Mike Markham on Chapter 11 Bankruptcies (pt 2 of 2)
Navigating the Tax Consequences of Real Estate Foreclosures, Short Sales, and Similar Transactions by Chris Denicolo
Flexible Planning For Uncertain Times by Ken Crotty & Seaver Brown
Special Preview of What Estate Planners (and others) Need To Know About Bankruptcy (includes definitions section)–by Alan Gassman, Al Gomez, Mike Markham, and Adriana Choi
Possible Advantages of Filing a Bankruptcy by Alan Gassman, Al Gomez, Mike Markham, and Adriana Choi
Planning Potpourri by Martin Shenkman
Richard Connolly’s World
Humor! (Or Lack Thereof!)
We welcome contributions for future Thursday Report topics. If you are interested in making a contribution as a guest writer, please email Alan at email@example.com
This report and other Thursday Reports can be found on our website at www.gassmanlaw.com
Quote of the Week
Halloween was confusing. All my life my parents said, ‘Never take candy from strangers.’ And then they dressed me up and said, ‘Go beg for it.’ I didn’t know what to do! I’d knock on people’s doors and go, ‘Trick or treat.’ ‘No thank you.’
Halloween or Hallowe’en (a contraction of All Hallows’ Evening), also known as Allhalloween, All Hallows’ Eve, or All Saints’ Eve, is a celebration observed in a number of countries on 31 October, the eve of the Western Christian feast of All Hallows’ Day. It begins the three-day observance of Allhallowtide, the time in the liturgical year dedicated to remembering the dead, including saints (hallows), martyrs, and all the faithful departed.
It is widely believed that many Halloween traditions originated from ancient Celtic harvest festivals, particularly the Gaelic festival Samhain; that such festivals may have had pagan roots; and that Samhain itself was Christianized as Halloween by the early Church. Some believe, however, that Halloween began solely as a Christian holiday, separate from ancient festivals like Samhain.
Halloween activities include trick-or-treating (or the related guising), attending Halloween costume parties, carving pumpkins into jack-o’-lanterns, lighting bonfires, apple bobbing, divination games, playing pranks, visiting haunted attractions, telling scary stories and watching horror films. In many parts of the world, the Christian religious observances of All Hallows’ Eve, including attending church services and lighting candles on the graves of the dead, remain popular, although elsewhere it is a more commercial and secular celebration.
Mike Markham on Chapter 11 Bankruptcies (pt 2 of 2)
Now you can even do a cramdown on equity. You don’t often see that. Sometimes there is value in equity, but again there is no inferior class to equity unless you have multiple levels of equity. In more complicated cases you can have A shares, B shares, C shares, common shares that you would apply the rule in that fashion – as long as an inferior class receives nothing, then equity can retain something for the higher class. As long as you are wiping out common, then you can give the holders of the preferred equity interests whatever you want to give them, and they are getting more than they would otherwise get.
We also need to discuss Executory Contracts. The classic definition of an Executory Contract is a contract where there is performance on both sides. So it could be a lease, it could be a purchase agreement that hasn’t closed yet, it could be a purchase agreement that has closed and it may have post-closing obligation. It could be franchise agreement. It could be an employment agreement. It could be a variety of things where both sides have performance obligations. One person is a supply agreement with a vender for a term of months or years, and you can reject it or you can assume it. The debtor has to make a choice. If they reject it, a rejection of an Executory Contract is deemed a breach on the moment immediately proceeding the bankruptcy filing, and then the creditor gets to file a claim for rejection damages, whatever damages they think they have suffered as a result of the breach. That breach isn’t necessarily a termination. There is a lot of confusion on that point.
People think that rejection of a contract is the same as termination of a contract. That is not the case. It can be, but is not always the same. The court will generally grant any motion to reject, because it is based on the best interests of the debtor, and generally it is in the debtor’s best interest to reject, although a purchase agreement, for example, that is still executorial – let’s say you signed the purchase agreement on a piece of property and you haven’t closed yet – if you move to reject that, you are going to give that party a very large unsecured claim, and that is a situation where unless there is a very unique situation, it might not make sense to reject that purchase agreement, because of the very large unsecured claim. But where you normally see rejection is in leases of either real or personal property where the debtor wants to close down certain locations. Under state law, obviously, if you move out, you can get sued for the balance of the rent under the lease.
