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Forbes: Protection Time

Protection Time
Janet Novack, 06.06.05

The new bankruptcy law is tough on debtors. So fill your retirement accounts. Retitle your property. Move to Florida. Get divorced.
You might not have paid much attention in April when President Bush signed a rewrite of personal bankruptcy laws long sought by credit card companies. After all, you pay your bills. You have medical insurance. You make a nice salary, and you have a six- or seven-figure net worth. The changes couldn’t affect you.

But they could–if you’re a doctor, accountant, lawyer or other professional at risk of a malpractice suit; an officer or director of a corporation or charity; own rental property; or have a teenager learning to drive. The fact is, anyone can get hit with a ruinous legal judgment. Moreover, many an entrepreneur has filed for a Chapter 7 “fresh start” personal bankruptcy after personally guaranteeing loans for a can’t-miss venture that did.

In a Chapter 7 you forfeit all your “nonexempt” property and then get to walk away from most of your unsecured debts, including liability judgments resulting from negligence. A lot can be exempt: your retirement accounts; and depending on your state, possibly all your home equity, the cash value of your life insurance and even all your annuities. It’s no accident that residents of states with the most liberal exemptions are more likely to gamble on starting their own businesses. (So says a study coauthored by Michelle J. White, professor of economics at the University of California, San Diego.)

After Oct. 16, however, if your income is above the median for your state–for a family of four that’s $55,000 in Texas, $68,000 in California, $69,000 in New York and $87,000 in New Jersey–you’re likely to be denied a Chapter 7 fresh start. Instead, you could be pushed into a Chapter 13 plan requiring you to use all your disposable income for five years to repay unsecured creditors. “Now,” says attorney Jay D. Adkisson, who coauthored a book on asset protection, “the last place a debtor wants to be is in bankruptcy.”

Debtor-unfriendly changes run throughout the new law. Consider the calculation of “disposable income,” supposedly what’s left after you’ve paid all secured debts (like your mortgage) and living expenses. In the old law this was based on your actual costs, provided a judge found them reasonable. In the new law housing allowances are based on Internal Revenue Service standards for each county. Should your mortgage payment exceed the IRS housing limit–say you’re paying $4,000 monthly and the IRS number is half that–tough. The $2,000 difference will likely be counted as “disposable” income and added to what you owe creditors each month. Alaska attorney Thomas Yerbich, an officer of the American Bankruptcy Institute’s consumer committee, says Congress meant to force debtors to make lifestyle changes.

We’re not just talking about giving up eating out. There’s no allowance in Chapter 13 for repaying student loans (which you must do) or for paying current college bills. The allowable kindergarten through 12th grade tuition is just $1,500 per child per year. In theory you get to keep your assets in a Chapter 13. In practice most affluent folks will end up spending down assets, including possibly exempt ones, during a five-year repayment plan.

If your debts are too large (more than $922,975 for a couple), you’re not eligible for Chapter 13 and get shunted to Chapter 11. This chapter, used primarily by businesses, is arguably more flexible than 13, but it’s no refuge for the rich–a new provision requires individuals in Chapter 11 to put five years of disposable income into the pot for unsecured creditors.

The pols also squelched a bankruptcy ploy that’s been used by high-profile debtors: dumping your net worth into a mansion in one of the eight jurisdictions (Florida, Texas, Arkansas, Iowa, Kansas, Oklahoma, South Dakota and Washington, D.C.) that exempt the dwelling’s full value. Now you can’t claim a state’s so-called “homestead exemption” until you’ve lived there two years (up from as little as 91 days), and your exemption is capped at $125,000 unless you have owned the house (or another in the same state) for at least 40 months. The law also caps your homestead exemption at $125,000 if your debt results from securities fraud or from a criminal act or reckless misconduct that caused death or serious injury within the past five years. Yet another provision reduces your exemption if in the ten years before bankruptcy, you attempted to defraud creditors by liquidating nonexempt assets and pumping the cash into home equity.

But none of this affects creditor-debtor cases in state courts–which means Florida’s status as a haven for those ducking debts is secure so long as the shirkers stay out of federal bankruptcy court. The Florida courts have ruled that the state’s homestead exemption applies even if a debtor acquires his home with “the specific intent to hinder, delay or defraud” creditors. In March a Florida court protected the 9,933-square-foot waterfront manse owned by former Conseco executive Ngaire Cuneo. After defaulting on loans she used to buy Conseco stock, Cuneo and her husband sold $8 million in securities, took out a $2.45 million mortgage on their Connecticut home and bought the Florida property for $10.2 million.

Not ready to flee to Florida? Here’s how to protect yourself in this new creditors’ world.

Get An Umbrella
A retired attorney with a $4 million net worth came to New York lawyer Gideon Rothschild recently after his wife was in a car accident and was sued for $10 million. Rothschild was dismayed to learn the couple carried only $100,000 in auto liability coverage and no umbrella insurance policy. “The first point of protection is to get an umbrella,” he says. “Not everyone needs to have an offshore trust,” adds Rothschild, an expert on offshore trusts and other arcane asset-protection planning strategies.

