In This Issue

• Equity Stripping
• Accounts Receivable Financing Programs
• Stupid Private Annuity Tricks
• The 2005 Bankruptcy Reform Act: Salt Into the Wound of Sarbanes-Oxley
• Delaware Overhauls Captive Legislation
• Recent Case Update
• Report from Quatloosia

In this edition of Developments, we examine the basics of the age old strategy of equity stripping assets to remove their value from the reach of creditors. Jay’s father, Ron Adkisson, who is the author of the new book, Accounts Receivable Financing for Retirement and Asset Protection, offers the first installment on what will be a series of articles by him on this asset protection technique.

The super-heated real estate markets have likewise caused a boom in the use of Private Annuities to avoid capital gains taxes. California tax attorney Joe Petrucelli warns us about the misuse of these transactions in “Stupid Private Annuity Tricks”.

Additionally, Jay Adkisson writes about the effects of the new Bankruptcy Act as it relates to Directors & Officers liability under Sarbanes-Oxley, and Chris Riser introduces us to the new Delaware Captive Insurance legislation.

The recent case updates looks at a tax evasion case involving sham trusts and two new fraudulent transfer cases. Finally, the Report from Quatloosia examines the phenomena of patented legal and financial strategies.

Editor

EQUITY STRIPPING

by Jay Adkisson

One of the oldest asset protection strategies is equity stripping. From the minute a person determines that he has equity in an asset, he probably started thinking about how to tie up the equity so that his creditors could not reach it.

The concept is simple: even though you continue to have the control and enjoyment of an asset, there is little or no equity in the asset for creditors to get. Usually, this is accomplished by borrowing against the asset and giving another party a lien for the debt obligation. But equity stripping comes in other and more sophisticated variants, too.

For example, let’s say that you live in a $500,000 home in a state with a $100,000 homestead exemption. If your home was paid off, that would expose $400,000 (the difference between the sale value and the exemption) to creditors. Instead, you just never pay down the mortgage to where you have more than $100,000 in equity.

If something happens and you have a judgment entered against you, the creditor will probably look at your property records, estimate the value of your house, and decide that it is not worth his time to foreclose because the homestead exemption would protect the rest of your equity. Because foreclosure is time-consuming and expensive, in terms of up-front costs for an auctioneer and advertising, the creditor is apt to forget about your house and look for easier assets to grab. The bank’s mortgage gives it a“ priority lien” over the judgment of the creditor. The concept of the“ priority lien” is central to most equity stripping strategies.

Congratulations, you have just successfully equity-stripped your home. Not rocket science, was it?

Yet, even with such a simple equity strip as a home mortgage, there are difficulties for the debtor. The main difficulty is that the bank will of course want to be paid on the mortgage, meaning that you will have to come up with dough every month to make your payments. If the creditor has been successful in freezing your free cash and garnishing your pay check, you might not be able to make these payments; thus, resulting in the bank foreclosing on its loan.

Thus, we are confronted with one of the main problems with equity stripping, which is how to provide protected cash flow to make the loan payments as they come due. Many equity stripping arrangements fail because no one considered the cash flow requirements.

Friendly Loans

Because you don’t want to end up in foreclosure if you have to miss a few payments, you may decide to arrange a “friendly” loan with a business entity or trust controlled by you or someone close to you. Even though your brother has loaned you money, he is not likely to foreclose if you get behind in your payments.

Friendly loans often help alleviate the cash flow problems, but they introduce problems of their own. The first problem is that for equity stripping to work, the loan that gives rise to the priority lien has to be a real loan. There has to be a compelling economic or financial reason why the loan was made in the first place, and the explanation must be one capable of being made with a straight face. Further, the loan must be properly documented, the lien immediately filed, and, most importantly, payments on the loan need to be regularly made according to its terms.

It is this last requirement that torpedoes most “friendly loan” arrangements. (i.e., people set up the loan and place the lien, but then they never make any payments or otherwise respect the loan as a real one).

Note to File: In any given year, the average civil judge sees dozens of attempts by distressed debtors to equity strip their property. Most judges can spot bogus loans a mile away. They look to see if the loan was treated as a real loan with real payments, or whether the lien was simply placed on the property and the entire arrangement was disregarded until the creditor showed up.

Bogus liens can be set aside by the court as shams or as fraudulent transfers. Fraudulent transfer laws specifically target this type of friendly insider transaction.

A similar problem involves control. Many equity stripping arrangements are set up so that the wife is extending a loan to the husband and receiving a lien on the husband’s assets. In some states, this arrangement can work, or at least create a hurdle that the creditor will have to spend some time and money overcoming. Thus, friendly liens work, so long as your friend stays friendly to you.

Equity Stripping and Taxes

Of course, where there is interest – even deferred interest and balloon payments - taxes are an issue. Taxes must be paid on interest payments (and on accrued but unpaid interest too in most cases), and the interest, may not be deductible to the payor. So, even in the case of a husband and wife who are lender and borrower, the lending spouse will have interest income, and the borrower spouse may not get an interest deduction. This is an issue whether or not the spouses file a joint return. If the interest payments are not deductible, then a tax liability that did not exist previously may have been created.

Certainly, if the interest income is being reported correctly to the IRS, it may help establish the validity of the loan. Conversely, if there is no such reporting, the arrangement will appear to be a sham. Indeed, many equity stripping arrangements are unwound because of the tax treatment of the interest on the loan.

