Asset planners such as CPA’s can be a great resource for avoiding tax liability or using trusts to avoid probate. However, such asset managers are often unfamiliar with bankruptcy laws, mainly bankruptcy exemptions, and their laser-like focus on short term gains and tax avoidance can cost you big time if you find yourself in need of bankruptcy protection.
Because of this potential blind spot, it is imperative to consider how asset planning moves will affect you in a potential bankruptcy case. This is because transfers of business and personal property are heavily scrutinized by the bankruptcy court, and many moves that look like a good idea to your CPA can actually cause you to lose the benefit of the bankruptcy exemptions, and worse.
Exempt property exists in every state as a means of protecting people with a base amount of property necessary for survival. It is essentially a list of assets and values prescribed under state or federal law which cannot be taken from you by a creditor, whether through a lawsuit or in bankruptcy.
Exempt property in Colorado, where I practice, includes $60,000 of home equity, $5,000 of vehicle equity, and $20,000 of stock in trade. Remember, the equity is the value of the property less the amount owed to secured debt on the property (i.e., mortgage, auto loan, etc.). While the list of Colorado exemptions includes more than these three exemptions, I bring mention these three because they are often overlooked for asset planning purposes.
Home ownership through a Trust
A common asset planning technique is to purchase your home through a trust in order to be able pass it on to your relatives outside of probate when you die. In general, probate is an expensive and time consuming process which people seek to avoid through asset planning.
Unfortunately, most don’t understand the downside of this move when it is made. That downside is that the equity in your home no longer falls under the homestead exemption because it is owned through a trust. While assets in a trust may be secure from your creditors in bankruptcy if the trust is a valid spendthrift trust, such trusts are restrictive and most do not utilize valid spendthrift trusts for purposes of holding real estate. Therefore, this move often prevents you from claiming the $60,000 homestead exemption (which is $90,000 if you are over 60) and exposes your home equity to your creditors.
Cha-ching – you’ve just help fund a banker’s bonus.
Fortunately, ownership of the home through a trust can often be undone prior to filing bankruptcy. However, if you get sued and there is a judgment against you, such a move prior to filing bankruptcy could be viewed as a fraudulent conveyance.
Placing personal assets in your small business
This is an old favorite of CPAs for tax planning purposes. It entails pledging a personal asset such as vehicle to your small business so that you can depreciate the asset against your business income. While the depreciation can often enable you to realize significant tax benefit, it has downside you need to understand.
In the case of pledging a vehicle to your business, this move prevents you from claiming the $5,000 motor vehicle exemption for your vehicle if your business is a legal entity such as an LLC, corporation or partnership. For other assets pledged to a legal entity, this move denies you the $20,000 stock in trade exemption (which may also apply to your vehicle). The trade-off for your tax deduction is often losing the ability to protect the asset against your creditors.
While it may also be possible to undo these moves prior to bankruptcy by distributing the assets back to you, this can be risky and costly. The distribution often carries fresh tax liability which cannot be discharged in bankruptcy.
Furthermore, if such a distribution is made after a creditor gets a judgment against you, it may be viewed as a fraudulent transfer. There is also risk of such a transfer being found to be fraudulent if the business is insolvent when you make the distribution, or if the asset distributed is secured by a corporate debt (ex., line of credit secured by the assets of the business).
Asset planning is an important exercise and one which should look at all of the facets of your financial situation. Unfortunately, many asset planners do not appreciate risk of defaulting on debt when giving advice about asset planning. As the economic events over the last few years have shown, this is a major oversight. When considering moving assets from personal ownership to ownership through a legal entity such as a corporation or trust, you should know that such moves may well expose an otherwise protected asset to your creditors. I suggest seeking the advice of a bankruptcy attorney before making any transfers of property while in debt. While you may not need to file bankruptcy, many firms such as Wink & Wink will perform bankruptcy-smart asset planning at a reasonable cost.