An umbrella unfurls when the limits on your homeowner’s and auto liability insurance policies are exhausted. You can buy a $1 million umbrella for under $200 a year. An average Chubb customer pays $500 a year for a $5 million umbrella covering two homes and two cars. A good umbrella should cover you for sundry events such as an accident on rented jet skis or liability while you do volunteer work. But the list of “exclusions”–stuff that isn’t covered–in most policies has been growing for 15 years, says Minnesota agent Jack P. Hungelmann, author of Insurance for Dummies. Since exclusion lists vary, shop around based on your own risks. Example: Most umbrellas now exclude long-term pollution damage, but some still cover damage from a sudden catastrophe. Say your in-ground heating oil storage tank springs a leak.

Stuff Your Retirement Accounts
In one of its few debtor-friendly provisions the new law strengthens protection for retirement accounts. Any money in a qualified retirement plan, such as a 401(k), even one maintained by a solo owner, is exempt in bankruptcy, as is all money rolled from a pension plan into an Individual Retirement Account and up to $1 million in regular or Roth IRA accounts. Previously, IRAs and solo-owner plans weren’t as well protected in bankruptcy in all states. If you’re having financial problems, keep making 401(k) contributions and borrow from your 401(k) if you have to–in Chapter 13, repayment of a 401(k) loan is now treated as a necessary expense.

While the new protection should extend to an IRA inherited by a spouse, it’s unclear whether it applies to IRAs inherited by a child, notes Boston trust lawyer and IRA expert Natalie Choate. If your child has potential liability or creditor risk, leave the IRA in a trust. (This gets a bit tricky: A trust can extend an IRA’s tax deferral and stretch out distributions, but only if all beneficiaries are individuals and only for the life expectancy of the trust’s oldest beneficiary.)

What if you’re fending off creditors in state courts? Federal pension law protects all but solo-owner pension plans; IRA protection depends on state law.

Fund Education Accounts
The new law also creates an exemption for funds put in a 529 college savings plan at least two years before you file for bankruptcy, so long as the beneficiary is a child or grandchild. Remember, however, that if you’re fending off creditors in a state court, state laws apply, and they may not give as much protection. So when a couple contributes to a 529, if one spouse is less likely than the other to be sued, the low-risk partner should be named the account’s “owner.”

Limit Your Business Risks
If you run a small business or are self-employed, insure–and incorporate. If your part-time delivery man hits a pedestrian, then a corporate shell, such as a limited liability company, can provide an extra layer of protection for your personal assets. If you own several rental properties, consider holding each in a separate LLC. Warning: A shell won’t protect you from liability for your own negligence–say, as the architect of a building that falls down. That’s why errors and omission insurance is a good idea even though it can cost thousands. (Check your professional association; some offer attractive group rates.)

Do you occasionally conduct your business from your home? Try to get a business “endorsement” for your homeowner’s and umbrella policies. Otherwise, if a FedEx man or a client slips on your steps, your insurer is likely to say you aren’t covered. And if you’re an employee who sometimes telecommutes, get an “incidental occupancy” endorsement; it might add $20 to your premiums, insurance agent Hungelmann says.

Finally, keep your business and personal debts separate: Don’t use your “small business” credit card for personal expenses, and if you tap your home equity to fund your business, keep records showing where the money went. Why? The provision in the new law denying a Chapter 7 fresh start to families with above-median income seems to apply only if what you owe is primarily “consumer debt.” If your debts stem mainly from business borrowings or a malpractice award, you should be able to use Chapter 7, says attorney Yerbich. Creditors may well fight this line of reasoning, but it’s worth a shot.

Brush Up On Your State Law
Get to know your state’s exemptions and property laws (summaries of each are at; this arcane stuff could dramatically affect how you hold and title your assets and even whether you buy term insurance or invest in a whole life policy. Example: Illinois’ homestead exemption is a miserly $7,500, but you can protect the entire cash value of life insurance and annuities so long as the beneficiary is a dependent. Maryland has no homestead exemption whatsoever, yet it’s one of the states allowing you to hold property as “tenants by the entirety.” Generally, creditors of just one spouse can’t reach property titled this way.

Transfer Assets Early
The best time to transfer assets–perhaps to your spouse, kids or a family partnership–is before you’ve been sued or threatened with a suit. Otherwise a court might decide you intended to stiff creditors, brand the transfer “fraudulent” and reverse it. The new law encourages judges to look back at transfers for longer periods before a bankruptcy filing. One section even creates a special ten-year lookback for transfers to certain trusts you create for yourself. Since 1997 seven states, with Alaska and Delaware in the forefront, have passed laws protecting assets in such “self-settled spendthrift” trusts from creditors. What’s unclear is how well these trusts protect assets for the out-of-staters who use them. Better to transfer assets into a straightforward trust for the kids and grandkids and to do it as part of your estate planning.

Under the new law even if only one spouse files for bankruptcy, the other’s future earnings can still be at risk. Say one spouse supports the family with a job, while the other runs a struggling business. If the entrepreneur goes bankrupt, some of what the solvent spouse spent on the family is imputed as income to the bankrupt one. That could make the bankrupt spouse ineligible for a Chapter 7 fresh start and boost the amount he must pay each month for five years in Chapter 13. The cold-hearted solution: Before filing for bankruptcy, file for a divorce.

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