To avoid the tax problems, equity stripping arrangements might be implemented using a grantor trust as the counter-party, so for tax purposes, it is a nullity. Of course, this gives a later creditor the chance to come in and argue, “Well, if it is a nullity from a tax standpoint, then it should be a nullity from a civil standpoint too.” Though logically suspect, this sort of rationalization may appeal to judges.

With a personal residence, keep in mind that for a home equity line of credit, only the interest on the first $100,000 is deductible. This may substantially impair the economics of many programs that are designed to equity strip personal residences. At any rate, you should never equity strip a primary residence unless there are funds immediately available somewhere with which to make mortgage payments.

Cross-Collateralization

To avoid taxation of the loan interest, sometimes equity stripping deals are created where there is no loan. Instead, the asset to be stripped is used as additional collateral for an existing loan or for some other guarantee of an obligation.

This situation usually occurs between two subsidiaries of the same business. Assume that Subsidiary A has borrowed money from a bank to finance the purchase of a new warehouse. For a fee, Subsidiary A obtains a guarantee from Subsidiary B that it will stand good for the loan in case Subsidiary A runs short of cash. To secure this guarantee, Subsidiary B allows Subsidiary A to take a loan on Subsidiary B’s equipment. The equipment held by Subsidiary B thus has been stripped of its equity.

Often such arrangements are done back-to-back between subsidiaries, so that Subsidiary A guarantees Subsidiary B and allows Subsidiary B a lien on Subsidiary A’s assets. Simultaneously Subsidiary B guarantees Subsidiary A and allows Subsidiary A to obtain a lien on Subsidiary B’s assets. Sometimes there are even arrangements where the two subsidiaries “swap checks” so that even though the money clears each subsidiary’s account at the same time, the appearance of each account by itself is that its assets have been tied up as part of a guarantee agreement. This practice is known as“ cross-collateralization” and is in fact almost a standard business planning procedure in many high-risk businesses, such as oil & gas production.

Premium Financing

For individuals, a common variant of equity stripping is a life insurance funding strategy known as “premium financing”. This strategy involves borrowing money to purchase a life insurance policy, with the loan being repaid at death. The idea is that equity which is otherwise dormant in an asset can be freed up and made to grow tax-free within the insurance policy.

Premium financing can work for asset protection if a valuable unprotected asset, usually a residence, is used as collateral. This then has the effect of equity stripping the residence while the policy is in effect. The downside is that when the insured passes away, the death benefit pays off the loan which then releases the collateral and makes it available for creditors. However, even if the creditor is then able to get at the residence, there will be an even greater amount of wealth created outside the debtor’s estate that creditors cannot touch (assuming the death benefit is not paid to the debtor’s estate).

From an economic perspective, premium financing often makes sense when the loan interest rates are low. The tax-free build-up within the policy will usually provide a large enough death benefit not only to pay off the loan, but also to benefit heirs substantially. Plus, the premium finance loan ties up the residence against creditor, since the loan will have priority over any subsequent judgment liens while the insured is still alive.

Accounts Receivable Financing

For businesses that carry accounts receivable, the financing of those receivables has the effect of equity stripping the A/R. A typical arrangement would involve the business taking a loan against the A/R, distributing the loan proceeds to the business owner, and then having the business owner purchase an annuity or life insurance policy (protected in many states) within an asset protected structure

In the long run, the business owner not only will have asset protected the A/R, but also will have created wealth from an otherwise dormant balance sheet asset by leveraging the tax-deductible simple interest paid on the loan against the tax-deferred compound interest earned in the annuity or life insurance policy. In the last year, accounts receivable financing has become a hot topic, and it is discussed more fully in Ron Adkisson’s article in this issue and in his upcoming book.

Can Equity Stripping be a Fraudulent Transfer?

An equity strip is in many ways a simple transfer of property, in the form of a security interest, from the debtor to the lender. This means that the fraudulent transfer rules can apply to equity stripping arrangements as they do to other transfers. Thus, prior to undertaking an equity strip, careful analysis and planning must be done to help ensure that the transfer will not later be set aside as a fraudulent transfer.

This planning includes not having any promotional materials or other planning documents that discuss “asset protection” as one of the principal reasons for doing the equity strip. Such discussion would possibly be prima facie evidence that the purpose of the planning was to hinder or delay creditors, which in fact is the primary reason for doing equity stripping, but also what is exactly prohibited by the fraudulent transfer laws. What this means is that equity stripping must be done for some reasonable personal or business planning purpose other than asset protection.

Unfortunately, the marketing materials of many programs that involve equity stripping, such as accounts receivables financing programs, discuss asset protection at great length; and, thus the marketing itself probably defeats the very result that they are trying to sell.

Summary

Equity stripping can be a very powerful asset protection tool when planned with foresight and implemented with care and subtlety. Many business owners can build it into their business structures. Even individuals can use it through such strategies as premium financing. Yet, when implemented poorly or overtly, equity stripping arrangements may be set aside by a court. Equity stripping strategies require the guidance of skilled counsel. Avoid canned programs that promise equity stripping benefits, especially if the marketing materials indiscreetly identify asset protection as a stated goal of the program.

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ACCOUNTS RECEIVABLE
FINANCING PROGRAMS

by Ron Adkisson

The concept of financing accounts receivable is simple enough. A simple interest-only loan, secured with a UCC-1 lien, is made against the value of the accounts receivable of a business. The loan proceeds are distributed to the business owner who invests them into either an annuity contract or life insurance policy. The lender may also take a lien against the annuity or life insurance policy as additional security.

Accounts receivable financing has two primary goals. One goal is the financial goal of generating additional income by arbitraging the compounded tax-deferred gains earned in the annuity or life insurance policy against the simple interest paid on the loan against the receivables. The other goal is to protect the accounts receivable by effectively “equity stripping” the asset by way of the UCC-1 lien.

