate records must be filed. Thus, for federal income tax purposes, the ownership by the trust is ignored and the income tax consequences are the same for the settlor as they were before he transferred the assets to the trust.

For U.S. gift and estate tax purposes, the effects of establishing an Offshore Trust are somewhat more complicated. In the typical offshore scenario, the settlor will be a beneficiary of the trust and, therefore, the trust assets will be included in the settlor’s estate for estate tax purposes. In such a scenario, the settlor may freely contribute to the trust without triggering any gift tax consequences. However, there are cases where foreign trust institutions encourage settlors to relinquish virtually all control over the assets. Whether a client would be comfortable with this arrangement is questionable. However, if such control were relinquished, then the settlor would effectively avoid the estate tax, similar to what is done with an irrevocable domestic trust. In that case, ownership of the assets would change and the lifetime transfer of assets to the trust might trigger gift tax upon amounts exceeding the annual exclusion. To accomplish this step, the settlor would be forced to pay a substantial amount of gift tax upon the initial transfer.

Fraudulent Conveyances

A transfer of assets may be fraudulent if the sole purpose is to avoid or hinder creditors. In this regard it is important that creditor protection not be the only reason for the transfer of the assets to the trust. In order to avoid fraudulent conveyance laws, the settlor of the trust must have other reasons for the transfer to the trust such as the desire to avoid probate. Can the attorney set up the same trust for his client offshore without triggering domestic fraudulent transfer laws? Typical Offshore Trust jurisdictions have very liberal fraudulent transfer laws.

Unlike U.S. law, which does not recognize spendthrift provisions in self-settled trusts, many foreign jurisdictions have passed legislation enhancing the protection given to debtors. For example, under Cook Islands law, a spendthrift clause is generally enforced even if the trust is revocable, amendable, and the settlor himself is the sole beneficiary of the trust. In other words, the fact that a spendthrift trust is self-settled will not adversely affect its enforceability. However, it is argued that, from a U.S. perspective, Offshore Trusts thwart public policy when they serve as a complete barrier to claims by support creditors of beneficiaries. As a result, a trend is beginning to develop that entitles children in need of child support, and sometimes spouses seeking alimony, to trust assets even when structured as discretionary trusts.

Tax Evasion Issues

The recent Budget Proposals included several provisions that might limit the use of offshore trusts for tax evasion. The offshore jurisdictions usually have bank secrecy laws that make it nearly impossible for the IRS to obtain accurate data on income distributions to U.S. taxpayers. Individuals may receive income and may not pay any income tax in chosen jurisdictions unless this income is voluntarily reported, the IRS has no way of tracking the income. As a result, the Budget Proposals significantly increase reporting requirements for transfers into foreign trusts and the penalties for failure to comply. Currently, a U.S. person who transfers assets into a foreign trust must file a 6048 report with the IRS. The former penalty for a failure to report the income was only five percent of the value of the assets but no greater than $1,000. Based on the difficulty of obtaining information, this penalty is not a strong deterrent. Thus, it is quite possible that many transactions are not reported. The proposed law would require that the grantor, transferor, trustee or fiduciary report any transfers to a foreign trust. In addition, the trustee is now required to file an annual report that includes all distributions to any U.S. beneficiary, and a domestic agent must be appointed to receive service of process. The failure to comply with these measures would result in a penalty equal to 35% of the gross value of property or a minimum of $10,000. An additional $10,000 will be imposed for every 30 day period which the trustee fails to comply with the request after a 90-day notice.

In more extreme cases, individuals have renounced their U.S. citizenship to avoid paying income taxes. Under current law, an individual who renounces their United States citizenship in order to evade taxes will be subject to an alternative taxing method for the ten years following expatriation. I.R.C. Section 877. Previously, the government had to show the taxpayer’s intent to evade taxes. The Budget Proposals, on the other hand, would treat any citizen of the United States who relinquishes citizenship as having sold all of his/her assets (at fair market value) at the moment the settlor receives a certificate of loss of nationality (“CLN”). As a result, the individual is forced to pay taxes on the deemed sale. This new law effectively discourages the transfer of low basis assets into offshore trusts. There is, however, a $600,000 exclusion for any deemed gain; therefore, the law seems to apply to a very small number of wealthy individuals. However, these are exactly the types of persons who can benefit the most from establishing an offshore trust.

