In This Issue

• Asset Protection for Aviators and Aircraft Owners
• 831(b) Captive Insurance Companies
• 419(e) Welfare Benefit Plans
• U.S. v. Townley
• In re Ehmann – Round II
• In re Baldwin
• Is Your Corporation Really Protecting Your Assets?
• The B.S. Behind Nevada Bearer Shares
• Asset Protection Short Summaries
• California Franchise Tax Board Taxes Separately Each Series of a Series LLC
• The Private Trust Company
• Introducing the Ownership Continuity and Control Plan
• Why Congress is About to Declare War on Pretty Much Everything Offshore
• Private Placement Life Insurance Deal Implodes
• Report from Quatloosia

The last two years have seen significant changes in asset protection planning. Last year brought the new bankruptcy act which significantly affected homesteaded property and ERISA plans, as well as driving what should be the final nail into the concept of the self-settled asset protection trust. This year has so far brought several obscure but potentially very significant cases that may signal how the courts will treat planning that is specifically meant to lessen the rights of unknown future creditors, i.e., asset protection.

Congress and the IRS have recently signaled they are going to make offshore planning unpleasant, if for no other reason than to deter rich people from using it to hide assets and income. Prosecutions are up of offshore promoters and their clients who are caught with unreported offshore entities and accounts, and the IRS is starting to pursue one of the most abusive offshore tax strategies ever – Private Placement Life Insurance tied to the ownership of closely-held business interests and intellectual property rights. I predict that offshore planning will in the future be used in only exceptional circumstances, such as for true multinational families and international estate planning. For the ordinary Dr. Joe, offshore planning is about to become too painful to pursue if it hasn't been such already. Certainly, night has fallen on the heyday of offshore planning, meaning that quality domestic planning will be more important than ever.

-- Jay

Asset Protection for Aviators
and Aircraft Owners

by Jay Adkisson

Merrill C. Meigs Field was a charming little airport next to downtown Chicago. A few years ago, the field was closed and turned into a park, much to the dismay of pilots nationwide, particularly those in the Chicago area. However, before it closed, Meigs Field was an unwitting participant in an aviation accident and subsequent lawsuit that should cause deep concern to every pilot and airplane owner.

On the slightly hazy afternoon on July 19, 1997, the owner-pilot of a small single-engine Bonanza was preparing to land at Meigs Field. An experienced controller employed by Midwest Air Traffic Control, Inc. (“Midwest”), a private contractor to the Federal Aviation Administration (“FAA”), was on duty. As the Bonanza was cleared for landing, the pilot noticed that his landing gear lights did not display the proper gear-down-and-locked indication.

At this moment, the controller advised the Bonanza to make a low fly-by over the runway so that the controller could make a visual inspection of the Bonanza’s landing gear. As the Bonanza passed by, the controller advised the Bonanza that the landing gear appeared to be up. The Bonanza pilot then asked to be routed over Lake Michigan so that he could attempt to hand-crank the Bonanza’s gear down.

The Bonanza pilot manually cranked down the landing gear, and told the controller that the gear appeared to be down. The controller then agreed to make a second visual inspection of the Bonanza.  On this fly-by it appeared to the controller that the Bonanza’s gear was down. The Bonanza pilot successfully landed at Meigs Field.  He parked the Bonanza, believing that the day had concluded without incident for him.

Meanwhile, a few miles away, while the Bonanza pilot had been dealing with his landing gear problems, the pilots and passengers of two other small planes were sightseeing along the Lake Michigan shoreline near Meigs Field. The pilots of both planes were commercially-rated and had hundreds of hours of flying experience. Conditions were such that visual flight rules (“VFR”) were in effect, although it was hazy on this mid-July day.

The FAA rule in visual conditions is “See and Avoid”, which means that every pilot is primarily liable for looking out for traffic himself, and that the air traffic controllers will only give advisories regarding other aircraft nearby when workloads allow. Nonetheless, both of these small planes were on the same radio frequency, which was the Meigs Field frequency, and could hear the controller giving instructions to the pilots of each of the two planes as well as to the pilot of the Bonanza with the gear problems.

Nonetheless, the pilots of the two planes (the only other planes in Meigs Field’s airspace) failed to look out for one another and collided, killing both the pilots and five other passengers. Mid-air collisions of small airplanes at small and loosely-controlled airports occur a few times a year, with hundreds of near-misses. Collisions are not ordinary or routine, but they do happen when pilots fail to look out for one another.

This crash had all the hallmarks of a high-wing/low-wing accident, which occurs when the high-wing plane is climbing (with its blind spot above) and the low-wing plane is descending (with its blind below).  The witness statements contained in the investigation by the National Transportation Safety Board (NTSB) bear this out.

There were many witnesses who observed the two airplanes collide. One witness, a military pilot, said he "...noticed [a] Cessna 172 at 300-feet less than a mile off [the] beach." He said it "Looked straight and level... moving south bound." He said a Learjet type aircraft was at 800-feet above the lake's surface heading north. This airplane was in "...full landing configuration..." in a 300 to 400-foot per minute descent toward the airport. He said it looked as though the Cessna 172's left wing hit the right side of the inbound airplane.

A second witness, a civilian pilot, said he "...observed a single-engine, low wing, aircraft that appeared to be heading north collide with what appeared to be a single engine high wing aircraft that appeared to be heading south." He continued by saying, "It did not appear to me that any of the two aircraft took any evasive action, although I only viewed the two aircraft shortly before the collision occurred. Both aircraft appeared to be flying normally, with no control problems. I would estimate the collision occurred at an altitude of between 500 and 1,000- feet AGL."

Whenever there is an air crash of any type, a lawsuit is almost sure to follow.  In this case, everyone in sight was sued, including the FAA, Midwest and the controller. None of this is surprising, and most of these parties settled with the estates of the victims to avoid a trial.