One of the unique things about bankruptcy is that certain types of rejected Executory Contracts have caps on the amount of the rejection damage claim. Leases of real property are one of those. Employment agreements also have a cap. On a lease of real property, the cap is generally one year’s rent, which is why it is important for landlords to get personal guarantees in case the lessee entity files bankruptcy and can then automatically limit the rent obligation to one year going forward. There is another more complicated formula, but generally speaking when you reject the lease of real property it is whatever rent was owed at the petition date plus one year’s rent, so that does a debtor that has multiple retail locations, like Toys ‘R Us for example, reduces the amount of unsecured claims dramatically that flow from those lease rejections.
The context of an Executory Contract in bankruptcy can apply to virtually anything, and the courts have been extremely inconsistent in what is and what isn’t an Executory Contract. There are cases on both sides that would suggest that an LLC Operating Agreement, or even a partnership agreement can be an Executory Contract. So there are cases on both sides that say that it is or it isn’t. Why is that important? I didn’t talk about assumption because the one option is rejection, which means you are out from under the contract and the person gets an unsecured claim, but when you assume an Executory Contract, that means you have got to live up to the terms of that Executory Contract. In other words, unlike a secured debt that you can modify under the plan, you cannot modify the terms of a lease or Executory Contract. If you assume it, you have to assume it per its terms. You can’t say, well I am going to assume it but I am going to reduce the rent from $5,000 a month to $4,000 a month. You can’t do that. And not only do you have to assume it with the terms, when you assume it you have got to cure any arrearage or any defaults that existed – and you’ve got to cure those within a reasonable period of time. So what is that reasonable period of time? That differs. There is no hard and fast rule. In the context of a lease, I think it is generally at least six months, so if you have a client that is leasing space and didn’t pay rent for three or four months, then they file, they want to assume it, they make the regular monthly payment plus call it 1/6th of whatever the arrearage is and then they are cured out over a six month period. I think that could also be as long as a year, depending on the circumstances. If the only thing that is going to get in the way of the reorganization is the cure of an arrearage on a lease or an Executory Contract, the court is probably going to extend that time longer than it might in another case, to allow that case to confirm because they are not going to let one creditor stand in the way. One of the important rules of Chapter 11 is to not be the last creditor standing that hasn’t yet cut a deal with the debtor, because if you are the only person objecting to that plan, you better have a real good objection, because the court is going to be looking to confirm that case. So you do not want to be the last man standing.
I want to talk about some unique claims that might come into play in Chapter 11. One of these are tax claims. Real estate (“ad valorem tax”) claims are considered to be secured and can be paid out over time like other secured creditors, but IRS is not secured. Penalties and interest on taxes owed to the IRS are not priority claims, but the taxes will be. The hard and fast rule in Chapter 11 is that those taxes have to be paid in full with interest at a very low federal rate within five years of the petition date. That was a change the IRS fought for several years ago. It used to be five years from the confirmation date and the IRS got it changed to five years from the petition date, so now if you linger in Chapter 11 for a year or two, instead of having five years from confirmation to pay out your tax claim, you only have five years from the petition date, so if you get confirmed one year in, you only have four years left. But that is the hard and fast rule, unless the IRS agrees otherwise, and they generally will not agree otherwise. Nevertheless, Chapter 11 does stop the IRS in its tracks to the extent that they have secured liens, which after some period of time, when you owe the IRS money they typically file liens in the public records. Those liens are good for ten years. But, think about what we talked about before about stripping down a secured claim and valuing it. If that IRS lien is behind secured debt, which it probably is, then there is probably no value to support that secured tax claim, which means you can strip it down, render it wholly unsecured, and depending on the age of the tax, it may not be a priority claim.
Certain income taxes that are owed more than three years in arrears may be discharged, but the discharge rules are extremely complicated and beyond the scope of this discussion.
If the tax is unsecured or stripped away from being secured, then the IRS is lumped in with the other general unsecured creditors, and may be out-voted in the class by other creditors who would like to see the business survive and continue to do business with them.
