For a debtor’s counsel, the easiest bankruptcy case involves a client with little or no non-exempt property. To quote Kris Kristofferson from his ballad “Me and Bobby McGee,” “freedom’s just another word for nothin’ left to lose.” But for many individuals who qualify for Chapter 7 relief in spite of the substantial hurdles imposed by the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005 (those with incomes below the state median or whose debts are primarily business related), the issue of exemption planning remains important. Attorneys representing clients contemplating bankruptcy must be familiar both with state and federal exemption statutes, and with inconsistent case law, that may limit a debtor’s ability to take full advantage of the protections to which the debtor is entitled.
As a general matter, upon the filing of a petition for bankruptcy, “all legal or equitable interests of the debtor in property” become property of the bankruptcy estate and will be distributed to the debtor’s creditors. 11 U.S.C. § 541(a)(1). To help the debtor obtain a fresh start, the Bankruptcy Code permits the debtor to exempt from the estate certain interests in property, such as one’s car or house, up to certain values. For counsel, the starting point in bankruptcy planning is a working knowledge of the exemption provisions.
Understanding the Exemptions Available under State and Federal Law
Under section 522(b), a debtor domiciled in Utah for the preceding two years may exempt individual retirement accounts, 401(k) accounts, and similar retirement funds, see 11 U.S.C. § 522(b)(3)(C), along with the property described in the Utah Exemptions Act, see Utah Code Ann. § 78-23-1 et seq. For example, in Utah a couple may exempt as their homestead, under section 78-23-3, up to $40,000 in equity of their jointly owned primary personal residence or (notice the disjunctive) $10,000 in value of jointly owned real property that is not their primary personal residence. Similarly, section 78-23-5 allows a debtor to exempt his interest in a laundry list of personal property, including:
a) a burial plot;
b) disability, unemployment, and medical and veterans benefits;
c) alimony, child support, and qualified domestic relation order assets;
d) household appliances, carpets, wearing apparel, and beds and bedding;
e) provisions sufficient for 12 months (this “food storage” allowance is apparently unique to Utah); and
f) life insurance benefits (not pledged as collateral) paid or payable to the debtor or his family.
Section 78-23-8 also protects, subject to dollar limitations, furniture, animals, books, musical instruments, heirlooms, tools of trade ($3,500), and one motor vehicle ($2,500).
From a planning standpoint, surely the most interesting and flexible exemption arises from the Utah Legislature’s 2005 amendment to the Exemption Act, which repealed former section 78-23-7 and inserted in section 78-23-5(1)(a)(xiii) an exemption for “proceeds and avails of any unmatured life insurance contracts owned by the debtor, excluding any payments made on the contract during the one year preceding a creditor’s levy or execution.” This exemption for the cash value of a life insurance contract is unlimited in amount and, within the confines of the one-year lookback, should provide a remarkable opportunity for the prudent individual to shield assets from the reach of creditors, both in and out of bankruptcy.
A careful review of the statutes will help debtor’s counsel to describe assets that are exempt, but only experience will enable an attorney to focus his client’s attention on assets that are not exempt, and thus subject to administration by the trustee. Early in the planning process counsel should advise his client that the following are not protected and may be liquidated by the trustee: subject to the tracing provisions of section 78-23-9, cash; non-retirement financial accounts such as checking, savings, or brokerage accounts; contract claims; certain lawsuit claims; and the non-exempt value of otherwise exempt assets. Unlike the wildcard provision in the federal exemption scheme, section 522(d)(5), the Exemption Act does not protect cash in a debtor’s checking or savings account on the petition date. Likewise, a trustee may sell a car or house, notwithstanding a proper claim of exemption, if the net sale proceeds after paying consensual liens, costs of sale, and the allowed exemption (returned in cash to the debtor) will provide a benefit to creditors.