Remarkably, the estates of the victims also sued the pilot of the Bonanza – the plane with the landing gear problems, which was miles away from the collision – claiming that the Bonanza pilot’s gear-up incident distracted the controller such that she was not able to warn the other two small planes not to run into each other. The pilot of the Bonanza quite understandably refused to settle.

At trial, the controller testified that she was not unusually distracted by the Bonanza’s situation, that she did not feel that the Bonanza pilot was monopolizing her communications to the detriment of other pilots, and that she warned the two pilots who crashed to look out for each other.

The plaintiff’s attorney, however, put an alleged aviation “expert” on the stand who testified that, based on his review of the FAA’s transcript of the controller’s communications with all the airplanes, the controller was distracted by the Bonanza’s gear-up incident, whether she thought so or not. Because of this distraction, the expert claimed, the controller did not give the other two airplanes sufficient instructions so that they could avoid each other.

The jury apparently believed the aviation expert, and awarded damages against the pilot who had the landing gear incident in the amount of $2,195,416. Walker v. Segal, Cook Cty. Cir. Ct. No.2002-L-2169.

So much for “proximate cause” as an element of negligence liability, eh?

To editorialize for a moment, this is a ridiculous verdict. The case should have been thrown out at the Motion to Dismiss stage, but now enters the Hall of Crazy Verdicts with the hot coffee from McDonalds and similar instances of legal absurdity that bring the whole legal system into disrepute.

However, my editorializing doesn’t help the poor Bonanza pilot who likely had only $1 million in general liability coverage (if that) and may now have the portion of the judgment that is unpaid by insurance collected from his personal assets – including probably his Bonanza. Not that he may care, since this incident is likely to cause him to want to give up flying permanently!

Having been an attorney for over 17 years, I have seen a lot of wacky cases and not just a few strange verdicts. But as a pilot myself, and having many pilots as clients and friends, I find the result in this case particularly disturbing because the Bonanza pilot simply did nothing wrong and could not have imagined that his gear-up incident would cause – in either a practical or a legal sense – the mid-air collision of two other aircraft miles away.

Solutions

Pilots are good about dealing with problems, and this is just another problem to be solved. There are no easy solutions, however. Aviation insurance is difficult enough to obtain as it is. It may be expensive to increase the coverage limits of your general liability policy, even if the insurer will allow an increase. Plus, how much insurance is enough?

Umbrella insurance, which I have strongly advocated for years, is of little help for such situations, because nearly all policies exclude aviation-related liabilities.

Put simply, pilots and aircraft owners must protect all of their assets, from their home to their aircraft to their business to personal assets, so that if they are sued they can work out a more favorable settlement on the basis that it may difficult for a plaintiff to collect.

In our book, websites, and presentations, Chris and I have talked at length about protecting various assets such as homes, businesses, and financial assets. There is no way that I can repeat all of that advice and commentary here. What we haven’t discussed is how to protect an aircraft from judgments against the owner.

In many ways, an aircraft is like any other moveable physical asset such as an expensive car. The ownership of the asset is evidenced not just by possession, but also by title. Protecting the title of the asset is very important, and this is typically accomplished by placing title to the aircraft in a limited partnership or LLC that offers so-called “charging order protection.”

If the entity and its ownership is properly structured, with properly drafted documentation, the individual owner’s creditors will not be able to reach the aircraft itself. Instead, creditors will be stuck with some form of a non-controlling, non-voting interest in the entity that owns the aircraft only (and perhaps only a lien on that interest, depending on the state).

Avoid Single-Member LLCs

Some manufacturers and brokers of aircraft recommend to the owners that their aircraft be owned by a “single member LLC”, i.e., an LLC which has only one owner. They claim that the LLC provides asset protection and a way for the new owner to avoid local sales taxes.

A single member LLC can provide the owner with protection against liabilities arising from the conduct of the LLC. In other words, if the LLC does something wrong, the owner is not necessarily responsible. To reach the owner’s personal assets, a plaintiff would have to "pierce the veil" of the entity by showing that it was undercapitalized for its intended purposes, formalities were not followed, the owner used the LLC mostly for personal purposes and it did not serve a bona fide commercial purpose, etc.

However, a single member LLC likely will not protect the assets of the LLC from judgments against the owner. Because charging order protection is based on protecting the innocent non-debtor owners of an LLC or partnership, there is no rational basis for charging order protection for the owner of a single-member LLC, regardless of the fact that the LLC statutes call for such protection.  This sort of legal reasoning has been followed in a few such cases recently, and there is no reason to expect the trend to change.  So, if there likely is no charging order protection for single member LLCs, as there is for multi-member LLCs, a plaintiff has a good chance of acquiring either the full controlling ownership of the LLC or the assets in it.

Single member LLCs are great tools as subsidiary asset holding entities owned by a charging order protected holding entity.  This sort of structure provides charging order protection at the holding entity level, and liability segregation at the level of the subsidiaries.  However, as the sole barrier between an individual owner and assets the owner seeks to protect from his own individual liabilities unrelated to the LLC, single-member LLCs should be avoided.  The good news is that it is not terribly difficult to avoid single-member status.  Trusts or other entities can be owners of LLCs.  This avoids single-member status, and likely provides opportunities for estate and tax planning.

With respect to sales tax avoidance, some aircraft owners who live in states with substantial sales taxes, such as California, may set up an LLC in a state with no sales tax to purchase the airplane. While there are some legitimate means of avoiding sales taxes, they involve a lot more than simply forming an LLC in a no-tax state.  Furthermore, in addition to violating state tax laws, unlawfully evading state sales taxes might be considered felony mail and wire fraud under federal law.

Is it worth risking a possible federal indictment to avoid a few thousand dollars in state sales taxes? Sounds like a bad bet. While such crimes are rarely prosecuted, they can result in investigations where the state complains.

