AUTHORIZE SPECIAL MEASURES TO STOP OFFSHORE TAX ABUSES by giving Treasury authority to take special measures against foreign jurisdictions and financial institutions that impede U.S. tax enforcement;

STRENGTHEN DETECTION OF OFFSHORE ACTIVITIES by requiring U.S. financial institutions that open accounts for foreign entities controlled by U.S. clients, open accounts in offshore secrecy jurisdictions for U.S. clients, or establish entities in offshore secrecy jurisdictions for U.S. clients, to report such actions to the IRS;

CLOSE OFFSHORE TRUST LOOPHOLES by taxing offshore trust income used to buy real estate, artwork and jewelry for U.S. persons, and treating as trust beneficiaries those persons who actually receive offshore trust assets;

STRENGTHEN PENALTIES on tax shelter promoters by increasing the maximum fine to 150% of their ill-gotten gains, and on corporate insiders who hide offshore stock holdings by increasing the maximum fine on them to $1 million per violation of U.S. securities laws;

STOP TAX SHELTER PATENTS by prohibiting the U.S. Patent and Trademark Office from issuing patents for "inventions designed to minimize, avoid, defer, or otherwise affect liability for Federal, State, local, or foreign tax"; and

REQUIRE HEDGE FUNDS AND COMPANY FORMATION AGENTS TO KNOW THEIR OFFSHORE CLIENTS by requiring them to establish anti-money laundering programs like other U.S. financial institutions, under regulations to be issued by the Treasury Department.

Mr. Bob Roach, the Senior Investigator for the Senate Permanent Subcommittee on Investigations was a guest of Jay Adkisson on a panel at the Southern California Tax & Estate Planning Forum in San Diego last October. Mr. Roach spoke at great length on S.681 and their ramifications for offshore planning.

The "must listen" audiotape from the panel, which included several other great speakers on asset protection related topics, is available by contacting Mr. Lonnie McGee at (619) 696-6773.

ARTICLE

Continuing Concealment
Doctrine and
Retained Interests

Wilferd v. Wardle, 2007 WL 391583 (D.Utah, Feb. 1, 2007)

Wardle bought two businesses from the Wilferds, giving them a promissory note for $1.2 million. Wardle later defaulted on the note and the Wilferds sued him. While this case was pending, Wardle sold his residence for $10 to his wife by quit claim deed claiming "asset protection" reasons for the transfer.

More than a year later, Wardle filed for bankruptcy but omitted that he had owned the residence which he had transferred to his wife. The bankruptcy court denied Wardle's discharge, applying what is known as the Continuing Concealment Doctrine.

A bankruptcy court is required to discharge the debts of a debtor under section 727(a)(2) unless the debtor has engaged in certain misconduct, such as fraudulently transferring or concealing property within one year before the filing of the bankruptcy petition.

Wardle claimed that because he transferred his residence to his wife more than one year before he filed for bankruptcy, that section 727(a)(2) would not apply.

The court rejected Wardle's argument by application of the Continuing Concealment Doctrine, which allows the application of section 727 to deny a discharge so long as property continues to be concealed within the one year period.

Wardle claimed that the Continuing Concealment Doctrine should not apply to his case because he lacked any intention to hinder, delay or defraud creditors.

The court rejected this argument on the grounds that the Continuing Concealment Doctrine can be satisfied by a transfer or title coupled with retention of the benefits of ownership. Importantly, the court also noted that there was evidence of Wardle's purpose to defeat anticipated creditors as found in Wardle's own deposition:

Q. You had indicated that you assigned your title in the home to [your wife.]

A. Yes.

Q. What consideration did you get for that?

A. What do you mean by consideration?

Q. Did you get any money from her?

A. A $10 transaction.

Q. All right. And so why did you do that?

A. Just asset protection.

Q. You wanted to protect the home from the Wilferds?

A. From the Wilferds, from anybody.

Wardle's contention that he had no actual intent to defraud creditors was belied by a number of factors, most importantly that "retention of the use of the transferred property very strongly indicates a fraudulent motive underlying the transfer."