Another advantage of filing bankruptcy is that the IRS will actually talk to you in the Bankruptcy Court once a case is filed. Many clients and their advisors can never get an IRS collections officer to have a reasonable conversation, or sometimes any conversion at all. Once a bankruptcy is filed, the IRS normally assigns someone from the U.S. Attorney’s Office, either locally or in Washington, D.C., to handle the file, and they normally assign a bankruptcy specialist. In the Tampa Bankruptcy Court, the specialist will be located in Jacksonville, but at least it gives you someone to communicate with so that you can learn with the IRS’s position is.
The next thing topic is what matters Bankruptcy Courts have jurisdiction over. It can be very critical to have lawsuits and other disputes heard and resolved in the Bankruptcy Court by the judge who handles the entire case, and may have a predilection towards assuring that the reorganization is successful.
Bankruptcy Courts have jurisdiction over anything that is related to the bankruptcy case. Related to a bankruptcy case means that it has a conceivable effect on the outcome of the case. So that is a pretty broad jurisdiction. It is intended to be pretty broad, because if something is going to impact the bankruptcy case, then the court should have jurisdiction to determine whether it is going to go forward. Remember, bankruptcy courts are Article III courts. They are not Article I courts like District Courts. They do not have the same powers and authority and jurisdiction that the regular District Court does. The courts have limited jurisdiction, and that jurisdiction has become more and more limited over the years after a couple of major United States Supreme Court cases that made it clear that they were not going to let bankruptcy courts just rule on everything that comes before them.
If court has jurisdiction because it is related to the bankruptcy case, then the next question is whether it is considered to be a core proceeding or a non-core proceeding. Many bankruptcy judges would determine that they had jurisdiction over a variety of cases that would have otherwise been heard in state court. We often call these “collateral disputes”, which have nothing to do with liens. Most debtors will prefer that the Bankruptcy Court have jurisdiction over disputes and most creditors will oppose this.
In the more recent cases, core jurisdiction has been limited to those matters specifically set forth in 28 U.S.C. Section 157 of the United States Code, which is intended to keep court proceedings limited to items that are very bankruptcy specific, like the recovery or avoidance of a fraudulent transfer, or a preferential transfer or an action to determine the extent and validity and priority of a lien or confirmation of a plan, or an object to somebody’s discharge. So core proceedings have gotten really down to where it is a pretty tight group and it has become difficult to convince bankruptcy courts to take matters and render them core. When they are core jurisdiction matters, the bankruptcy court will prepare a final judgment no different than a District Court, but if it is non-core, then the bankruptcy court can only enter a findings of fact and conclusions of law, or a report and recommendation, but then it goes up to the District Court, and a completely fresh opinion is issued, with the Bankruptcy Court’s opinion having no precedence, and with the review thus being “do novo”.
There is some subtlety there – and what’s the difference?
In Bankruptcy Court your first appeal is to the District Court, unless you are in a circuit that has what is called a Bankruptcy Appellate Panel. For Floridians, the 11th Circuit does not have a Bankruptcy Appellate Panel, so all bankruptcy appeals go to an individual District Court judge, who then reviews findings of fact on a clearly erroneous basis, and reviews conclusions of laws on a de novo basis.
The difference is that in a non-core proceeding where the bankruptcy judge can only enter findings of fact and conclusions of law, those findings of fact are reviewed by the District Court on a de novo basis. If you think about that, some of the most critical findings of fact that you are going to see are did the debtor commit fraud? Was there intent to defraud or any intent issue? The bankruptcy judge might view that intent factual question much differently than a District Court judge would, so it becomes very critical – its really more your standard of review, that it is the difference between a core and a non-core proceeding, but a lot of times bankruptcy judges are reluctant to hold onto non-core proceedings because of the cumbersome nature – they conduct an entire trial over the matter. They render findings of fact and conclusions of law. They send them up to the District Court, and then people have to wait for the District Court to enter a final order either confirming or disapproving the findings of fact and conclusions of law of the bankruptcy court. So a lot of times for that reason bankruptcy courts don’t like dealing with non-core proceedings.