Aircraft as a Hot Asset

An aircraft is a "hot asset". It is not just that they look really cool, go really fast, and are hands-down the most fun toy on Earth, but they can also crash into things and generate liabilities. Because of this, aircraft should not be owned by trusts or entities with other valuable assets. The reason is simple: If the aircraft generates a liability to the trust or entity, then every other asset held by the trust or entity will be exposed to satisfy a judgment. Like any other hot asset, an aircraft should be segregated into its own entity, with relatively few other assets in that entity.

Very Light Jets (VLJs)

Concern about the liabilities arising from aircraft operation come at a time when several new so-called "Very Light Jets" have recently obtained FAA certification and are now being manufactured and sold. These are jets with typically six seats, including two for the pilots. With most prices under $2 million and fuel consumption relatively low, these jets give business owners the mobility they need without waiting around for hours at the airport.

New aircraft include the:

• Eclypse Aviation 500 – This is a new design by a new manufacturer that is made of composite materials instead of aluminum, with a cost of only $1.2 million.

• Cessna Mustang – This is a scaled-down version of Cessna’s popular and dependable Citation jet for $2.8 million.

• Adam Aircraft A700 – This new manufacturer’s new design is another composite aircraft, and is backed by corporate financing from Goldman Sachs.

• Diamond Aircraft D-Jet – A manufacturer known for quality, low-cost designs presents a 5-seat jet for a cool million. Probably more of a jet for those who already have a pilot's license than for those who will hire a pilot.

Not surprisingly, many buyers have signed up to purchase these aircraft by paying deposits and obtaining delivery positions. Getting the jet will not be the problem, but finding somebody to fly it might be. With airlines reporting record travel seasons, the demand for commercial-rated pilots is higher than ever meaning that the airlines are going to snatch up all the best pilots.

If you are a pilot, owning one of these planes will be like being a kid in a candy store. For everyone else, finding qualified pilots may be a difficulty. You will be much more likely to get the 23-year old kid with 600 hours mostly in a Cessna 172 than the seasoned pilot with 7,500 hours in a 737. Plus, while all of these jets will be certified for flying with one pilot only, having only one pilot creates the risk of a bad accident in the case of "pilot incapacitation", i.e., an unforeseen heart attack, stroke, etc. This will increase the potential for liability arising out of the operation of these new jets.

As with all other aircraft, it will be very important to create a solid asset protection structure to own title to the VLJs and to conduct flight operations. Just make sure that the technology of your asset protection plan matches the technology of your new jet.

PLAN NOW FOR YEAR-END TAXES

The end of the year will be here faster than you think. If you want to develop a quality – and not "last minute" – plan for your business to deal with taxes, the time to do that is now and not on December 31.

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831(b) Captive Insurance Companies

by Jay D. Adkisson

A captive insurance company is one that primarily underwrites the insurance risks of other companies owned by the same owner as the insurance company. A captive often underwrites certain risks for which ordinary commercial insurance cannot be obtained cheaply or at all. For instance, captive insurance companies are used to underwrite environmental risks as well as earthquake and flood risks.

Another significant non-tax benefit of a captive is that policy terms may be carefully tailored to meet specific needs. Many captive insurance policies are drafted as "litigation expense only" policies that pay only to fund attorney fees and litigation costs, but do not provide a fund for the plaintiff to tap if the claim is successful. This effectively creates a war chest to fight litigation, without creating additional assets to later be pursued.

The 831(b) provision allows an insurance company to take in up to $1.2 million in premium income every year without the company being taxed on that income. Taking into account IRS requirements under Rev.Ruling 2005-40 and otherwise, this means that an 831(b) captive has the potential to transfer up to $1.2 million in premiums out of the operating companies (giving it a deduction for the premiums paid) and into the insurance company without any corresponding tax being paid.

Caution that the tax treatment of insurance companies is very complicated, and captive insurance companies are particularly so. Along this line, one must especially beware of the risk spreading and risk shifting requirements discussed in Rev.Ruling 2005-40 and other IRS notices. To become an 831(b) company requires that an election be affirmatively made by the company, much like making an S-corporation election. No election; no 831(b) treatment.

Another benefit of captive insurance is that the premium payments effectively deplete the assets of the business being underwritten. In other words, every dollar of premiums paid to the captive is a dollar that has been moved out of the business and thus away from creditors. A good captive arrangement can keep other businesses appearing as only a "break even" enterprise on paper, because the profits have been effectively shifted to the captive. Because the premium payments are "for value", it would be very difficult for a creditor to claim that such payments are fraudulent transfers.

A lot of insurance and tax planners have tried to move into selling 831(b) companies the last couple of years, by claiming experience in setting up and managing captives that they do not have. Some of these planners will take the fact that they have associated with an insurance manager who actually has, say, 10 years of experience and then claim to their clients that they themselves have 10 years of experience when they don't have any or little experience with captives. You may be one of their first cases, which is a dangerous thing.

Between us, Chris and I have formed many dozens of captives over the last decade. The captive professionals we work with have formed many dozens more. Yet, it never ceases to amaze any of us that so many "bad" captives are being formed and badly run by others. Captives are a great tool when formed and managed correctly, but doing that is the catch. Offshore providers especially do not seem to understand what it takes for a captive to properly qualify as such under the tax code.

Forming an 831(b) insurance company and getting it licensed is the easiest part. The real difficulty is in running the insurance company and internally managing taxes on the investment income, while also creating a game plan for later winding the insurance company down on a tax efficient basis if that need arises because of unforeseen economic problems, sale of the operating business, death of the owner, or changes in the Internal Revenue Code.

Because of this, it is most important to have a sound game plan before the first steps are taken by having an actuarial analysis completed, having an agreement between the insurance professionals and the tax professionals on how the company will be run, and having a good CPA firm available to conduct the required annual audits.

Once upon a time, most captives were formed in the offshore tax havens such as Bermuda, the Caymans and the British Virgin Islands. Today, most states have passed captive enabling legislation such that there really is no compelling reason to form a captive offshore. To the contrary, with the IRS's war against pretty much anything offshore and with onerous reporting requirements for even properly formed and run captives, it is easy to understand why most captive formations are now done at home.