Advising the Client of His Duties and All Available Exemption Claims
An effective exemption plan begins with the client’s full, complete, and candid disclosure of all of his property, whether real, personal, or intangible. The attorney must advise the client of the client’s duty under section 521 to disclose all assets and of the sanctions that may be imposed for failure to do so, including: 1) loss of an otherwise allowable exemption, see section 522(g); 2) loss of the right to a discharge, see section 727(a)(2); and 3) loss of liberty, see section 18 U.S.C. § 152.
Once the client has provided a complete list of assets, the attorney can begin to advise the client of strategies to use in obtaining an allowable exemption for as much property as possible. For example, since cash is not exempt, the attorney should counsel his client on the prudent purchase of exempt provisions to carry his family through the period following the filing of the petition. Assets with significant values above allowable exemption limits may be sold, with the net proceeds used to purchase needed exempt assets (to replace a worn-out refrigerator or stove, for example), or to pay down an otherwise nondischargeable obligation such as a tax debt, student loan, or child support arrearage. Keeping in mind that prebankruptcy sales and transfers must be disclosed, and that some transfers may be avoidable under section 547 (preferences) or section 548 (fraudulent conveyances), low-dollar exemption planning rarely results in the kind of scrutiny that leads to litigation. Nor should it.
Providing the Client with an Informed Understanding of Pre-Bankruptcy Planning Under Current Law
The real challenge arises with converting large amounts of non-exempt assets to exempt property. For example, a client with $200,000 of non-exempt equity in his homestead might ask if he can sell his house and purchase with the proceeds a single premium whole life insurance policy, claiming the policy as exempt under section 78-23-5(1)(a)(xiii). Although the attorney’s response should be in the affirmative, case law addressing aggressive exemption planning requires a more deliberate approach because courts have been inconsistent in their attempts to describe the boundaries of permissible bankruptcy planning.
The analysis begins with the premise that “the conversion of non-exempt to exempt property for the purpose of placing the property out of the reach of creditors, without more, will not deprive the debtor of the exemption to which he would otherwise be entitled.” Marine Midland Bus. Loans, Inc. v. Carey, 938 F.2d 1073, 1076 (10th Cir. 1991). Carey first cites the legislative history for the proposition that exemption planning permits the debtor to make full use of the exemptions to which he is entitled under the law. However, the Tenth Circuit then states that simple exemption planning can be found fraudulent when tested against the classic badges of fraud, such as whether the conversion was concealed or disclosed, whether the conversion took place “immediately before the filing of the bankruptcy petition,” and the monetary value of the assets converted. The Tenth Circuit ultimately affirmed the lower court’s determination that the debtor’s systematic liquidation of non-exempt assets to pay down the mortgage on her homestead did not rise to the level of fraud necessary to deny her discharge or her exemption. It is interesting to note that Congress addressed the conduct complained of in Carey when it enacted new section 522(o), which imposes a 10-year lookback to recover increases in homestead value relating to transfers of non-exempt assets “with the intent to hinder, delay or defraud a creditor.”
In Bank of Oklahoma, N.A. v. Boudrot, 287 B.R. 582 (Bankr. W.D. Okla. 2002), the bankruptcy court held that the debtors’ liquidation of their non-exempt savings accounts, in the amount of $54,000, and use of the proceeds to pay down the mortgage on their exempt homestead was such as to warrant denial of their discharge. Noting the lack of a coherent body of law on the subject, the court cited another source for the proposition that “fraud in bankruptcy planning appears to enjoy the same precise definition as pornography – the federal courts know it when they see it.” Id. at 585.
And in Mathai v. Warren (in re Warren), Adv. No. 04-2671 (Bankr. D. Utah March 28, 2005) (unpublished memorandum decision, Boulden, J.), aff’d, 350 B.R. 628 (Table), 2006 WL 2882816 (10th Cir. B.A.P. 2006), the court noted the debtor’s pattern of sharp dealing, consistent with “a scheme to liquidate each and every asset, no matter the loss, to prevent payment to his creditors.” The court stated that although “some pre-bankruptcy planning is appropriate,” there exists a “precarious balance” between the competing interests of debtors and creditors in pre-bankruptcy planning. The court was struck by the debtor’s animosity toward the creditor and found the debtor abused pre-bankruptcy planning because his purpose was to place assets out of the reach of the creditors.