On the financial side, these programs have the chance to create significantly more money for a business owner than if he did nothing. On the asset protection side, these programs offer to remove from a creditor’s reach what would otherwise be a very easy asset to collect against. Another way to look at these programs is that they offer “free” asset protection and some profits too!

Several programs now offer accounts receivable financing, and new programs are coming on line at a monthly rate. Life insurance agents and financial planners, motivated by the prospects of juicy commissions generated from the sale of the annuities or life insurance policies, are rapidly being mobilized to take these programs to their clients. But do these programs really work? And is the program right for all businesses?

Beware the Hidden Dangers

The truth is that accounts receivable financing can work but at least several things must occur for these programs to work successfully for the business owner. Note, however, that some programs do not make any sense at all other than potentially offering a death benefit if the business owner dies prematurely.

. . . some programs do not

make any sense at all . . .

The original loan must be efficient, meaning that it must be at a sufficiently low interest rate that the arbitrage will have a chance of working for the business owner. Most programs use a variable rate that is tied to LIBOR or a prime bank rate, plus an added 0.5% to 2% for the program administrator’s profit. A problem with variable rate programs is that if the rates skyrocket the business owner may not be able to support the interest payments. A business owner must have an exit strategy in the event the payments become too cumbersome.

Nearly all programs are designed to protect the lender, and protecting the interests of the business owner is an afterthought. For instance, if the lender can simply call the loan at any time, this means that the accounts receivable can become re-exposed to creditors at the whim of the lender. What if the business owner’s situation changes? Is he locked into something he cannot get out of? Are there onerous termination fees?

Similarly, the marketing materials of many programs overtly talk about the alleged asset protection benefits and these marketing materials alone will probably make the program vulnerable to a creditor’s challenge based on fraudulent transfers. The better programs will barely mention asset protection and will focus on the financial benefits.

The arrangement must be efficient from a tax perspective or else the arbitrage will not work. If the interest payments on the loan are not deductible by the business, the program will be significantly less efficient. Some programs are negligently designed so that there is little chance of interest payments being deductible since the loan is fully collateralized by the financial product and the accounts receivable is not really at risk. Also, some programs may fudge on the tax consequences when the program is wound-up, which could easily eat away part of any gain.

The program as a whole must beat the “opportunity cost” as if the business owner had not financed the accounts receivable but instead had invested the interest payments, which would have been paid to the lender, into the same annuity or life insurance products. In other words, everything – loan, tax and product – must all work together efficiently so that the outcome is positive.

Successful Implementation

These are only some of the problems with accounts receivable financing programs. New programs will introduce new features and opportunities, and, therefore, new problems. Nonetheless, when accounts receivable financing works properly it is a great vehicle for business owners to increase their retirement income as well as protecting a very vulnerable asset.

There are several keys to making a program work correctly but the most important factor is to have an attorney who is familiar with these programs carefully review the lender’s documents to make sure the business owner’s interests are protected and that the numbers make sense over time. It is probably as important to have an insurance agent or financial planner who is experienced with these programs who can advise which products work or do not work and can then design an annuity or life insurance policy suitable to the business owner’s specific needs.

Another key to the successful implementation of an A/R financing program is that it be tightly integrated with an overall and integrated business, estate, and asset protection plan.

Perhaps the dumbest thing that a business owner can do is to simply hear about a single program through their agent and allow that program to be implemented in a cookie-cutter fashion without negotiating terms, without getting competing quotes from other programs, or without tightly integrating their A/R program with their other planning.

Sadly, this is probably the way most accounts receivable financing programs are sold today. Educate yourself and make sure the insurance agent or financial planner who recommends a plan is educated also.

My goal in writing Financing Accounts Receivable for Retirement and Asset Protection is to help you understand A/R financing so you can make an informed analysis of programs presented to you and to guide you through some of the buzz words which are used in the program. Part I of the book explains accounts receivable financing, the economics of an A/R program, retirement planning, asset protection, who the players are, and tax considerations. Part II explains the various types of annuities and how they can or cannot be used in A/R financing. Part III explains various types of life insurance policies and how they are used in A/R financing. Part IV offers a discussion about other structured solutions, factoring and, most importantly, finding the right program for you.

The bottom line is that anytime you have taxes and asset protection involved in any long term transaction, a business owner should obtain the benefit of an experienced attorney, planner and/or agent to carefully review the program to insure it is right for that business owner and that it does not put up some difficult hurdles in the business owners current and future estate and wealth preservation planning.

Ron Adkisson is author of the book Financing Accounts Receivable for Retirement and Asset Protection, to be released soon. More information about Ron’s book and about A/R financing programs is available for free at http://www.farbook.com

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STUPID PRIVATE ANNUITY TRICKS

by Joseph Petrucelli, JD, LLM

When carefully planned and properly used, private annuities can be very powerful tax deferral and estate planning tools. Like any such tool, however, private annuities do come with significant limitations and complexities. With the recent boom in the real estate markets and sellers desiring to defer the capital gains on the sale of their property, many unscrupulous and often unqualified promoters have started hawking private annuities to the masses by promising them a tax planning panacea that is simply not supported by the tax laws. Persons who are about to sell an asset and defer capital gains through the sale of a private annuity should be cautious about the following practices. As with all complex tax planning strategies, the review of the transaction by an independent tax attorney who is familiar with private annuity transactions is not only suggested, but is essential, since the tax consequences if a private annuity fails or if the payments are not calculated correctly can be horrendous to the seller. ~ Editor

1. Too Late Sales of Property via Private Annuities

Recently, a number of people have inquired about using Private Annuities to defer income tax on the sale of property that has already been placed in escrow. This poses significant tax issues under some or all of the Assignment of Income, the Step Transaction and the Sham Transaction Doctrines. Under the Assignment to Income doctrine, the Courts have consistently held that when a person attempts to shift income to a different taxpayer after the income has been earned, the income will be taxable to the taxpayer who earned the income rather than the taxpayer to whom the income was shifted. Once property has been placed in escrow, it would be difficult to argue that the property was actually sold by a "Private Annuity Trust" or any other form of Annuity Obligor.