As a captive insurance company typically takes 60 to 90 days to get up and running, it is not a last-minute strategy where you can make a decision on December 31 and get a deduction for premiums paid. Typically, the steps to form a captive need to begin no later than October 15 for the company to be formed and licensed in time for premium payments to be made to it before year's end.

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419(e) Welfare Benefit Plans

The term "419(e) plan" refers to a plan that qualifies under paragraph (e) of Internal Revenue Code Section 419, which provides for the treatment of funded welfare benefit plans.

A 419(e) plan is an employee benefit program that is sponsored by the employer and which provides welfare benefits to its participants. It is a "single employer" welfare benefit plan, meaning that all of the employee benefits are paid for by the same company. There is no pooling of benefits among the employees of various companies. Since Welfare Benefit Plans are for the benefit of employees and the business owners, the assets in the plan should not normally be available to creditors of the business.

The plan typically involves an independent trustee that holds the trust assets and a third-party administrator that arranges actuarial certification of funding and benefits, and approves plan administration.

Cash contributions are made irrevocably to the trust without the possibility of reversion. They are determined actuarially based on an annual census using projected retirement ages of all employees and projected medical costs from retirement through actuarial death. The sponsoring employer may choose a target contribution or a target benefit. Contributions on behalf of key employees are kept separate from contributions for rank-and-file.

This type of plan allows a company a suite of benefits to its employees – including the owners of the business – ranging from death benefits during their working years to medical and long term care benefits in retirement. Essentially, the goal of a 419(e) plan is to allow the company to pre-fund certain retirement benefits in advance; thus, larger contributions may be made to the plan in the early years.

The employer is allowed to decide which benefits to provide to employees. New benefits may be coordinated with existing employee benefits, and new benefits that supplement the existing benefits may be offered.

One of the more popular benefits of 419(e) plans is post-retirement medical benefits. These benefits provide funding for health expenses incurred during retirement. Employees do not vest in the benefits, but instead become eligible when they reach a retirement age set by the employer.

The welfare benefits provided by a 419(e) plan are meant to enhance the financial security of employees and can include:

• Supplemental Disability Benefits

• Severance Benefits

• Post-Retirement Medical Benefits

• Long Term Care Benefits

• Death Benefits

If you will need certain welfare benefits through retirement anyhow, a 419(e) plan allows you to essentially pay for those benefits in advance and obtain a substantial current-year tax deduction. Some 419(e) plans additionally pay death benefits on behalf of current employees and add substantial medical benefits for retirees. The medical benefits can include reimbursement for amounts paid for medical, dental, and psychological care, prescription and over-the-counter drugs, long term care services, nursing home care, home care, premiums for medical, dental, Medicare and long term care coverage and more.

The investment growth inside section 419(e) plans is taxable to the employer. Because of this, many plans choose to invest in life insurance since life insurance grows on a tax-deferred basis. This creates the potential double-benefit that if an employee dies early, then death benefits are paid to beneficiaries, but if the employee lives too long then the tax-deferred build-up of the life insurance policy is available to fund benefits.

Typically, the medical benefit is funded with one or more insurance policies owned by the trust on the life of one or more owners, using cash values and accrued death benefits to cover medical expenses. This takes advantage of the tax-free buildup within the life insurance policy. On the other hand the death benefit is funded with an insurance policy on the life of each participant, payable to the trust but then passed entirely to the participant’s beneficiaries. Non-discriminatory rules apply except employees do not vest until actual retirement at a defined retirement age. Contributions to plans compliant with section 419 are deductible by the employer to the extent permitted by law. Distributions in the form of medical expense reimbursements are not taxable income.

The downsides of 419(e) plans include that, depending on the benefits provided, the contributions to the plan might not be fully deductible (such as where death benefits are provided) and discrimination among employees might not be allowed (such as where medical benefits are provided). Also, these plans are somewhat complex and require the services of an actuary who is experienced in these plans to correctly implement them.

Nonetheless, 419(e) plans are good for businesses that desire to tailor an employee benefit plan to their specific needs or which need flexible funding options. The plans may also be structured to provide valuable incentives to employees to remain with the company.

The benefits of Welfare Benefit Plans include:

• The employees benefit: the employee has the comfort of knowing that his family is protected in case of untimely death while covered and has the comfort of knowing that much of his medical needs in retirement — and the needs of his spouse and dependents — are met, including long-term care.

• The owner-employees benefit: like all employees the owner-employee has the comfort of knowing there is a death benefit and medical benefit awaiting the owner and the owner’s family as a before-tax expense of the company.

• The company benefits: the company can offer valuable benefits to reward valued employees at affordable costs; benefits formerly offered only by large employers which are now available to small and mid-size companies; it can use these benefits as “golden handcuffs” to stem turnover of expensively trained and valuable employees; its contributions are deductible so long as the rules of §419 and §419A are met, in other words contributions are more affordable with before-tax dollars to the extent deductible; and, the assets within the insurance policies grow tax deferred.

• A company that wants to offer supplemental benefits: Companies looking to reward their most important employees – the owners and executives – are often limited in the amount that can be contributed to plans for their benefit, particularly retirement plans. A Welfare Benefit Plan can offer additional benefits for these employees, such as family protection and retiree medical benefits, without limitations as long as actuarially reasonable.

• Post-retirement medical accounts are not vested and only become available for use by an employee when retirement age is reached while still an employee. Amounts forfeited due to termination of employment are retained by the plan.

In summary, 419(e) welfare benefit plans offer significant advantages to farsighted business owners and their employees, with a substantial portion of the offered benefits being currently deductible to the business. When correctly structured, they allow the business to pre-fund valuable post-retirement and other welfare benefits for employees.

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U.S. v. Townley

Slip Copy, 2006 WL 1345248 (9th Cir. No. 04-35767, May 17, 2006), case below (E.D.Wash. No. CV-02-00384-RHW, July 29, 2004).