So how do you end up with a non-core proceeding? One of two ways. Either the debtor files an adversary proceeding against somebody, and if the debtor files an adversary proceeding against somebody that is a creditor or an antagonist of some kind that is not a fraudulent transfer or one of the listed core proceedings, then you are going to immediately have a fight over whether that’s core or non-core. The other way is by removing a state court proceeding to the bankruptcy court. There is a rule in the bankruptcy rules – Rule 9027, that permits the removal and there are also jurisdictional statutes that permit the removal of pending state court proceedings to the bankruptcy court. There is time frames for doing that. If it is a case that was already pending, you have 90 days from the petition date to remove it. If it is a case that gets filed after the bankruptcy – you have 30 days to remove it. However, that removal time frame is not a jurisdictional bar like it is in the federal court removal statutes that permits the removal, for example, from state court to federal court on diversity grounds. In any event, one of the first things that happen after a case gets removed to the bankruptcy court, which is usually done by the debtor because they are looking for a friendlier forum to adjudicate the dispute that is going to take a look at the bankruptcy cases as a whole and not just that one little isolated dispute. The first thing the court is going to do is have to determine whether its core or non-core, because again if it is non-core, the court has to issue findings of fact and conclusions of law and it becomes a little cumbersome. So what you usually see from the creditor party, or whoever the third party was that was opposite the debtor that wants a proceeding is removed to the bankruptcy, you often see a motion to remand, and one of the factors – there are many factors about why the court should remand, but one of those is whether it is a core or a non-core proceeding.
So that is kind of the way bankruptcy jurisdiction works. There is also an abstention doctrine and an abstention statute that says that if an adversary proceeding is filed in the bankruptcy court that really does nothing but mirror a dispute that is pending in state court, that there are grounds very similar to the remand grounds, that the bankruptcy court should abstain from determining that proceeding in favor of the pending state court proceeding. So remand and abstention are very similar doctrines, but they are slightly different in their procedural application.
The Office of the United States Trustee is a branch of the Department of Justice based in Washington, D.C. that then has a United States Trustee located in each region, meaning there is one in Atlanta that governs the 11th Circuit. That person is the boss of that office, kind of like the U.S. Attorney, but then in each local office there are, for example, I think in Tampa that there are five lawyers that represent regularly every day of their life the Office of the United States Trustee, and then a similar number of what they call bankruptcy analysts, who are usually accounting-type people that dig through the paperwork. It is their office’s job to monitor bankruptcy cases, and they monitor individual cases and they monitor corporate cases, Chapter 11 cases. They are the ones that get involved in disputes over the means test, in individual cases. They are the ones that file motions to dismiss individual cases as bad faith filings under Section 707. They are the ones that investigate, and if they think crimes have occurred, they are the ones that generally would be the ones that would make the referral to the U.S. Attorney’s Office. They are going to be there and they are going to be present in every bankruptcy case, and how closely they look at your case as opposed to another case is just kind of a crap shoot in a way. Obviously they don’t have time to pay attention to the hundreds, if not thousands, of cases that get filed, so they do what they can and they keep an eye on the cases.
Navigating the Tax Consequences of Real Estate Foreclosures, Short Sales, and Similar Transactions
By Chris Denicolo
While the real estate market and the economy in general have improved significantly since the nadir of 2007-2009, it is important to understand the tax implications of a foreclosure, a short sale or forgiveness of indebtedness.
Internal Revenue Code Section 108 provides the general rule that any indebtedness which is forgiven or cancelled will be ordinary income to the debtor, unless an exception applies. The exceptions to the recognition of discharge of indebtedness income are provided in Section 108(a), and include the following:
- Indebtedness that is discharged in a bankruptcy case;
- Indebtedness that is discharged when the debtor is insolvent;
- The indebtedness discharged is qualified farm indebtedness;
- The indebtedness discharged is qualified real property business indebtedness; and
- The indebtedness discharged is qualified personal residence indebtedness.
To the extent that one of the above exceptions applies, the debtor does not recognize income from discharge of indebtedness.