Further, merely pulling the property out of escrow and then placing it immediately back into escrow with a newly named "seller" will likely not remedy the situation. In such an instance, an argument would likely be made that the Annuity Obligor is simply acting as agent for the real seller of the property and the IRS would likely prevail in such an instance.

2. Using Private Annuities to Sell Commercial Annuities

Over the past 18 months or so, several organizations have begun marketing the use of Private Annuities as a means of deferring capital gains on the sale of real estate. Generally, these marketing groups have as an added agenda, the "management" of the money earned by the "Private Annuity Trust." The management consists typically of the purchase of commercial annuities from life insurance or annuity companies. There are several problems with this strategy.

First, is that these marketing organizations often do not have much experience in the use of Private Annuities.

Second, the transaction is susceptible to challenge by the IRS as a Step Transaction. Generally, a Private Annuity transaction should not be susceptible to a challenge under the Step Transaction doctrine because they are generally intra-family estate planning devices that do not result in the exchange of an asset for a different asset. However, when real estate is being sold and "replaced" with a commercial annuity, the IRS may argue that the use of the Private Annuity is nothing more than a device to trade real estate for a commercial annuity. Because there are no provisions in the Internal Revenue Code or under Federal tax doctrines which allow a direct exchange of real estate for commercial annuities without taxation of the transaction, the use of a Private Annuity as an intermediate step will not be recognized as a valid tax transaction and the IRS may collapse the transaction and consider the taxpayer to have sold property and bought the commercial annuity with what amounts to after-tax dollars. This could result in immediate taxation of the entire gain associated with the sale of the real property.

Additionally, certain provisions of the Code may result in inclusion of the commercial annuity in the estate of the taxpayer.

3. Long-Term Deferral of Private Annuity Payments

While it is possible to defer the payment of Private Annuities for some period of time, there is no bright line test in the Code or under Federal tax law for the length of deferral. Certain marketing organizations have adopted the "rule" that an annuity may be deferred until age 70 ½. While this may be legal, it can pose significant issues with the calculation of the annuity payments due from the "Private Annuity Trust." Generally, a private annuity will be treated as a sale of property and therefore not subject to gift tax as long as the Fair Market Value ("FMV") of the property is equal to the Present Value ("PV") of the stream of Private Annuity payments.

Generally, for the PV of the Private Annuity payments to remain equal to the FMV of the property transferred to the trust, the annuity payments would have to increase for periods of deferral. The use of a commercial annuity as the sole funding mechanism may not result in the necessary accrual of value to ensure the PV of the Private Annuity stream remains equal to the FMV of the property. It should be noted, that for the transfer of property to be considered a gift, there would also need to be some gift intent so whether there is some disparity between the PV of the Private Annuity and the FMV of the property there may not automatically be a gift tax due.

However, if there is a significant difference between the PV of the Private Annuity and the FMV of the property that was originally transferred, the transfer of the property to the Annuity Obligor might be considered a fraudulent conveyance as something other than a transfer for reasonably equivalent value. A disparity between the PV of the Private Annuity and the FMV of the property could also result in the property transfer not being considered a sale and therefore subject to inclusion in the estate of the taxpayer under §2036.

4. Canned Opinion Letters

Changes to Circular 230 have made it less appealing to rely on tax opinions as a means of avoiding potential penalties associated with the assessment of tax by the IRS. While a properly drafted opinion letter should still be able to be reasonably relied upon in good faith by a taxpayer, opinion letters provided by promoters (or the counsel of promoters) of the use of Private Annuities as a means of deferring capital gains tax with an eye toward selling commercial annuity products should not be relied upon and independent counsel should be used to provide an opinion letter upon which a taxpayer can rely to avoid penalties. Where time allows, a more prudent course of action would be to obtain a Private Letter Ruling on aspects of the Private Annuity transaction. If a promoter advises against the taxpayer obtaining a Private Letter Ruling, the taxpayer should take this as a sign to be cautious in dealing with the promoter.

5. Private Annuity Trusts

The term "Private Annuity Trust" has become a part of the new lexicon of estate/tax planning (as well as insurance and real estate sales seminars). However, there is no such thing as a "Private Annuity Trust" and it is no special species of trust anymore than a "Family Limited Partnership" is a special species of limited partnership. Ultimately, a trust that is used as an Annuity Obligor is either a grantor or non-grantor trust (or potentially some hybrid of the two). The tax treatment associated with the Private Annuity transaction is largely dependent on how the trust will be treated. It should be noted that in some instances, companies marketing "Private Annuity Trusts" tout the use of trusts which begin as a grantor trust and then later become a non-grantor trust. In such an instance, it is highly likely that the conversion of the trust to a non-grantor trust following the transfer of property to the "Private Annuity Trust" will have no effect on basis of the property and that there will be no tax deferral available as a result of the conversion of the trust.