Summary: A couple made transfers of property to a trust created ostensibly for the benefit of their children. At the time they created and funded the trust, they had no current creditors. But they admittedly created and funded the trust for the stated purpose of protecting their assets against the claims of future unknown creditors. The couple, after the creation of the trust, incurred a sizeable federal income tax liability. This court held that the fact that they had engaged in asset protection planning to defeat the claims of future unknown creditors was sufficient evidence to satisfy the "actual intent" element of the Washington fraudulent transfer laws as to the IRS.

The court also held that since the couple made no rent payments to the trust while continuing to live in the home that had been transferred, and the affairs of the trust and the couple were so intertwined as to be indistinguishable, the trust to which the couple transferred their assets was in fact their nominee and alter ego.

The 9th Circuit affirmed that the couple transferred their real property into the trust in violation of the Washington Uniform Fraudulent Transfers Act.

FACTS

The Townleys had owned their personal residence since 1977. In 1990, the couple borrowed against the equity in their personal residence to purchase an interest in investment property.

In 1995, the Townleys created the Beaver Valley Trust and conveyed both their personal residence and their interest in the investment property into this new trust. Although the Beaver Valley Trust has an independent trustee and their children were the beneficiaries, the Townleys were named the "Trust Managers" for an indefinite period and given the power to handle all trust affairs. The Townleys continued to live in their personal residence, but did not pay any rent to the trust or even make the utility payments.

By 2000, the Townleys had gotten themselves into tax trouble and had been assessed nearly $175,000 in unpaid taxes, interest and penalties.

In 2001, the Townleys filed for bankruptcy to attempt to avoid their personal federal tax liability.

Although the Townleys' objection to the IRS's claim was denied, the Townleys were given a discharge and the bankruptcy trustee reported that there was no unsecured property available for distribution.

The IRS then filed suit in U.S. District Court to reduce the federal tax assessments to judgment, set aside the transfers to the Beaver Valley Trust as fraudulent, and to foreclose on the federal tax liens.

The Townleys claimed that they did not make the transfers to defraud the IRS, since the IRS was not even their creditor at the time they created and funded the trust. They argued that they created and transferred property into the Beaver Valley trust to protect their assets from unknown future creditors.

Townley testified that he was concerned about potential "lawsuits from the exposure we had from liability from troubled boys in the State of Washington."

The District Court held that since the Townleys transferred their property to the Beaver Valley Trust before the IRS became a creditor, the IRS would be considered a future creditor of the Townleys under Washington law.

But, far from exculpating the Townleys from a fraudulent transfer, the District Court held that their admission that they made the transfers to protect against unknown future creditors was a veritable confession of their actual intent to hinder, delay or defraud all creditors, including the IRS.

According to the Court:

"[The Townleys] assert that no 'hypothetical future judgment creditor' exists, nor did one ever exist. * * * [The Townleys fail] to realize that the IRS is such a creditor. Under [the Townleys'] reasoning, the Washington Uniform Fraudulent Transfer Act would never protect future creditors. A close reading of ' 19.40.041, however, demonstrates that this section provides protections to both present and future creditors."

"Section 19.40.041 states:

"(a) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor's claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation: (1) With actual intent to hinder, delay, or defraud any creditor of the debtor.".

"If this statute is read by inserting the players in this case, it would read as follows: A transfer made or obligation incurred by the Townleys (debtor) is fraudulent as to the United States (a creditor), if the Townleys made the transfer or incurred the obligation with actual intent to hinder, delay, or defraud any potential plaintiffs who may have a cause of action (any creditor) against the Townleys (debtor). Mr. Townley's statement that he wanted to protect his assets from any potential 'lawsuits from the exposure we had liability from troubled boys in the State of Washington' represents direct evidence of his intent to defraud one of his potential future creditors, which is prohibited by ' 19.40.041(a)."

The District Court then noted that, in addition to satisfying the actual intent test, the Badges of Fraud that constructively prove the Townleys' intent to defraud creditors were also satisfied by their admissions:

"Here, [the Townleys] have not filed any affidavits in which they denounce any intent to defraud. Nor have they filed any affidavit testimony of other witnesses that would support that they did not intend to protect their assets from any future creditors. * * * On the contrary, [the Townleys] were very open and honest about their intent to defraud potential or future creditors."

The District Court further held that a trust may be considered an "insider" for purposes of a Badges of Fraud analysis, and additionally a trust may be considered an "insider" where it for the benefit of the debtors' children, since children would be considered an insider as well.

The court found other factors that indicated that the transfers were fraudulent. The Townleys

• retained possession and control of their personal residence by continuing to live in it after the ostensible transfer.

• did not make any rent payments.

• did not pay the utilities.

• transferred substantially all of their assets to the trusts (so they had no means of paying their tax (or other) bills as they came due).

• received no consideration for the transfer of their properties when they gifted them to the trusts.

The District Court also adopted an alternate theory: The trust amounted to the nominees of the Townleys, and thus its assets were available to satisfy their creditors under a nominee or alter ego theory:

"Here, [the Townleys] have retained control over the property of Beaver Valley Trust. [The Townleys] have the beneficial use of the property owned by the Trust, and they do not compensate the Trust for this use. There is a fluid financial arrangement between [the Townleys] and the Trust. Sometimes Defendants are paid for working for the Trust, sometimes they are not. Sometimes [the Townleys] pay the utility bill, sometimes the Trust pays the bill. The office of the Trust is located in [the Townleys'] residence. The ownership of the property changed hands without any consideration. The Townleys created and controlled Beaver Valley Trust, with the intent to protect their assets from potential creditors.