The nuances and tricks associated with these exceptions are beyond the scope of this article, but it is important to understand their existence and the benefit of planning to have one of these exceptions apply in a situation where a client might have discharge of indebtedness income. Stay tuned to the Thursday Report for a future article which addresses these exceptions in greater detail.
It is also important to understand situations where discharge of indebtedness income might apply. Many practitioners can be confused by the interplay between general tax law associated with the sale of assets, and the discharge of indebtedness income rules, which is especially important in the context of a foreclosure or short sale.
The IRS takes the position that, where a debtor is personally liable for a mortgage on a property that is subject to foreclosure or that is part of a short sale transaction, the debtor who owns the subject property is treated as having sold the property to the purchaser at the foreclosure or short sale. Accordingly, the debtor must pay income tax on the excess of: (a) the greater of (i) the amount of the debt forgiven; or (ii) the amount of the sales proceeds; over (b) the debtor’s adjusted basis in the property.  To the extent that the amount of the mortgage in excess of the sales proceeds is forgiven, such excess amount is treated as income to the debtor from discharge of indebtedness under Internal Revenue Code Section 108.  Such discharge of indebtedness income can be avoided if the debtor qualifies for one of the exceptions described above and in Internal Revenue Code Section 108 in more detail.
For example, if the debtor’s adjusted basis in the property is $1,000,000, the amount of the foreclosure sales proceeds are $600,000, and the outstanding debt is $1,200,000 which is forgiven by the lender on the foreclosure sale, then the debtor will have a tax loss of $400,000 on the foreclosure sale, and will also have $600,000 of discharge of indebtedness income. The fair market value of the property is irrelevant.
As another example, if the debtor’s adjusted basis in the property is $1,000,000, the amount of the foreclosure sales proceeds are $600,000, and the outstanding debt is $900,000 which is forgiven by the lender on the foreclosure sale, then the debtor will have a tax loss of $400,000 on the foreclosure sale, and will also have $300,000 of discharge of indebtedness income. The fair market value of the property is irrelevant.
The loss and income might not offset because they might be of different character, as the discharge of indebtedness income is ordinary income and the tax loss on the foreclosure sale could be a capital loss. If the real estate was property “used in a trade or business” under Internal Revenue Code Section 1231, then the loss on the foreclosure sale would be an ordinary loss, which could be used to offset the discharge of indebtedness income. Likewise, if the real estate is ordinary income property due to the debtor being a “dealer” in real estate sales, then the loss might be used to reduce or eliminate the discharge of indebtedness income.
If the debtor is not personally liable for the mortgage, the debtor nevertheless is subject to income tax on the excess of the amount of the sales proceeds over the debtor’s adjusted basis in the property, as if the debtor sold the property to the purchaser at the foreclosure sale or the short sale. However, no discharge of indebtedness income results to the debtor if the forgiven mortgage balance exceeds the sales price, because the debtor is not personally on the mortgage. 
For example, if the debtor’s adjusted basis in the property is $1,000,000, the amount of the foreclosure sales proceeds are $600,000, and the outstanding debt is $1,200,000 which is forgiven by the lender on the foreclosure sale, then the debtor will have a tax loss of $400,000 on the foreclosure sale, but will not have any discharge of indebtedness income (because the debtor was not personally liable for the debt). The fair market value of the property and the amount of the outstanding debt are irrelevant. Thus, the same result would occur regardless of the amount of the outstanding debt.
The tax treatment of a deed in lieu of foreclosure (i.e., where the debtor conveys the property to the lender in exchange for extinguishment of the debt) is slightly different from what occurs under a foreclosure sale or a short sale. Generally, the deed in lieu of foreclosure with respect to a mortgage for which the debtor is personally liable is treated as a sale to the lender where income tax would be based upon the excess of the fair market value of the property over the debtor’s adjusted basis in the property.  If the amount of the forgiven mortgage exceeds the fair market value of the property, such excess is treated as discharge of indebtedness income, which might be avoided by the debtor under the exceptions described in Internal Revenue Code Section 108(a) (e.g., insolvency or bankruptcy).