Our analysis:

Bankruptcy is an arena to be avoided for those who have attempted to engage in asset protection planning. The primary purpose is not to protect the debtor, but instead is to marshal the debtor's assets for the benefit of creditors. The bankruptcy laws create many traps for debtors and many avenues for creditors to circumvent debtors' schemes.

This is another case where the admission by the debtor that he engaged in asset protection planning tended to indicate an actual intent by the debtor to engage in planning meant to hinder, delay or defraud creditors. One cannot testify that "asset protection" was a substantial reason for planning, and expect that the planning will survive a fraudulent transfer analysis.

Because of the Continuing Concealment Doctrine, a debtor may be denied a discharge for attempting to hide his interest in a personal residence even if the residence was transferred some time before the debtor files for bankruptcy, if there was any evidence (including an admission that the debtor engaged in asset protection planning) that the debtor meant the transfer to remove assets from the reach of creditors.

Although Wardle claimed that he had sold his residence to his wife, in fact he continued to benefit from the residence. Absent evidence of a transaction for reasonably equivalent value, which a gift or transfer for nominal consideration will never satisfy, the transfer of a residence in which one continues to live may be ineffective for asset protection purposes.

For estate planners, this point is particularly relevant in the case of a transfer to a Qualified Personal Resident Trust (QPRT) in which the transferor retains the right to live in the residence for a period of years.  During the fraudulent transfer limitations period, the residence will be subject to claims of creditors of the transferor.  This period lasts for four years from the date of the transfer in most states.

In California, for example, the four-year limitations period in some circumstances does not begin to run until  a creditor has obtained a judgment.  Therefore, the transfer of a California residence to a QPRT may be subject to a fraudulent transfer claim for seven years from the date of the transfer, the period of unique “extinguishment” statute of limitation under the California UFTA. That's an awfully long period of time to wait to see if a transfer might survive a fraudulent transfer challenge.

Even after the limitations period expires, although the residence might not be available to the creditors of the transferor, the transferor's retained interest in the QPRT will be available to her creditors.  If a creditor were able to force the sale of the residence within the QPRT, the creditor would be able to attach the income stream of the grantor retained annuity trust (GRAT) to which the QPRT would convert for the remainder of the QPRT term. There are other potential flaws with a QPRT as an asset protection tool, but you get the picture.

Asset protection is not a game, and those who attempt to game the system will find that judges may use obscure rules such as the Continuing Concealment Doctrine to get around a ploy by the debtor that might otherwise technically avoid being a fraudulent transfer. Admitting that a transfer was done for asset protection reasons sends up a bright red flag and, as here, makes the judge both suspicious and willing to thwart the debtor's intent.

Retaining interests is particularly dangerous in asset protection planning, since retained interests can by themselves support a finding that an arrangement was a fraudulent transfer. It is skating on thin ice to keep strings over an asset or maintaining the beneficial use of an asset that was purportedly transferred away. That you might be able to do it for tax purposes will be of absolutely no relevance at all when creditors come a'calling.

Saying that a debtor did something for asset protection reasons can be, in some circumstances, tantamount to an admission of the debtor's intention to engage in a fraudulent transfer. Since there is never a need to make such an admission, just don't put your clients in a position where they might have to do that.

ARTICLE

Circular Transaction
Bites Client On Both Ends

Bermant v. Broadbent, 2006 WL 3692661 (D.Utah, Slip Copy Dec. 12, 2006)

Merrill Scott & Associates, Ltd., was a Salt Lake City law firm that had established a variety of entities to help their clients with their tax planning, asset protection, and investment needs. These entities included Gibraltar Permanente Assurance, Ltd., an offshore insurance company, Legacy Capital, and Fidelity Funding, Inc.