For all intents and purposes, Beaver Valley Trust is the Townleys and the Townleys are Beaver Valley Trust and the interests of Beaver Valley Trust are inseparable from the interests of the Townleys. As such, Beaver Valley Trust is a nominee or 'alter ego' of the Townleys. As nominee or 'alter ego,' it holds the Residential and Investment properties for their benefit. Thus, even if the transfers of the Residential and Investment Proper! ties to Beaver Valley Trust by the Townleys were not fraudulent and could not be avoided, the Residential and Investment Properties owned by Beaver Valley Trust are available to satisfy the Townleys' tax liabilities."

Based on all the foregoing, the District Court entered an order granting the IRS summary judgment and allowing the Service to directly foreclose upon those assets. In a short memorandum opinion, the Ninth Circuit affirmed:

"The district court did not err in holding that the Townleys transferred their real property into the Beaver Valley Trust in violation of the Washington Uniform Fraudulent Transfers Act. The Townleys' repeated admissions that they transferred property to the Trust in order to avoid potential future creditors provide direct evidence of fraud. Further, by demonstrating that the property transfer was characterized by multiple badges of fraud, the government also showed compelling circumstantial evidence of fraud. Therefore, the government provided the requisite 'clear and satisfactory proof' that the Townleys possessed! an 'actual intent to hinder, delay or defraud a creditor' under the UFTA."

This case illustrates at least five very important points for planners:

(1) The fact that that your clients have no creditors now when you are doing the planning does NOT mean that their planning cannot be challenged as a fraudulent transfer by a later- appearing creditor.

(2) If the stated purpose of your clients' planning is asset protection, i.e., to protect assets against future unknown creditors, that by itself may be enough to establish actual intent to engage in a fraudulent transfer.

(3) If your clients are living in a house that is owned by a trust of which they are not beneficiaries, and they are not paying rent to the trust, the arrangement is in danger of being set aside as a fraudulent transfer.

(4) If your clients' relationship with their trust is such that there is little separation between their financial identities, the trust may be considered your clients' alter ego and its assets will be available to satisfy their creditors.

(5) If you are making transfers to trusts where asset protection is an issue, make "for-value" transfers instead of gifts.

No Existing Creditors Does

Not Ensure Safety

A myth has persisted in the asset protection world that as long as you do planning when there are no creditors around, it will ipso facto be safe. That ignores that the UFTA has an entire section 4 that relates to "Transfers Fraudulent as to Present and Future Creditors," and which applies "whether the creditor's claim arose before or after the transfer was made or the obligation was incurred . . .."

There is what amounts to a "transferred actual intent" in fraudulent transfer law. If you make a transfer that is meant to defeat the rights of one creditor, that may be sufficient for a completely different creditor who comes along later to say that the planning was done with actual intent to defraud it too.

This transferred actual intent also applies on what amounts to an undefined group of unknown future creditors. If you do planning with the intent to defeat the rights of any future creditors who may later appear, regardless of who they are, then that intent will be applied to set aside the transfer as to any particular creditor who does in fact appear later.

[Query: But what is "asset protection" if not planning that has as its very intention the desire to defeat the rights of creditors, whether appearing now or in the future?]

This also means that the UFTA does NOT, repeat NOT, provide anything like a safe harbor simply because the planning was done when no creditors were present IF the planning was done with the intent to defeat any creditors, including future unknown creditors.

Do not also delude yourself into thinking that because you had your clients execute an Affidavit of Solvency that such gives you a free pass to thereafter to do asset protection planning willy-nilly for your clients, because it doesn't. In fact, the value of such affidavits is somewhere between speculative and dubious, though some planners swear by them.

My gut feeling is that these affidavits accomplish little more than creating a list of assets for creditors to start investigating where stuff disappeared to.

Planning Must Be Done For

Non-Asset Protection Reasons

Except for recognized homestead and statutory exemption planning, and some business entity planning and spendthrift trust planning, you should not conduct asset protection in its own name.

As this case shows, the very fact that the clients engaged in transfers to protect assets from unforeseen future creditors had the practical effect of a sworn confession that they had the intent to fraudulently transfer assets as to all creditors who came later. You cannot allow your clients to make this confession, which means that you cannot allow them to admit that they engaged in planning for the purpose of defeating ANY creditors of any kind.

This has significant practice implications:

• You should not have an engagement letter that says that a purpose for your planning is asset protection.

• You should not give your clients a memorandum that discusses the asset protective effects of what they are about to do.

• And you can't let your clients give affidavits or testify at depositions that the reason that they engaged in their planning was because of concerns of unknown future creditors. That doesn't work.

If your clients so testify or the creditors gets possession of any documents that talks about asset protection, that will be evidence of actual intent to hinder, delay or defraud creditors under UFTA, even if the creditor who does appear later was totally unforeseen.

There is little in the law that authorizes asset protection planning generally.

However, there is plenty that prevents it, including primarily the fraudulent transfer laws of each state. By and large, the legislatures and the courts want to see creditors get paid on their judgments and they have not given unconditional approval to planning that has as its stated purpose the shielding of assets from creditors.

If a client can't stand up and give a straight-faced reason why the planning was done for legitimate purposes (other than to lessen the rights of creditors), that planning will be in grave danger until the UFTA statute of limitations has run.

Trusts With Personal Residences

SHOULD Charge Rent To Be Respected

The District Court repeatedly focused on the fact that the Townleys had transferred their home to the trust, but had continued to live in it while paying no rent or even the utility payments. This fact was important in determining that the trust was really just a nominee of the Townleys or their alter ego.

The upshot of this is obvious: If you expect to put a personal residence into a trust of which your clients are not beneficiaries and have the arrangement respected for creditor-debtor law purposes, it is critically important that a normal landlord-tenant relationship exist between the clients and the trust, with rent, utilities, renter's insurance, etc. paid by the clients.

Also note that the tax law usually does not matter in determining state creditor-debtor issues. There is a Grand Canyon-sized disconnect between tax law and creditor-debtor law.

What often makes the difference in both tax law and creditor-debtor issues is the existence - or non existence - of a truly independent entity or an arms-length relationship.