For example, if the debtor’s adjusted basis in the property is $1,000,000, the fair market value of the property is $700,000, and the outstanding debt is $1,200,000 which is forgiven by the lender as a result of the deed, then the debtor will have a tax loss of $300,000 on the foreclosure sale, and will also have $500,000 of discharge of indebtedness income. The amount of the sales proceeds is irrelevant.
As another example, if the debtor’s adjusted basis in the property is $1,000,000, the fair market value of the property is $700,000, and the outstanding debt is $900,000 which is forgiven by the lender as a result of the deed, then the debtor will have a tax loss of $300,000 on the foreclosure sale, and will also have $200,000 of discharge of indebtedness income. Again, the amount of the sales proceeds does not matter.
If the debtor is not personally liable for the mortgage in a deed in lieu of foreclosure situation, the fair market value of the property is irrelevant. The debtor’s income tax is based upon the amount of the forgiven mortgage debt over the debtor’s adjusted basis in the property, regardless of the value of the property. There is no discharge of indebtedness income because the debtor was not personally liable for the mortgage. 
For example, if the debtor’s adjusted basis in the property is $1,000,000, and the outstanding debt is $1,200,000 which is forgiven by the lender as a result of the deed, then the debtor will have no gain or loss or discharge of indebtedness income on the transaction. The fair market value of the property and the amount of the sales proceeds are irrelevant. Therefore, the same result would occur regardless of the amount of the outstanding debt.
The tax consequences of a foreclosure, short sale or deed in lieu transaction vary significantly based upon the nature of the transaction, the use of the property, and whether the debtor was personally liable for the mortgage. It is important to note that a guarantor does not recognize discharge of indebtedness income under the tax law, and that the tax classification of the applicable real estate might be different based upon the ownership structure of the underlying real estate and whether an entity is treated as a partnership, S corporation or C corporation for federal income tax purposes.
As discussed above, we will be providing additional articles in the future regarding the nuances and details of the discharge of indebtedness income rules and exceptions, and we hope the above is helpful.
1 Helvering v. Hammel, 311 U.S. 504 (1941).
2 Treasury Regulation § 1.1001-2.
3 Commissioner v. Tufts, 461 U.S. 300 (1983).
4 Treasury Regulation § 1.1001-2.
5 Commissioner v. Tufts, 461 U.S. 300 (1983).
Flexible Planning for Uncertain Times
By Ken Crotty & Seaver Brown
Because of the uncertainty related to the potential reformation of the tax code and the impact that it could have on the estate tax and estate planning, we have summarized five of the best planning techniques that clients may want to consider implementing now. These flexible strategies allow advisors and their clients to take advantage of present opportunities, while also providing them with the ability to reverse their decisions based on what changes occur in the future.
- Using Qualified Disclaimer Rules to “Undo” Gifts
Most practitioners only think of using disclaimers in the context of inheritances and bequests. However, trustees can also disclaim gifts made to a trust similar to how a person can disclaim an inheritance. Generally, if a trustee disclaims an interest in property that otherwise would have become trust property, the interest does not become trust property. Using this technique gives clients a nine month lookback to “undo” a gift.
In addition to the requirement that a disclaimer be made within nine months of the gift, the disclaimer must be made in writing, must be delivered to the appropriate custodian/trustee, the disclaimed interest must pass without any direction on the part of the person making the disclaimer, and the disclaimed interest must pass to a person other than the disclaimant unless the disclaimant is the spouse of the donor.
Whether a trustee can disclaim on behalf of a trust is a question of state law. Many states require that the trust instrument specifically grants the trustee the power to disclaim property on behalf of a trust. Practitioners should not rely on a clause buried in boilerplate trust language related to disclaiming property for CERCLA/environmental reasons. Instead, practitioners should research the applicable state law and add very specific language to ensure that a trustee has the power under both the trust instrument and state law to make a qualified disclaimer. Practitioners should also include language in the trust protecting the trustee from potential liability to the beneficiaries as a result of disclaiming the interest.
Assets disclaimed by the trustee can revert back to the donor to undo a transaction but make sure the donative instrument and state law are clear of the result. See, e.g. Uniform Probate Code §2-1106(b)(2). For example, some state anti-lapse statutes would deem a disclaimant to have predeceased and have title to the donated assets pass to a donee’s issue upon disclaimer. Generally, if a gift is not to an individual, then upon disclaimer the assets pass as if the non-individual had never existed.
