The new bankruptcy law changes the rules of asset protection.
Planners usually are not lawyers, but many will now
have to learn a little more about law. The potential impact of the new
federal bankruptcy law means that planning asset-protection strategies
should now be a bigger part of the advisor's practice, according to
lawyers and planners with experience in estate planning.
Gideon Rothschild, a New York-based trusts and estates attorney, warns that many high-net-worth professionals could now be at risk. Asset-protection strategies, he asserts, must change to address these new risks. "The new bankruptcy law changes how and when people can use these strategies and how people should plan for these problems," says Rothschild, the former chairman of the American Bar Association's Committee on Asset Protection.
Most financial planners agree. "Advisors should familiarize themselves with this, and should be ready with lawyer referrals for clients who need lots of information," says A. Raymond Benton, a certified financial planner with his own firm in Denver. Benton, interviewed in early October, notes that businesses and individuals were rushing to file for bankruptcy under the expiring code. A record 1.3 million Americans are expected to file for bankruptcy this year, about double the number of a decade ago, according to a recent article in the American Bankruptcy Law Journal. It labeled the numbers an "epidemic."
The Bankruptcy Abuse Protection and Consumer Protection Act of 2005 (BAPCPA) changed or tightened rules on things that include trusts, business liability, IRAs and homestead exemption laws. The new law, which took effect on October 17, represents the biggest change in the nation's bankruptcy rules since 1978. Under its provisions, it will be more difficult for families and individuals who earn more than the median income to qualify for bankruptcy protection under the code's Chapter 7, which wipes out debts and allows someone to begin again.
Many people now asking for bankruptcy protection will also be required to pay more to debtors than under the previous code. The new code also clarifies and, in some cases, expands protections from creditors for retirement accounts. "Wealthier Americans and even those of more modest incomes are going to find it more difficult to file for Chapter 7 protection," says Gary Schatsky, a New York attorney and planner.
Scott Farber, a certified financial planner in Natick, Mass., has mixed feelings about the new bankruptcy law. He also is a certified public accountant and a lawyer with extensive experience in trusts and estates. "I think the IRA protection is a very good thing. But I have some doubts about some of the new tests for people to qualify for wiping out their debts," Farber says.
Both Schatsky and Farber disagreed with the credit card industry's contention that there was "widespread abuse" of the previous law. Nevertheless, both agree with Rothschild that it is duty of advisors to alert clients to the greater risks of the new act.
"Perhaps asset protection is now more important because now one of the asset-protection vehicles, bankruptcy, is almost being taken off the table for every middle- and upper-middle-income American," says Schatsky.
But do advisors understand this? The problem is that advisors tend to view the client's world based from a tax and investment point of view. "We're planners. We're usually not lawyers. Even if we wanted to, we don't have the expertise to give legal advice," says Michael Kitces, a certified financial planner with his own practice in Colombia, Md.
Kitces says the new bankruptcy law magnifies an existing advisor problem: The average advisor, if he or she ever thinks about potential liability issues, usually doesn't think about asset protection until it is too late. "Once a lawsuit is filed against a client, it's usually too late to do anything," explains Kitces.
For example, advisors rarely consider the possibility of a client's children or business facing a lawsuit. That, adds Rothschild, can sometimes put client assets at risk.
"The best evidence of that is the number of wills I have seen where there is no effort to go beyond a credit-shelter trust. As a result, spouses and children inherit assets outright instead of in a trust, which is often a big mistake," Rothschild argues.
Credit-shelter trusts can help couples avoid estate taxes. However, when the second spouse dies the assets in the trust typically go to the children rather than remain in a trust, so they are no longer protected from creditors. "The planners fail to note the possibility that the children, after their receive this inheritance, could file bankruptcy. They could have judgments against them. Or maybe they will be subject to business failures," the attorney adds.
