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How The Bankruptcy Law Affects Wealthy Individuals

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was primarily designed to make it more difficult to walk away from credit card debt. Along the way to passage, however, the law also took on important implications for wealthy individuals hoping to protect assets from creditors.

One key change involves homestead exemptions. In most states, those who declare bankruptcy are allowed to shield from creditors only a limited amount of home equity. However, Kansas, Florida, Iowa, South Dakota, and Texas have provided an unlimited homestead exemption that protects a primary residence from creditors regardless of the value of the home. As Congress wrangled for years over the ultimate shape of bankruptcy reform, these unlimited exemptions got frequent play in the press particularly when it was noted that disgraced (and sometimes indicted) executives from Enron could plow millions of dollars into mega-mansions in Florida and Texas while declaring personal bankruptcy and walking away from their obligations to employees and shareholders.

Effective for bankruptcy filings made after October 17, 2005, anyone who has had a run-in with securities laws will have strict limits on the ability to shelter assets in a personal residence. Specifically, individuals who have been charged with financial fraud, securities violations, any criminal act, or have a judgment against them arising out of a case of serious physical injury or death will be limited to a homestead exemption of only $125,000. And even that won’t be available until after a 40-month waiting period, during which creditors can attack home equity. Prior to passage of the bankruptcy law, several states had waiting periods of as little as six months.

The 2005 law also makes life more difficult for creators of asset protection trusts, also known as self-settled trusts because they’re set up so that the grantor is also a beneficiary. Doctors, lawyers, corporate executives, and other high-income individuals often establish such trusts to protect assets against future claims. But as with the homestead exemption, these trusts carry the potential for abuse. Individuals who know they’re going to be sued have been able to create a self-settled trust now available in eight states and offshore to squirrel away assets. Then they can declare bankruptcy and avoid making good on creditors’ claims.

If assets are transferred to a self-settled trust with the intent to hinder, delay, or defraud current or future creditors, the asset transfer will be deemed fraudulent if the person moving the assets declares bankruptcy within 10 years. Under existing provisions in most states, the maximum period covered by such fraudulent transfer provisions is four years.

Though it curtails the illicit use of self-settled trusts, the bankruptcy law does appear to recognize these planning vehicles as a legitimate way to protect assets, notes Gideon Rothschild, a partner at New York City law firm Moses & Singer. Now, for example, a young physician concerned about malpractice liability could establish a self-settled trust early in his or her career. As long as at least a decade passes before the trust is needed, it should be able to shield assets from creditors’ claims.

The law has other potential benefits as well. While IRS-approved “qualified” pension and profit-sharing plans have long been off-limits to creditors, protection for assets rolled into individual retirement accounts has depended on state law, and most states have provided only limited safeguards. IRAs created by the transfer of assets from a qualified plan will be afforded full protection against creditors, just as if the assets remained in a qualified plan. The bankruptcy law also helps contributory IRAs, established through annual contributions, though only $1 million in assets is shielded.

Another plus: The law provides greater protection for section 529 college savings plans. Contributions made at least two years before filing bankruptcy are largely shielded from creditors, and deposits into a 529 between one and two years prior to filing get a $5,000 exemption.

Because many states have opted out of the federal bankruptcy exemption system, there is some uncertainty about how the U.S. law will affect state provisions. Courts will have to sort out the issues, says Rothschild. In the meantime, though, the 2005 act makes it more important than ever to address asset protection issues early in the financial planning process.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.

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