Practitioners and clients need to remember the doctrine of “acceptance and control,” which negates the ability of a donee to disclaim a gift. It is important to understand this concept if the trustee wishes to preserve the right to disclaim a gift for a full nine months.
Mere retitling or naming a trust as the beneficiary of an account is not acceptance. However, selling the assets, or spending or reinvesting dividends from stock may be acceptance. Consider using minority or non-voting LLC interests to avoid some of this risk, because assets of the LLC may be sold by a non-donee manager without being deemed to have been accepted by the donee trustee. Pledging assets for a loan constitutes acceptance. Taking cash from a brokerage account does not preclude disclaiming the stocks or bonds in the account, unless such assets were traceable to dividends that were taken out of the account.
2) Making Gifts via Intervivos QTIP’s for Married Individuals
If the settlor is married and wants to fund a trust for his or her spouse (and there is no pending divorce likelihood), the client can make an inter vivos QTIP election for the trust. The election needs to be made on a timely filed gift tax return, including extensions. This flexibility allows the settlor to decide up until the gift tax return is filed whether to use some of his or her gift exclusion when reporting the gift or to avoid such use by electing to have the gift qualify for the marital deduction. No gift tax exclusion is used if QTIP election is made, and unlike the disclaimer technique discussed above, there is no worry that trustee acceptance disqualifies the technique.
The donee spouse can be provided with a testamentary power of appointment to direct how the QTIP trust assets will be held after his or her death. The donee spouse can exercise this power of appointment so that the assets can be held in trust for the primary benefit of the donor spouse. If this occurs and the trust is properly drafted, the assets should not be considered to be owned by the donor spouse for estate tax purposes. If the trust has a spendthrift clause, the assets should also not be exposed to creditors of the donor spouse, notwithstanding that the donor spouse initially funded the QTIP trust prior to the death of the donee spouse.
3) Funding Domestic Asset Protection Trusts
In states like Delaware, Ohio, and Nevada individuals may establish a domestic asset protection trust (DAPT) that enables the settlor to remain as a beneficiary, and the gift to the trust by the individual can be a completed gift based on the terms of the trust. However, whether there is any Section 2036 retained interest remains a fact-dependent question based on the circumstances of administration, which could cause the assets of the trust to be included in the settlor’s estate. A different technique that might prevent this issue would be to omit naming the settlor as a permissible beneficiary in the trust document, but allow a trust protector to add the settlor as beneficiary at a later date.
In the Steve Leimberg Estate Planning Newsletter entitled “The Reversible Exempt Asset Protection (“REAP”) Trust for 2017 Planning,” we noted that the REAP Trust, which is “also known as the Reversible Mirror Trust, allows clients to take advantage of presently available and effective estate tax planning opportunities, while providing the flexibility needed to address the possible uncertainties that might exist on the horizon, while also providing asset protection that may greatly exceed what is now otherwise in place.”
4) “Swap Powers” in Irrevocable Grantor Trusts
“Swap powers” in an irrevocable grantor trust (“IGT”) can be used to swap assets if any tax reforms occur. When irrevocable trusts are drafted to be grantor trusts, which are deemed to be owned by the grantor for income tax purposes, one of the common provisions used in the trust to cause it to be a grantor trust is a swap power which allows the grantor to acquire any part or all of the Trust Estate by substituting other property of equal value, and providing that such power may be exercised in a non-fiduciary capacity without the approval or consent of any third party except as to the value of property exchanged.
If we assume that Joe Settlor funded a $5 million IGT with LLC interests. If President Trump’s provisions exempting family business/farms from being subject to “mark to market” capital gains tax triggering at death are passed, then Joe might want to transfer $5 million of his stocks/real estate into the IGT, taking back the LLC interests, enabling his estate to escape an additional $5 million deemed capital gains event.