6. Basis if no payments

While most private annuity arrangements end up in the property that was transferred to the obligor being sold, there are instances when an obligor may hold property for some period of time prior to the property being sold. In such an instance, if no annuity payments have been made and the annuitant passes away, the obligor will have zero basis in the property and therefore would be taxable on the full amount of the gain associated with a later sale of the property. Many promoters fail to point this risk out to their clients. Certain steps can be taken to reduce this risk, if desired, but many promoters may not understand the issue, let alone the potential ways of mitigating the risk.

7. Ballooning Payments

Many promoters extol the virtue of deferring the start of the annuity payments due in a private annuity transaction. While it is true that in certain circumstances there may be benefits to deferring the start of the annuity payments, many promoters fail to understand the long-term effects of the deferral. In a properly structured private annuity transaction, the fair market value of the property transferred for the annuity should equal the present value of the annuity stream. This "test" needs to be made as of the date of the transfer of the property. This means that as annuity payments are deferred, they must increase in size to keep the present value of the annuity stream equal to the fair market value of the property. This means that the required annuity payments may become very large if the annuity starting date is deferred for a long period of time.

8. Trust Taxation Issue

A fundamental issue to consider is that the trust/obligor of in a private annuity transaction is a taxable entity (or the beneficiaries of the trust are taxable) and that the obligor must therefore pay tax on income it earns.

9. No Deduction

The obligor in a private annuity transaction does not receive a tax deduction for the annuity payments. Because the obligor is taxable on its income, the obligor may be in the position of having to satisfy annuity payments with after-tax dollars which can significantly raise the economic cost of the transaction.

10. Estate Tax

Most private annuity promoters will list mitigation of estate tax as a benefit of utilizing a private annuity transaction. While this is true, what many promoters will fail to point out is that the annuity payments received by the annuitant are typically received back in their own name and therefore each payment that is received rebuilds the taxable estate of the annuitant. Once again, there are ways to mitigate this potential problem but most promoters will not consider means of mitigating the problem.

11. Stop and Go Annuity

The "stop and go" annuity is another problem. Once annuity payments begin, they should not be stopped. The definition of an annuity revolves around periodic payments being made. If the annuity contract allows payments to begin and then cease, there is a question as to whether the contract is actually an annuity.

12. Live Too Long

Private annuities can result in the annuitant paying more tax than they would have if they paid the tax at the time of the sale. Additionally, a private annuity transaction can result in the conversion of capital gains to ordinary income. This can happen in a situation when the annuitant outlives his or her actuarial life expectancy. All payments made by the obligor after the date of the annuitant's actuarial life expectancy are ordinary income because the annuitant will have received back all of his capital gains and his basis.

13. No Asset Protection for Annuity Payments

One of the benefits of using a private annuity is the potential for asset protection. However, the payments received by the annuitant are subject to creditors in most instance and generally private annuity transactions are not structured in a way that will provide asset protection to the annuity payments.

14. Annuitants Are Not Entitled to the "Growth" in the Annuity

When an annuitant exchanges property for a private annuity, the annuitant is entitled to an annuity stream equal to the fair market value of the property transferred. So, if property valued at $500,000 is transferred to the obligor, the annuitant is entitled to a $500,000 annuity. The obligor, particularly in situations where an annuity is deferred, might accrue significant value in excess of the original fair market value of the property transferred for the annuity. Some promoters will build in" interest" for foregoing the annuity payments. They may also draft a private annuity in such a manner that the annuity will be made up of the accrued value of the annuity obligor. In these situations, it is possible that the annuity calculations will not result in the appropriate "balance" between the fair market value of the property and the present value of the annuity. If a client wants to have what amounts to a variable annuity or to have" access" to the growth of the annuity obligor, the client should seek a private placement annuity.

15. Private Annuities Are Not "Exchangeable"

In certain instances, promoters will seek to defer payments by having a client exchange the original annuity for a new "re-valued" annuity. The re-valued annuity will often include the accumulated value of the annuity obligor. There are several problems with this but the glaring one is that the provisions of the Internal Revenue Code which allow the exchange of annuity contracts probably do not apply to private annuities. Therefore, such an exchange of annuity contracts would likely result in taxation.

Joe Petrucelli, JD and LLM (tax) is a California tax attorney with offices in San Diego County, California and may be contacted at 760.431.4575.

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THE 2005 BANKRUPTCY REFORM ACT:
Salt Into the Wound of Sarbanes-Oxley

by Jay Adkisson

The Sarbanes-Oxley Act of 2002 dramatically expanded the duties and responsibilities and the potential liabilities of corporate officers and directors. The new Act introduced strict rules relating to conflicts of interests, such as personal loans for directors. Sarbanes-Oxley also requires corporate officers and directors to make certain reports and disclosures relating to internal controls. Additionally, the Statute of Limitations for securities fraud was expanded to the longer of five years or two years from disclosure of the fraud, and whistleblowers have greatly expanded protection as well as a right to sue for special damages.

There were no shortages of securities class-action lawsuits even prior to Sarbanes-Oxley, but after its passage, litigation became much more personal, especially for outside directors. To settle their liability on the accounting fraud claims alone, ten outside directors of WorldCom agreed to pay $18 million from their personal assets, which represented an estimated 20% of their net worth. Another $36 million was paid from their D&O insurance. Similarly, ten former Enron directors agreed to personally pay $13 million as part of a $168 million settlement for fraudulent accounting practices.