BAPCPA was the result of years of lobbying by frustrated banking and credit-card industry officials. The industry charged that many delinquent cardholders were abusing the previous bankruptcy code and maintained that the old code too easily allowed people to qualify for Chapter 7. The latter discharged debts and required very little repayment. That's even though many debtors could have repaid a bigger portion of the red ink, the credit card companies argued.
Therefore credit card companies and banks, in some seven years of lobbying Congress, worked to ensure that a new bankruptcy law treated the average delinquent cardholder much more stringently. But, under pressure from credit-card industry critics, last-minute provisions were added to the new law that were aimed at corporate rogues, such as WorldCom's Bernie Ebbers and others, Rothschild says. Congress, in taking aim at corporate heavyweights who committed fraud, also went after vehicles such as self-settled trusts and other asset-protection trusts, which have some legitimate uses, he says. A self-settled trust is one in which the client names himself the beneficiary.
Under the previous bankruptcy law, individuals could use these trusts to seek some protection from creditors, Rothschild says. "Self-settled and asset-protection trusts, whether they are onshore or offshore, have been dealt a blow," he adds.
Under BAPCPA, a new fraudulent transfer provision has been added, which means these trusts don't offer as much protection, Rothschild claims. He says that the provision of the new law is too stringent because "anyone" can be sued today.
Rothschild says that traditionally these trusts have been used as an asset-protection strategy for those in high-risk professions, professions in which one easily could be sued. Rothschild uses, as an example, a young doctor. "Let's say the doctor just came out of medical school and has inherited $5 million. He puts it in an asset-protection trust because he is in a business in which it is easy to be sued and have a $10 million judgment against him," R Rothschild explains. "Should he have his inheritance at risk if he makes one mistake over the course of a 40-year career? I don't think that is right."
Rothschild also argues that there is little evidence that most people who set up these trusts were engaged in fraud.
Still, Kitces isn't upset about any clampdown on self-settled trusts or other forms of domestic asset-protection trusts, neither of which he uses in his practice. "These trusts are based on untested theory and they must be in place for ten years to be recognized," he says. The new bankruptcy law also limits the homestead exemption. Under the new bankruptcy law, the homestead exemption is now limited to $125,000 per debtor. It also requires that one own the house for three years and four months, according to Kitces.
One of the common strategies of those filing for bankruptcy protection previously was to move to a state with easy bankruptcy laws, then put much of their assets in a home. In many states, all the assets in the home were exempt from bankruptcy proceedings.
Former baseball commissioner Bowie Kuhn used this tactic-he moved to Florida and bought a house after his business debts became onerous. Former football star O.J. Simpson also used this strategy and bought a house in Florida. The house and his pro football pension were shielded through the bankruptcy law from the multi-million legal judgments levied against him. Those winning judgments against him couldn't collect.
Planners now have to do more research, says Kitces. "It's not enough anymore just to tell the client that he should buy a house in Florida or some other state," he says.
IRA rules have changed as well. Previously, some states had an unlimited exemption on an IRA in a bankruptcy action, but in other states there was no protection of IRA assets from a bankruptcy proceeding. Under the new federal law, bankruptcy protection is capped at $1 million for IRAs. However, the $1 million cap doesn't apply to rollover IRAs.
"You should be very careful in terms of IRA rollovers, not to merge them because you could have $20 million in a rollover IRA and it would still be protected," says Benton, the Denver planner. He also adds that some rollover IRAs of less than $1 million should not be merged. "No IRA should be merged if one thinks it has the potential to grow to over $1 million," Benton cautioned.
Farber believes that advisors should draw up a balance sheet of client assets that might be subject to legal dangers. And even those advisors who take such a step, he points out, cannot guarantee that all assets are safe.
"The problem is that nothing is 100% bulletproof," Farber says. He says insurance is often a good way of protecting an asset. But he also wonders how far each client wants to go in protecting a business or some other property. "Almost any asset can be vulnerable to creditors or legal problems. The issue is to devise strategies that make sense for each client," Farber says.