Trust and Individual Affairs

must be Separately Identifiable

Alter ego law is once again being expanded to set aside an obvious asset protection scheme, where the debtors claimed that they transferred assets but continued to enjoy and control them.

You simply can't have it all ways: If you expect the trust to be treated as a legally independent entity, then you must treat it as a legally independent entity. That means an arm's length relationship between your clients and the trust must exist at all times.

We recently saw in the Ehmann case in relation to a family LLC that you cannot treat a business entity like the family piggy bank and think that it will still be respected for creditor-debtor purposes. Ditto for trusts.

Merely because you may be able to do some things from a tax standpoint and have them survive scrutiny does not mean that they will survive the civil court's scrutiny under nominee and alter ego theories. It may very well be in many cases that a much higher standard of separation and independence is required to survive a judgment collection challenge than would be required to meet a tax treatment standard.

Asset Protection's

Four-Letter Word: G i f t

The fraudulent transfer laws are primarily aimed at transactions that are without "reasonably equivalent value". The quite logical reason for this is simple: If the debtor doesn't get back something of value from the transferee, there is nothing available for the creditor to satisfy the judgment.

Gifts are inherently without "reasonably equivalent value" since by definition, there is no consideration for a gift.

Because of this (and although I know that gifts are a bread-and-butter technique for estate and charitable planning), if asset protection is an issue then gifts should be avoided because they are easy for creditors to set aside.

The Bottom Line

Asset protection is a very difficult planning area. This case illustrates that there is no "safe harbor" simply because the planning was done at a peaceful time when there were no creditors on the horizon. That is a myth and one that is now exploded.

You cannot do asset protection planning in its own name and expect it to survive scrutiny. Either the asset protection will be explainable for legitimate, non-creditor reasons, or in many situations it will probably fail.

And, as with business entities, you must respect trusts as separate stand-alone legal entities. This includes paying rent when a home is in the trust.

Finally, you must avoid making gifts where asset protection is a concern, because gifts are inherently weak forms of transfers for creditor-debtor purposes.

Arguably, the real art of asset protection planning is creating a fundamentally sound plan to accomplish legitimate client objectives that, as an incidental and collateral consequence, has a solid asset-protective effect.

CAUTION A POSSIBLE

STATE-BY-STATE VARIANCE

Note that some states have rejected the notion of transferring and intent to defeat the rights of an "intended but unidentified future creditor", contrary to the plain text of the Uniform Fraudulent Transfer Fact. Thus, there may be some states where the Townley result would not necessarily occur based on existing case law.

The problem is that the concept of "asset protection", i.e., specifically planning to defeat the rights of unknown future creditors, is relatively new and nobody really knows how the courts will treat this type of planning. Until this area of law is better settled, the smart planners and clients will presume the worst.

My feeling is that the arguments now being raised as to why the fraudulent transfer will not defeat asset protection planning done in its own name has the same ring as the arguments pitched in the 1990s as to why so-called foreign asset protection trusts would be respected by the U.S. courts and the contempt remedy would not be used – and we all know now what a disastrously wrong analysis that turned out to be.

The courts want to see their judgments enforced, and planning that is specifically meant to defeat such enforcement will always and quite understandably be viewed with the greatest skepticism by the courts.

__________

Movitz v. Fiesta Invs., LLC

(In re Ehmann)

319 B.R. 200, 206 (Bkprt. D. Ariz. 2005); Order Granting Trustee's Motion for Summary Judgment, etc., of December 7, 2005; Order Withdrawing Court's Opinion and Order Dated December 7, 2005, dated January 25, 2006; Case No. 2-00-05708-RJH; Adversary No. 04-00956.

An opinion unfavorable to debtors gets even worse, but then there is a surprise ending!

Summary: A federal bankruptcy court in Arizona granted the motion of a bankruptcy trustee to take possession and control of an LLC of which the bankrupt debtor was a member, and to make distributions or dissolve and liquidate the LLC as necessary to satisfy creditors. If followed, the decision has the potential to circumvent charging order protection in bankruptcy for purely passive membership interests in limited partnerships and LLCs, especially where the entity is used primarily to administer family assets without any significant business purpose.

EHMANN I

On February 9 of 2005, Chris Riser and I related what happened in the federal bankruptcy case of Movitz v. Fiesta Investments, LLC (In re Ehmann), 319 B.R. 200, 206 (Bankr. D. Ariz. 2005) (a/k/a "Ehmann" or sometimes "Fiesta Investments"). The bankruptcy judge had at that time just held that the debtor's non-managing membership interest in an LLC, including the debtor's non-economic rights, may be the property of the debtor's bankruptcy estate. This holding was despite Arizona law restricting the involuntary transfer of a member's LLC interest, which was deemed inapplicable under the Bankruptcy Code.

The central issue of the earlier Order was whether federal bankruptcy law applied, or the restrictive Arizona LLC law applied. This turned on whether the articles of organization and operating agreement defining the membership interest was an "executory contract" requiring the application of Arizona law under section 365 of the Bankruptcy Code. The flip side was whether the membership interest was a "non-executory contract", and thus simply a property interest under section 541 of the bankruptcy code such that federal bankruptcy law would apply, rather than Arizona law.

[As a refresher, executory means that there are duties that must be performed in order to receive benefits; non-executory means that the benefits will be received even if nothing further is done.]

After a very detailed analysis, the court concluded that a membership interest which does not include any management rights or responsibilities and does not require the non-managing member to do anything of substance should not be considered an executory contract. Such a membership interest should be considered part of a non-executory contract, and the membership interest would be subject to section 541 of the Bankruptcy Code, rather than Arizona law.

The Court noted that the membership interest might have been considered an executory contract if the member had substantial obligations to perform, and the non-performance of which would have amounted to breach of contract. But the debtor simply had no such obligations under the LLC's operating agreement.

The effect of the court's ruling is that the restrictive language of an operating agreement does not control the creditors' rights in bankruptcy if the debtor's interest was non-executory. In other words, the bankruptcy trustee becomes a full member of the LLC even if the operating agreement provides otherwise.