Stung by large claims against the D&O policies issued to these unfortunate directors, the insurance carriers have tightened up their policies and expanded their exclusions. Future corporate officers and directors who are caught up in similar circumstances may have to litigate with their own insurance carriers to provide defense and coverage. Also, a sustained series of financial collapses, such as the savings & loans crisis of the 1980’s, might challenge the solvency of a particular insurance carrier and its ability to timely pay claims.

Corporate officers and directors now face the specter of personal liability unrecompensed by their company or its insurance carrier for shareholder losses, whistleblower claims, and similar types of liabilities. Such liability in the past would have been met with personal bankruptcy. Or, with little foresight or strategy, a person expecting difficulties could simply move to Texas or Florida, where the creditor exemption for homestead was unlimited. It was also easy for corporate officers to load millions into their ERISA-protected pension plans knowing that they would be protected from any future creditors as well.

Not any more.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 appears to specifically target corporate officers and directors so that they will not be able to protect any significant assets in bankruptcy. While the new Bankruptcy Act significantly pared down the exemptions available to all debtors, it virtually eliminates any meaningful protection for those who are successfully sued for securities fraud or breach of fiduciary duty.

The key provision is the new section 522(q), which limits any exemption existing under State law to $125,000 for several types of debts including those arising from:

(i) any violation of the Federal securities laws (as defined in section 3(a)(47) of the Securities Exchange Act of 1934), any State securities laws, or any regulation or order issued under Federal securities laws or State securities laws;

(ii) fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under section 12 or 15(d) of the Securities Exchange Act of 1934 or under section 6 of the Securities Act of 1933; and,

(iii) any civil remedy under section 1964 of title 18 (this is the civil RICO remedy provision).

These are, of course, three of the most common avenues to the personal liability of a corporate officer or director. For persons who are successfully sued under one of these theories, the effect is that they will not be able to protect more than $125,000 in their house, regardless of how much the state allows, nor will they be able to protect more than $125,000 in their pension or similar types of retirement plans. In other words, if you are successfully sued for securities fraud, breach of fiduciary duty or civil RICO, you will not be able to protect much more than 250,000 in your combined home and retirement plans, and a few personal effects.

If all this isn’t bad enough, prospective debtors are also limited in the type of pre-bankruptcy planning that they can do. A new section 522(o) creates a 10-year period during which the bankruptcy trustee can claw back non-exempt assets that were converted to exempt assets to avoid creditors. Other provisions of the new Bankruptcy Act create numerous other limitations for debtors to protect assets.

So how about those asset protection trusts that you read about all the time? Form one in the Cook Islands, or even in Alaska or Delaware these days, and your assets in them will be bulletproof from creditor claims, right?

Wrong.

Stung by criticism in a New York Times article about a “loophole for the rich” in the new Bankruptcy Act, Congress passed a new section 548(e) that allows a bankruptcy trustee to clawback assets that were transferred to an asset protection trust within ten years of the filing of the voluntary or involuntary bankruptcy petition, if the transfer was meant to diminish the rights of creditors. Since the very purpose of an asset protection trust is to diminish the rights of creditors, the import is that assets transferred to such trusts can be easily backed out by the bankruptcy trustee.

The new 548(e) not only applies to asset protection trusts, which are self-settled trusts that one creates for his own benefit, but also applied to “like devices”. Congress did not attempt to define “like devices,” but one could reasonably infer that it is anything that has a specific purpose for protecting assets while allowing the person who created the structure to have the beneficial use of those assets.

Congress did not need to worry about asset protection trusts. The bankruptcy courts had never respected them anyway, and in a series of cases the courts simply treated the assets in such trusts as part of the bankruptcy estate. In one case, involving former derivatives trader Stephen J. Lawrence, the court ordered him to provide information relating to his offshore trust and when he refused, the court cast him into prison for contempt. Lawrence went into jail in August of 2000, and was still in the pokey as of the writing of this article.

The truth is that foreign asset protection trusts have a chance of working if you flee the jurisdiction of the U.S. courts when things get dicey. Of course, doing that may cause your other creditor protections, such as homestead, to dissolve, and you may be precluded from defending the claims against you under what is known as the “fugitive disentitlement doctrine”. The new Domestic Asset Protection Trusts that are heavily marketed by trust companies based in Alaska, Delaware and a few other states have little chance of protecting assets under the new 548(e).

To make doubly sure that corporate officers and directors could not hide their wealth in asset protection trusts, Congress specifically mandated that in interpreting 548(e) “a transfer includes a transfer made in anticipation of any money judgment, settlement, civil penalty, equitable order, or criminal fine incurred by, or which the debtor believed would be incurred by” a violation of the securities fraud and securities registration laws. While this language seems redundant, it sends a clear message: Persons active in the securities industry should be personally liable for their decisions, and this liability should not be defeated by asset protection subterfuges.

So what does work?

There is an old adage that “As the laws get tighter, the lawyers get smarter.” Asset protection will not go away, but it will necessarily become more complex and sophisticated to meet such evolutions in debtor-creditor law as the new Bankruptcy Act.

It is important is to keep assets off of the personal balance sheet, so that if there is a bankruptcy the assets will not show up in either the debtor’s schedules or in any recent history of past transactions. This can be legally accomplished through sophisticated estate and business planning done well in advance of any potential creditor problems.

Estate planning is a legitimate form of personal planning that does not by itself raise unnecessary suspicions of anti-creditor planning. While the new Act makes clear that one cannot create a trust for one’s own benefit and still hope that the assets will be protected from creditors, it did not impact ordinary, non-self-settled trusts at all. One can still, for instance, create a trust for one’s children or grandchildren and convey valuable assets to that trust. So long as it is done at least several years before problems arise, both the transfer and the trust should be respected and stand-up even in bankruptcy.