Self-proclaimed "Advisors to the Affluent", the Merrill Scott aggressively marketed their services to high net worth individuals through high-profile advertisements in the Robb Report and similar media. Merrill Scott promised their clients significant tax reduction and asset protection, along with the potential for tremendous investment gains.

Like most schemes that sound too good to be true, Merrill Scott’s schemes were neither good nor true. The SEC concluded that their investment deals were actually pyramid schemes where the funds of later investors were used to pay off earlier investors, and that Merrill Scott and its principals had been embezzling client funds. The assets of Merrill Scott and its associated entities were frozen, and a receiver was appointed to marshal the assets for the benefit of creditors and investors.

Jeffrey C. Bermant made the unfortunate decision to contact Merrill Scott after reading their advertisement in the Robb Report. Thereafter, Merrill Scott prepared an impressive-looking Master Financial Plan for Mr. Bermant, and Mr. Bermant paid Merrill Scott $113,000 for initial planning and certain fees for arranging certain loans.

One of the strategies advocated by Merrill Scott was that Mr. Bermant purchase Loss of Income Insurance (“LOI”) Policies from Gibraltar Permanente, Ltd., an offshore insurance company owned and controlled by Merrill Scott. Mr. Bermant would pay $2 million in supposedly deductible premiums for policies to protect his business from a loss of income. Merrill Scott guaranteed that his premiums paid to Gibraltar Permanente would be segregated away from the company's other assets and held in a special account that would earn no less than 5% annually.  The promise was that Mr. Bermant eventually would receive premium refunds and earnings on those premiums amounting to a total of $4.4 million after twenty years, and that he would save over $1 million in income taxes over a ten-year period.

As the day approached for Mr. Bermant to start writing checks, he became apprehensive. To encourage him to go ahead with the transaction, Merrill Scott told Mr. Bermant that (contrary to their earlier advice) he could borrow from other Merrill Scott entities using the LOI account as collateral, i.e., Mr. Bermant would pay his premiums to Gibraltar Permanente, take his deductions, and then his money would be immediately loaned back to him.  Merrill Scott promised that they would lower the interest rates on the loans and that Mr. Bermant would incur only nominal tax-deductible interest expenses until Merrill Scott returned the LOI premiums. When Merrill Scott returned the LOI premiums to Mr. Bermant, then Mr. Bermant could use those funds to reduce his loan balance.

Merrill Scott also told Mr. Bermant that he could cancel the LOI insurance at any time, with a full refund of premiums less a 5% surrender charge and less any outstanding loans secured by the policy account. Merrill Scott gave a "cancellation letter" to Mr. Bermant that purported to modify the terms of the LOI policies issued by Gibraltar Permanente.

Satisfied that his LOI premiums would be safe with Merrill Scott, Mr. Bermant set up two new LLCs to facilitate the arrangement, with one LLC paying a $350,000 premium and the other LLC paying a $1,650,000 premium. Mr. Bermant was named as the insured on both policies. Mr. Bermant later claimed that he had the LLCs purchase the LOI policies "as a matter of convenience and tax return presentation."

After having the LLCs pay the $2 million in premiums to Gibraltar Permanente, Mr. Bermant then requested and received a $1.5 million loan from Legacy Capital, another Merrill Scott entity. Legacy Capital transferred the $1.5 million directly to Mr. Bermant, and Mr. Bermant gave a promissory note for $1.5 million to Legacy Capital.

Later, when things fell apart, Mr. Bermant claimed that Merrill Scott really just loaned him $1.5 million of his own money back, but of course that was not the representation made to the IRS at the time of the transactions.

A year after engaging in this transaction, Mr. Bermant told Merrill Scott that he wanted to unwind it. Merrill Scott advised him that it would be unwise to do this so soon because it would draw IRS scrutiny. So, Mr. Bermant did nothing.  In the meantime, Merrill Scott collapsed and a receiver was appointed.