A different approach is suggested in Murphey v. Crater, 286 B.R. 756 (Bankr. D. Ariz. 2002), which draws a rational distinction between transfers of assets that are truly fraudulent and those conversions of non-exempt assets to exempt assets that do not support a finding of fraudulent intent. The court held that unless the creditor that seeks to deny a debtor’s discharge based upon his pre-bankruptcy exemption planning shows some deception or concealment, an insider transaction, a fraudulent conveyance, a secretly retained possession or benefit, or debtor explanations that lack credibility, the presence of other badges of fraud that are not themselves intricately indicative of fraud (such as the timing of the transmutation or the amount at issue) are insufficient to shift to the debtor the burden of going forward, even if all of the debtor’s non-exempt assets are converted into exempt assets just after the debtor is sued and just before the debtor files for bankruptcy.
Given the express Congressional statement that conversion of “nonexempt property into exempt property before filing a bankruptcy petition…is not fraudulent as to creditors, and permits the debtor to make full use of the exemptions to which he is entitled under the law,” ¹ one could easily argue that factors relating to timing or the amount converted from non-exempt to exempt assets are policy matters that should be left to the legislature. For example, under BAPCPA, Congress constrained the “Florida option” by imposing a 730-day residency requirement before allowing a debtor to claim the homestead of his new domicile, see section 522(b)(3)(A), and directly limited efforts to convert non-exempt assets into exempt homestead assets if made with the intent to hinder, delay, or defraud a creditor within ten years of the petition date, see section 522(o). The Utah Legislature has made similar policy determinations by providing for unlimited exemptions for individual retirement accounts, see Utah Code Ann. § 78-23-5(1)(a)(xiv) and unmatured life insurance contracts, see id. § 78-23-5(1)(a)(xiii), while at the same time limiting the protection to amounts contributed to such plans or contracts one year or more prior to bankruptcy or execution. Unfortunately, a rational policy argument is of small comfort to a client deciding whether to engage in otherwise lawful exemption planning, knowing that one risks offending a trustee or judge because one took advantage of an unlimited exemption shortly before filing a bankruptcy petition.
Incorporating Ethical Responsibilities
In light of the case law surrounding the issue of bankruptcy planning, how should attorneys advise their client? A review of an attorney’s ethical duties provides some guidance. The preamble to the Utah Rules of Professional Conduct provides that “as advisor, a lawyer provides a client with an informed understanding of the client’s legal rights and obligations and explains their practical implications. As advocate, a lawyer zealously asserts the client’s position under the rules of the adversary system.” Rule 1.1 requires that an attorney must provide competent representation to a client, and Rule 1.4(b) provides that a lawyer must explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation. Further, Rule 1.2(d) provides that while a lawyer may not counsel a client to engage in fraudulent conduct, the lawyer “may discuss the legal consequences of any proposed course of conduct…and may counsel or assist a client to make a good faith effort to determine the validity, scope, meaning or application of the law.” An attorney representing a debtor in bankruptcy thus has the following duties:
1. To understand the exemptions available under state and federal law;
2. To advise the client of the client’s duty to fully disclose all property and prepetition transfers;
3. To assert for the client all available good faith exemption claims; and
4. To provide the client with an informed understanding of the client’s ability to engage in exemption planning and to explain the practical implications given the current state of the case law.
Bankruptcy exemption planning is an area of law demarked by shades of gray rather than bright lines. A working knowledge of the exemption statutes and relevant case law will assist attorneys in leading their client to an informed decision of how to make best use of the exemptions to which the client is entitled.
The Mathai v. Warren decision was recently affirmed by the Tenth Circuit. 2008 WL 62557.
1. H.R. Rep. No. 595, at 361 (1977), as reprinted in 1978 U.S.C.C.A.N. 5963, 6317; S. Rep. No. 989, at 76 (1978), as reprinted in 1978 U.S.C.C.A.N. 5787, 5862.