V. FRAUDULENT CONVEYANCES.

Fraudulent conveyances occur when the owner transfers property to another and the transfer harms creditors. Upon showing that a conveyance was fraudulent, the creditor may recover the item transferred and levy upon it. Thus, when acting to protect assets from creditors, it is imperative that any given action not be considered a fraudulent conveyance.

A. Michigan Law.

Michigan has adopted the Uniform Fraudulent Conveyances Act (“UFCA”). MCL 566.11-566.23. Conveyance is broadly defined and includes any payment of money, assignment, release, transfer, lease, mortgage, or pledge of tangible or intangible property, and the creation of any lien or encumbrance. MCL 566.11. Under the Act, several types of conveyances might be considered fraudulent. It is also important to remember that Michigan courts may look for guidance to other jurisdictions when interpreting the UFCA because it is a uniform act.

1. Conveyances Made with Intent to Defraud. Any conveyance made with the intent to delay, defraud or hinder the ability of future of present creditor to enforce the debt is fraudulent. In such instances, the transfer is void regardless of whether valuable consideration was received. This also includes conveyances made without fair consideration when obligations are incurred beyond an individual’s ability to pay or when an entity incurs obligations leaving the entity with an unreasonably small amount of capital. Any transfers where any of these items are present might subject them to attack by creditors as fraudulent. Spearing Tool & Mfg. Co., Inc. v. Buccaneer Tool & Die Co., 141 Bankr 578 ED Mich, 1994).

2. Constructively Fraudulent Conveyances. Any conveyances made or obligations incurred by a person currently insolvent or rendered insolvent due to the conveyance is fraudulent unless the person receives fair consideration in return. MCL 566.14. Insolvency is determined by a balance sheet definition and is measured at the time the transfer occurs.

3. Conveyances made and obligations incurred without receipt of fair consideration when the transferor making same intends or believes that he will incur debts beyond his ability to pay as they mature. MCL 556.18.

4. Conveyances made without fair consideration when the owner engaged in or about to engage in a business or transaction for which the property remaining is unreasonably small capital. MCL 566.15.

5. Conveyances of partnership property or obligations thereon that renders the partnership insolvent if made without fair consideration to the partnership. This includes conveyances made by a partner with or without a promise by him to pay partnership debts. MCL 566.18.

B. Federal Bankruptcy Code.

Under Section 548, the trustee in bankruptcy may recover assets transferred within 1 year prior to the filing of bankruptcy.

C. Entireties Property

1. Many fraudulent conveyance cases in Michigan involve entireties property. As a general rule, the creditors of one individual spouse cannot attach property held as tenants by the entireties. However, by moving one spouse’s assets into entireties property, the assets are basically removed from the reach of the individual spouse’s creditors. Thus, a transfer of individual property to property held by the entireties may qualify as a fraudulent conveyance. King v. Comstoc, 245 Mich 156 (1928); Doe v. Ewing, 205 Mich App 605, (1994) (where a spouse was subject to a tort claim and transferred stock to entireties ownership, the transfer was a fraudulent conveyance because the loan did not constitute adequate consideration). These decisions have potentially far-reaching effects. It is quite possible that a spouse using individual assets to pay a mortgage upon entireties property is a fraudulent conveyance. Glazer v. Beer, 343 Mich 495 (1955); McCaslin v. Schouten, 294 Mich 180 (1940). Michigan National Bank v. Chrystler, Supra.

D. Exempt Property

1. Under Michigan state law, the transfer of exempt assets does not constitute a fraudulent conveyance. See e.g., Cross v. Commons, 366 Mich 665 (1953) (amount of mortgage not included for amount greater than homestead exemption, creditors may not complain of transfer of exempt property); Baltrusaitis v. Cook, 174 Mich App 180 (1988) (disclaimer of life insurance proceeds not a fraudulent conveyance in part because proceeds are exempt).

2. However, under federal bankruptcy law, the exempt status as determined on the date of the bankruptcy petition is not relevant in evaluating whether a transfer was a fraudulent conveyance. When the debtor transfers property, it voluntarily waives present or future exemptions. Even if the property is subsequently recovered, the exemption is not reinstated. Lasich v. Estate of A.N. Wickstrom (In Re Wickstrom), 113 Bankr 339 (WD Mich, 1990).

E. Partnerships.

A non-partner must provide fair consideration to the partnership, (not to the individual partners) to avoid characterization as a fraudulent conveyance. If a conveyance is made by the partnership to a partner and the partnership is or will become insolvent, it is fraudulent as to partnership creditors regardless of any promise by the partner to pay the partnership debts. MCL 566.18.