The key to making estate planning perform an asset protection function is to avoid utilizing gifts as the method of transferring assets to the trust. Gifts by their very nature are without reasonably equivalent value and, thus, are susceptible to being set aside as fraudulent transfers. Instead, for-value transfers such as self-canceling installment notes and private annuities should be utilized for transfers. While these transfers are much more complicated from a tax perspective, they are much safer from a debtor-creditor law perspective.

Business planning can also have the effect of moving assets off of the future debtor’s balance sheet and into an entity where a creditor will have a difficult time accessing them to pay a judgment. By contributing assets to a limited partnership, the assets are effectively transformed from a form that is easy for creditors to collect upon into partnership interests against which a creditor will be limited to a charging order that restricts the creditor’s rights to receiving the distributions that the debtor would have normally received. Of course, if no distributions are made to the debtor’s interests, the creditor gets no distributions either, and the case law has, with only rare exceptions, protected the valuable assets within the limited partnership from creditors’ collection attempts.

Future strategies may involve the creative use of life insurance and annuities in the numerous states that offer substantial levels of protection to those products when properly structured and drafted. Although Congress eviscerated some of the most common forms of debtor planning, it did not seek to change the existing state exemptions for those products, although they will still be potentially subject to the ten-year limitations period for the conversion of non-exempt assets into exempt assets. However, by combining sophisticated forms of insurance with certain forms of ERISA planning, plans could be created that would offer formidable barriers to even the most sophisticated creditors.

An important factor in asset protection planning has always been to do the planning well in advance of creditors. Prior to the new Bankruptcy Act, the required amount of time for a debtor to reach a degree of comfort that transfers would not be reversed was sometimes measured in months, or, at worst, a couple of years. Future asset protection planning will require much greater foresight and passage of time before the same levels of comfort can be achieved. In other words, if you want protection that will have a chance of standing up, you need to start that planning as soon as possible in the hope that some significant water will pass under the bridge before it is challenged.

A final word of advice is to avoid those asset protection solutions that are heavily marketed. Such solutions will not escape the notice of creditors, who may attempt to lobby Congress for additional changes to the bankruptcy code so as to mitigate the effects of those solutions. Instead, seek personalized solutions that have substantial purposes not ordinarily related to asset protection, but which have the effect of challenging those assets unpalatable to creditors. The best asset protection plan is one that is so subtle that it cannot be readily identified by creditors or by the court as an asset protection plan.

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DELAWARE OVERHAULS
CAPTIVE LEGISLATION

by Chris Riser

Usually on the leading edge of corporate legislation, Delaware uncharacteristically has come late to the captive insurance game. However, the drafters of recently overhauled Delaware captive insurance company legislation used their time wisely, watching the sector develop and deciding what would be needed to put Delaware on the cutting edge.

Some key features of the new Delaware legislation, which was adopted as of August 2005, include:

• A very low premium tax

• Relatively low application and annual fees

• Examinations by the Commissioner only once every three years

• Relatively low capitalization requirements

• All entity forms allowed, including LLCs (this could be a very significant advantage because it theoretically allows a captive to have charging order protection)

• Allows RRGs, protected cell, industrial captives, and “special purpose” captives

Notably, the Delaware statute allows a captive to underwrite not only the risks of other subsidiaries of the owner, but also other entities that have contractual affiliations with the owner, which should make it easier for Delaware captives to comply with recent IRS Rev. Rul. 2005-40.

The new Delaware statute raises the bar for captive legislation. It is likely that Delaware quickly will become a major captive jurisdiction, mirroring the quick success of South Carolina.

In related news, Wilmington Trust Company, a major Delaware trust company, has bought Charleston Captive Management Company and apparently will aggressively pursue the formation of captive insurance companies in Delaware. Also, a Delaware Captive Insurance Association has been formed and are now hosting an informative website at http://www.delawarecaptive.org

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RECENT CASE UPDATE

United States v. Larson and Palmer,
2005 U.S. App. Lexis 16188 (7th Cir. 2005).

The Seventh Circuit Court of Appeals affirmed the conviction of Dwight Larson and Paul Palmer for their involvement in a tax evasion scheme.

Larson and Palmer evaded taxes and cost the Internal Revenue Service an estimated $2.6 million by hiding assets in a series of sham trusts. Larson and Palmer’s clients opened bank accounts in the name of trusts and transferred assets to the accounts. However, the clients did not cede the control of the trust assets to the trust but retained full control over the trust assets. Further, the clients did not report the income from the trust assets, evading income tax. Larson and Palmer filed the tax returns on behalf of the trusts and funneled payments back to their clients while deducting payments from the trust income.

Larson also encouraged and created foreign trusts for his client, but the trusts were no more than trust names with addresses in foreign countries. Larson knew that his clients retained control over the trust assets and did not send any money to the foreign accounts. Larson did not file income taxes on behalf of his clients on the money claimed to exist in the foreign trusts. Further, Larson falsely represented that the taxable income was distributed to the foreign entities when the income was actually still controlled by the taxpayer.

Larson was indicted with conspiracy to defraud an agency of the United States in violation of 18 U.S.C. § 371 and willfully making and subscribing a fraudulent tax return in violation of 26 U.S.C. § 7206(1). The district judge sentenced Larson to 55 months imprisonment and three years of supervised release. The judge also ordered Larson to pay $701,513 in restitution.

Palmer was also found guilty of the same charges and was sentenced to 108 months imprisonment, three years of supervised release, a $150,000 fine, and $1,369,662 in restitution.