Shortly after the SEC had filed its action against Merrill Scott, the IRS informed Mr. Bermant that it would disallow the deductions that he had taken for the LOI premium payments.  The IRS has also taken the position that Mr. Bermant owes $1.2 million in back taxes, penalties and interest.

After Merrill Scott was placed into receivership, Mr. Bermant attempted to exercise his letter agreement to cancel the LOI transaction and get his $2 million back. Not only did the receiver refuse to cancel the $2 million transaction, but the receiver also demanded that Mr. Bermant repay the $1.5 million that he received from Legacy Capital, pursuant to the promissory note that he gave to it.

Mr. Bermant also submitted a claim to the receiver demanding the complete cancellation of his $1.5 million promissory note to Legacy Capital, plus an additional $613,000 which apparently represents the remaining $500,000 of the $2 million in LOI “premiums” paid, plus the $113,000 planning fee.

This case thus pitted the claims of Mr. Bermant versus Merrill Scott against the claims of the Receiver versus Mr. Bermant. Mr. Bermant argued that the Receiver merely stepped into the shoes of Merrill Scott and thus is subject to all of his claims and defenses against Merrill Scott. Conversely, the Receiver argued that Mr. Bermant was simply another claimant who should not be treated specially, and that Mr. Bermant's claims for cancellation, set-off, and recoupment would "unadvisedly undercut the broader equitable purposes the receivership is designed to serve". The Receiver also argued that Mr. Bermant's claims failed on their merits.

Mr. Bermant essentially asked the court to disregard the paperwork that evidenced the LOI policies and the loan to him from Legacy Capital, and simply treat all the transactions as having been between him and Merrill Scott. But the court chose to hold Mr. Bermant's feet to the fire by forcing him to recognize the transactions that he himself entered into, stating:

"Mr. Bermant must prevail upon the court to ignore the manner in which he actually chose to structure his relationship with Merrill Scott and instead enforce the parties' 'understanding' of what their association truly entailed. Mr. Bermant has failed to provide any persuasive authority that would support disregarding the chosen structure of the various agreements involving Merrill Scott."

The court rejected Mr. Bermant's assertion that the letter from Merrill Scott allowed him to terminate the LOI policies at any time and get his money back.

"Far from an enforceable contractual right, the letter from Mr. Landis is simply further evidence that Merrill Scott and its clients frequently attempted to retain the benefits that flowed from structuring transactions in a certain way while never intending to honor the commitments or recognize the limitations attendant to utilizing such a structure. Mr. Landis's letter may be an alteration to the 'understanding' between Merrill Scott and Mr. Bermant, but the parties' understanding of a relationship does not necessarily control over the manner in which the parties finally structure their association. This is especially the case here, where the record indicates that the parties' understanding of their association was purposefully inconsistent with the mechanisms used to effect that association."

And furthermore,

"Mr. Bermant is asking the court to characterize the form of and parties to his various transactions with Merrill Scott as mere formalities although he fully recognized that those same formalities were necessary to maximize the financial benefit he would gain by making use of Merrill Scott's services."

Accordingly, the court ordered Mr. Bermant to pay the receiver the $1.5 million that he received from Legacy Capital. The court denied Mr. Bermant's claim for recoupment of the other $500,000 and the $113,000 fee, and denied his claim to set off the $1.5 million against the $2 million that Gibraltar Permanente allegedly owes him. However, the court declined to enter judgment for the Receiver for a precise amount until the Receiver's claims for attorney fees and interest were resolved.

The lesson here is one that is often forgotten in asset protection planning: There is a near total disconnect between tax law and debtor-creditor law. How a structure or transaction is treated for tax law purposes does not dictate how it will be treated for debtor-creditor law purposes.

Here, the IRS (correctly) disregarded this series of transactions, disallowed Mr. Bermant's deductions, and imposed penalties, while the Receiver was able to enforce the same transactions for debtor-creditor purposes.