The Ehmann ruling caused much consternation in asset protection circles, since it had the potential to defuse the charging order protection in bankruptcy for most limited partnerships and limited liability companies for partners or members who had purely passive roles and no substantial duties to the entity. Planners had to find some duties for the partner or member to perform, but not duties that they might find a creditor someday doing. This isn't always easy to do. And as difficult for planners as this decision was, it was about to get much worse . . .

EHMANN II

Having established that federal bankruptcy law, and not Arizona law, applied to the debtor's membership interest in the LLC, the bankruptcy trustee attempted a bolder move to get around the charging order protection. The bankruptcy trustee moved for summary judgment to establish that the bankruptcy estate was a full member of the LLC, and appoint a receiver to take charge of the LLC so that proper distributions could be made and creditors satisfied.

The Court agreed, granted the Trustee's motion for summary judgment, and ordered the appointment of a receiver with the admonition that the receiver could, if necessary, cause the dissolution and liquidation of the LLC in order to satisfy creditors of the member debtor.

The debtor, other members, and even non-members had taken loans from the LLC. Although the loans were fully repaid with interest, the Court noted that these loans were all violations of the LLC's operating agreement. Although the loans did not harm the LLC, at the same time little or no distributions were made to members (including the debtor member, which distributions would of course have gone to satify creditors). The Court rejected suggestions that it was limited to an injunction to prevent further loans from being made, since:

"The conduct of Fiesta and its manager since the Trustee's appointment demonstrates an unequivocal intent to operate Fiesta as if it were a revocable living spendthrift trust. * * * Utilizing a legitimate business structure for the sole purpose of shielding assets from creditors borders on a fraud on creditors . . .. "

Section 365 of the bankruptcy code gives the trustee power to accept or reject executory contracts. However, subsection 365(c)(1)(B) says that the trustee cannot assume or assign contractual rights if the other party to the contract does not agree. It is against this provision that operating agreements are often drafted to prevent a bankruptcy trustee from taking over the debtor's interest. However, the Ehmann court went out of its way in Footnote 17 to warn practitioners against relying on § 365(c) for passive membership interests:

"[E]state planners' reliance on § 365(c) to prevent creditor access to assets is probably misplaced, at least where an operating agreement imposes no affirmative obligations on the members. In this arcane and overly technical area of law, it is worthwhile to remember the fundamental reason why special treatment is accorded executory contracts as compared with other assets and liabilities of an estate -- to permit trustees to realize on contracts that have a net asset value to the estate, while also permitting them to avoid the administrative liability that would accompany contracts that lack such a net value."

COMMENTARY

There are many painful lessons to learn from the Ehmann opinion. These lessons go to how business entities are used for asset protection purposes. Planners must realize that trusts are the vehicle for holding personal assets, and that business entities are for fulfilling bona fide economic ventures. Trouble often results when this dichotomy is forgotten or ignored.

Planners should take this sentence from the Ehmann opinion and have it tattooed on their forearm: "Utilizing a legitimate business structure for the sole purpose of shielding assets from creditors borders on a fraud on creditors". Yet, that is precisely what many planners are doing when they stuff purely personal assets into a family limited partnership or LLC having no real purpose but to hold title to the assets.

Another lesson of Ehmann (and a lesson that is endlessly repeated in case after case without being heeded), is that no matter how well a business entity is originally structured, it cannot be expected to stand up to creditors if it is used as the family piggy bank. The Ehmann court expressed great interest in the fact that at one time more than 70% of the LLC's assets were loaned out to either family members or projects owned by family members. Even though the loans were all paid back with interest, these loans clearly violated the LLC's operating agreement and indicated to the court that the members' real intention was to operate the entity as a living trust disguised as a business entity.

Client must be warned that they cannot misuse a business entity as the family loan vehicle to the exclusion of the rights of creditors and then later hope that the entity will stand up to prolonged creditor attack. Such misuse is an open invitation to the courts to search for unusual theories for relief, such as the Ehmann court's prior executory/non-executory analysis, to make the assets of the entity available for creditors.

Planners must further realize that most creditors' attorneys are not stupid, but often are just as creative in developing theories to get at assets as planners are at protecting them. Bankruptcy trustees, who daily watch the debtor's game of creditor dodge ball, can be even more creative in addition to being patient and tenacious. Any judge who has sat on the bench for any appreciable period of time has seen his or her share of debtor tricks.

When a business entity is making myriad loans to members and other insiders but not making distributions to benefit the creditors of a member, one can expect the creditors, the bankruptcy trustee, and the judge to all be looking for a theory that will allow the invasion of the entity to avoid the injustice of a debtor protecting assets within such an entity as if it were a spendthrift trust. (The Ehmann court made precisely this point by referring to Arizona's spendthrift trust statute in footnote 18 of the opinion.)

Another lesson of Ehmann is that not only must a planner create business entities only for bona fide business purposes, but even after the entity is formed the planner probably must assist clients in seeing that the entity continues to be used as intended and is not misused for either personal purposes or in violation of its own operating agreement. Clients should also be expressly educated and warned against using business entities for personal purposes, and the dangers of repeated insider loans. Simply creating an entity and waiving goodbye to the client when the check clears is doing poor service to the client.

The Ehmann decision is a troubling outcome for those who have family limited partnerships and LLC and have used their entity as a family funding vehicle. And that is exactly why the decision was later withdrawn!

THE SURPRISE ENDING

The Ehmann decision was so unfavorable to family limited partnerships and LLCs that Fiesta Investments LLC (the LLC at issue) paid $85,000 to settle all creditor's claims against the LLC and all administrative costs in full, which was conditioned on the court's withdrawal of its December 7 opinion in the case. The grounds were obvious enough:

"Here, it is essentially conceded that the general manager of Defendant Fiesta Investments is particularly interested in eliminating any precedential effect this Court's Dece