Waldon and Environmental Water Solutions, Inc. v. Burris, et. al.,
2005 NC App LEXIS 1763 (2005).

The Court of Appeals of North Carolina affirmed the trial court’s decision to award plaintiffs shareholder and corporation a constructive trust against the proceeds of a contract fraudulently obtained by defendant corporation and its shareholders.

Grace and Jesse Waldon formed a company called Environmental Process Systems, Inc. (EPSI). Subsequently, the Waldons formed Environmental Water Solutions, Inc. (EWSI-NC), which was incorporated in North Carolina, to act as a sales and marketing arm of EPSI. Defendant Dan Burris acted as selling agent for EWS and acquired contract with a company, Dynpar, to manage an industrial water treatment plant at Tinker Air Force Base in Oklahoma. Grace Waldon was issued 51% of the shares, and Jesse Waldon was issued 49% of the shares in EWSI-NC. Dan Burris later became vice president of EWSI-NC and also formed and incorporated an Environmental Water Solutions, Inc. (EWSI-OK) in Oklahoma. Burris issued 51% of the shares in EWSI-OK to his wife and 49% of the shares to himself.

In 2000, when the Tinker contract was about to close, Burris and Jesse Waldon held a meeting for EWSI-NC, where Burris and Waldon redistributed the shares of EWSI-NC without Grace Waldon’s consent. Defendants Burris and Waldon issued 51% of the shares to Waldon and 49% of the shares to Burris. Grace Waldon later discovered the redistribution and insisted that Burris mail the corporate books back to her; however, she later discovered the corporate books had been stripped and other files shredded. Jesse Waldon later informed plaintiff Grace Waldon that he was leaving her to live with his mistress in Vietnam. Grace sought an attorney to help her recover her shares of NWSI-NC and the profits from the Tinker contract.

Burris informed Grace that EWSI-NC was never a party to the Tinker contract, and the contract was in the name of EWSI-OK. Because Grace was unable to obtain help from Jesse to sue Burris on behalf of the company, she called a shareholders’ meeting to regain control of EWSI-NC. She gave written notice to Burris and used her power of attorney for Jesse to remove both Jesse and Burris as officers. Grace sued Burris and Jesse, obtaining a default judgment against Jesse. The jury found in favor of Grace, awarding one half of the profits from the Tinker contract to EWSI-NC.

Subsequently, Burris resigned the Tinker contract with Dynpar. Grace filed a motion for relief pursuant to the Uniform Fraudulent Transfer Act, claiming that Burris’ resignation of EWSI-OK rendered EWSI-OK insolvent and prevented Grace and EWSI-NC from recovering the profits under the Tinker contract. Grace claimed that Burris moved the contract from EWSI-OK to a new company, Water Resources Corporation, in order to avoid paying the judgment in favor of NWSI-NC. The trial court issued a mandatory injunction awarding EWSI-NC a constructive trust against any proceeds of Water Resources Corporation from the Tinker contract and appointed a receiver for NWSI-NC.

The appellate court affirmed the trial court’s decision.

Runez v. Seaton,
2005 Cal. App. Unpub. Lexis 7731 (2005).

The Court of Appeal of California, First Appellate District, Division Four, affirmed the trial court’s decision to set aside a fraudulent transfer of property and order the sale of the property in order to satisfy creditors’ judgments against debtor. The court ruled that, even if the debtor’s spouse owned the house with the debtor, the property is a community property asset that may be sold to satisfy a judgment against one spouse.

Fildres Runez was the creditor of Guy Roland Seaton III and obtained a judgment against Seaton. In order to avoid paying the judgment, Seaton transferred his residential property, with a fair market value of $1,025,000, to his wife. The trial court voided the transfer and deemed the property community property, ordering the sale of the property to satisfy the judgment.

Seaton appeals, arguing that the property is not community property shared by him and his wife, but is held by Seaton and his wife as tenants in common. Thus, Seaton argues that the judgment may only be satisfied out of Seaton’s one-half interest in the property.

The appellate court affirmed the trial court’s decision, ruling that the trial court had sufficient evidence to classify the property as community property. The court noted that Seaton admitted that he owned the property as community property before transferring it to his wife in an answer to the complaint in this case.

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REPORT FROM QUATLOOSIA

By Tony-the-Wonder-Llama

I like to go to seminars where new products and strategies are being introduced. Primarily, this is because the continuing education credits are free, and they usually offer you a free continental breakfast and lunch. This latter is not to be discounted, as it provides you a professional incentive to eat lots of high fat pastries and chicken florentine dishes that your spouse wouldn’t let you eat at home.

The other cool thing about product and strategy seminars is that they give you lots of shwag. if you don’t know, “shwag” is the term for the free promotional goodies that are given out by the promoters, such as golf shirts or pens or tote bags that have the promoter’s logo on them. Go to any seminar hosted by a life insurance company and you will walk out with more shwag than you can carry, although usually by the time that you make it back to your hotel room you have discarded everything but the logo pens and the logo baseball caps (you can never have too many of either, IMHO).

The purpose of shwag is to make you feel good about the promoter and their product or strategy, and to make you think that they are special. The better the shwag, the better you will feel about the promoter so their marketing gurus say. But at the end of the day, shwag is really ridiculous since you never really wanted it in the first place and it doesn’t do you any professional good. But it serves its purpose by making you think, to some degree or another, that maybe the promoter who gave you the shwag is maybe an iota better than another promoter who didn’t give you quite as good shwag (or maybe their muffins or chicken florentine wasn’t as tasty).

Lately at these seminars, I have been hearing various promoters – inevitably