There simply is no rule that transactions must be treated consistently for tax and debtor-creditor purposes.

Note, however, that there is a peculiar one-way street involving tax filings. If you attempt to offer your own tax filings in court as evidence of the characterization of a transaction or entity, they may be inadmissible hearsay. However, if your opponent offers your tax filings against you, they may be allowed as your admissions. In other words, you should presume that your tax filings will be used against you, not for you.

This case was more a matter of tax fraud than asset protection. However, the lesson is the same from both perspectives: if you engage in “wink and a nod” transactions, don’t be surprised if someone not a party to the winking and nodding enforces them according to their terms.

ARTICLE

Asset Protection for
the Crashing Client

In re Middendorf, ___ B.R. ___, 2008 WL 331095 (Bkrtcy.D.Kan., No. 05-21748, Feb. 1, 2008); see also Wittman v. Weir ( In re Weir ), 1990 WL 63072 (Bankr.D.Kan.1990)

A recent bankruptcy court opinion rejected the contention by the bankruptcy trustee that the debtors' pre-payment of taxes to the IRS was either a preferential transfer or a fraudulent transfer. FN1

Only a couple of weeks before filing for Chapter 7 relief, debtors liquidated $112,000 of their stocks, resulting in a $70,000 capital gain.  The week before their Chapter 7 petition was filed, the debtors pre-paid $22,250 of their anticipated federal capital gains tax liability. The bankruptcy trustee challenged their tax payment on both preferential transfer and fraudulent transfer grounds, and demanded that the IRS return the $22,250, which would have left the debtors with a non-dischargeable tax debt.

The court first rejected the trustee's claim that the transfer was preferential. One of the elements of a preferential transfer under Bankruptcy Code § 547 is that the payment be made "for an antecedent debt owed before the date of the transfer".  Since the tax liability did not technically arise until December 31 of the year when the pre-payment was made, and the estimated tax payment was made on April 11 of that year, this element of a preferential transfer was not met.

The court also threw out the fraudulent transfer claim under Bankruptcy Code § 548 on the basis that:

"debtors receive reasonably equivalent value for tax pre-payments where they face significant tax liability and obtain a dollar for dollar credit against that potential liability and the right to a refund if the tax debt is ultimately less. The Trustee may no more recover the tax pre-payment as a fraudulent transfer than he could recover pre-petition wage withholdings under the same theory. There is nothing nefarious about paying estimated tax liability out of the very income to be taxed."

When a client gets into financial difficulty, there are some things that can and should be done immediately.

Tax Liability

The first one, as indicated by the referenced case, is to calculate the client's tax liabilities and pay those immediately. This should be done for the previous tax year if returns have not been filed yet, and for the current year with pre-payments being made as quickly as possible. Clients will often go into a funk as things go down and neglect their tax issues ("What's the point? I'm not making any money anyway!") as they struggle to stay afloat financially. However, liability for taxes related to the most recent few years is difficult or impossible to discharge.  Therefore, consideration should be given to paying otherwise non-dischargeable tax liabilities, including, e.g., the trust fund portion of payroll tax liabilities, before paying other creditors.

Inheritances

Clients may go bust, but that doesn't mean that their parents and other relatives have gone bust too. Even if creditors cannot get anything out of your client, a creditor may linger around and wait for somebody to die so that the creditor can then reach the debtor’s inheritance.

You should ask your client about inheritances likely to be received, including how the client expects to receive it – outright, in trust, etc. If the client will receive an inheritance outright, you should suggest that the relative instead provide that the gift is made to a discretionary spendthrift trust so that it will be protected from the client's creditors.

This is a sound plan for most clients anyway, even for those not headed south financially. We are often surprised to review asset protection plans only to discover that a significant inheritance will be received outright.

Cleaning Up

Just as a person with a terminal illness needs to get their affairs in order, so does a failing business need to get its affairs in order. You may not be able to do prospective planning for a failing client without involving yourself in a civil conspiracy, but you can clean up the existing planning by making sure that corporate annual meetings are held and properly documented and that other necessary paperwork is put in order.

The client’s current plan may not be the best, but you probably can make it better by tying up loose ends.  Prepare documents as if they will be presented tomorrow at a debtor's examination. Ensure that the state filing fees for the client’s business entities fees are paid up, and don't allow entities to lapse their registration.

Subtle Changes

Slight changes to a client's planning structures may have substantial benefits. For instance, adding one or more additional members to a client’s single-member LLCs may significantly bolster the protection afforded to the assets in the LLCs in and out of bankruptcy.  A new member will need to pay reasonable value for the interest, but better to have a friendly co-member buy in to the LLC than to risk losing all the assets in the LLC.

Reorganize S-Corporations

If a corporation, partnership or non-resident alien ends up the owner of S corporation stock as the result of the seizure and/or sale of S corporation stock, negative tax consequences may arise for the debtor and for other shareholders.   Consider reorganizing the corporation into an LLC which elects S corporation status so that a creditor will be limited to a charging order against the debtor-member's economic rights to distributions (but will not own the membership interest itself).

Face the Reality

Clients often do not want to confront the reality that they will crash financially. They hope beyond hope that something will save them, whether a fantastic new business deal, a miraculous rebound in the real estate market, or a winning lottery ticket. With this hope, they keep their employees on board a lot longer than they probably should, and continue to run businesses that are losing money.

It is part of the planner's job to help clients see that they have gone bust or are headed there, and to help them plan accordingly. If severe choices must be made, they should be made quickly, otherwise they may make no difference. The sooner that a client collapses their empire, often the better chance he or she has at saving something and recovering more quickly.

Eliminate Credit

Clients may have built up a great deal of credit in good times, but this credit can be a noose in bad times. Credit encourages clients to throw good money after bad. If creditors find out about the debtor's remaining borrowing capacity, they likely will take a hard line and try to require the debtor to borrow from another creditor to pay them.  The IRS does this routinely in collection cases.

So, as tough as it will seem to the client, open credit lines may need to be eliminated. The less the client borrows in what is likely a hopeless situation, the less deep the hole he can dig for himself.

Control the Crash

When a client has a financial crash, assets may be liquidated to satisfy debts. If these sales result from sheriff’s levies and execution sales, expect bottom dollar. Most clients can and should liquidate their own assets. They will get better prices, with lower costs of sale, and liquidation will be more orderly.

Many creditors do not like to incur the costs of liquidating assets, particularly knowing that they will get bottom dollar, so they often will be receptive to deals where the client liquidates the asset but keeps some percentage of the liquidation price. For a client, it is better to get this piece than to get nothing, and to get better prices for the assets, resulting in less debt in the end.

In the last real estate bust, some attorneys became very good at "non-judicial workouts", orderly liquidation of the assets and other payment arrangements agreed by debtors and creditors outside the courts. Often, a non-judicial workout can result in a debtor left with more remaining assets, with the benefit of avoiding the stigma of bankruptcy. Creditors usually end up with more assets too, which is why they often go along with such plans. It is worth trying, and there is rarely a downside even if the deal can't be pulled off.

Prepare for Full Disclosure

Trying to keep as many of their assets as possible, many debtors will not want to disclose their true financial status. However, most creditors will refuse to cut deals unless a debtor is completely honest about assets and income. If your debtor client wants to cut a deal, prepare now for full disclosure to the creditor and prepare answers to such questions as "Where are you getting money now to live on?" and "Where did that asset go?".

Summary

A client’s impending financial failure does not signal the end of the relationship for the business or estate planner. It just signals that the relationship and type of planning have changed. Troubled clients usually have as much need for quality planning – often more - than clients whose businesses are doing well. Don't let the fact that a client is financially troubled keep you from doing good work for him or her.