5) Trust Protectors (or Limited Trustee Amendment Powers)
Another technique that planners can utilize to hedge their bets against tax reform is to allow trust protectors to radically change the trust, even adding the settlor as beneficiary. Trust protectors provide flexibility within trust vehicles that are traditionally not-so-flexible. This flexibility, however, can pose some significant problems in the future that the settlor and estate planner failed to contemplate. In order to minimize these potential complications, the provisions of the trust should clearly delineate the rights and responsibilities between protectors, trustees, and beneficiaries. Trust protector provisions could provide the trust protectors with the ability to:
- Remove or replace trustees
- Remove, replace or add beneficiaries
- Terminate the trust
- Vary trust provisions to reflect changes in tax laws
- Modify distribution provisions
- Consent to or veto discretionary powers of the trustee, such as investments or distributions to beneficiaries
- Change trust situs to a state with favorable laws
- Resolve disputes between beneficiaries and trustees
- Appoint successor trustees
Some or all of the above techniques can be used by a client to incorporate flexibility into the client’s estate plan, allowing the client’s estate plan to be modified and adapted to provide the maximum benefit for the client and the client’s family as a result of future changes in the tax law.
Special Preview of What Estate Planners (and others) Need To Know About Bankruptcy (includes definitions section)
By Alan Gassman, Al Gomez, Mike Markham, and Adriana Choi
Bankruptcy is a federal law right given to all Americans to resolve debt situations and receive a “fresh start” if certain circumstances exist.
Most Americans, including affluent, but creditor-challenged individuals, are not aware that it is possible to file a Chapter 7 individual bankruptcy and receive a total discharge of all indebtedness, while maintaining ownership of considerable assets that are exempt from creditor claims where most of the debt is business and/or tort obligations, as opposed to consumer debt. When most of the indebtedness is consumer debt, then a Chapter 13 payment plan may be required to the extent of ability to pay over-time based upon somewhat complicated formulas.
While a high percentage of debt situations can be worked out without resorting to bankruptcy, the ability to file a bankruptcy proceeding, or the possibility that creditors could force a debtor into bankruptcy, must be considered for individuals, companies and other entities that may not be able or willing to pay all of their creditors in full. Conduct and strategies employed years before filing for bankruptcy can have significant impact on the outcome of a bankruptcy proceeding, or the ability to even file for bankruptcy. There are many bankruptcy lawyers who are not aware of the significant number of nuances under the Bankruptcy Code that can be impacted by advanced planning.
For example, filing a bankruptcy petition may cause loss of attorney/client privilege, criminal prosecution for failure to disclose past concealment, scrutiny from the U.S. Trustee’s office, and will cause the federal rules of evidence to apply.
That is why it is critical for conscientious estate planners and business lawyers to have a general understanding of how bankruptcy law works, and when to bring in a specialist lawyer to assist with planning. This outline is designed to enable estate planning lawyers to have significant background in how what we do, advise, document and communicate may impact what happens to clients who have to negotiate with bankruptcy as a possible strategy or predicament, or when bankruptcy is actually filed.
The following definitions have been written to give the reader a background in basic bankruptcy terminology and methodology. It may be useful to read these before proceeding through the outline, and to refer back when helpful.
- Bankruptcy– The federal law and process that permits debtors to adjust creditor situations and receive a “fresh start” under the separate bankruptcy court system.
- Chapter 7 Bankruptcy– A process that provides for the appointment of an independent trustee to liquidate the non-protected assets of a debtor as pre-bankruptcy debts are discharged if certain requirements are met.
- Bankruptcy Estate– Upon filing bankruptcy, assets of a debtor become property of the bankruptcy estate, and are then under the control of the trustee in bankruptcy or the debtor in possession, pursuant to 11 U.S.C. § 541.
- Discharge– The actual Order that results in debt being cancelled under a Chapter 7 bankruptcy, or upon completion of a successful Chapter 11 or Chapter 13 bankruptcy payment plan. No discharge is issued to non-individual entities (such as corporations and partnerships) under the Bankruptcy Code.
- Loss of Discharge– What occurs when a debtor in bankruptcy is denied the right to discharge by reason of pre-bankruptcy or post-bankruptcy conduct which causes the debtor to never be entitled to receive a discharge of debt then existing, leaving the debtor in “debtor purgatory.”
- Chapter 13 Bankruptcy– A payment plan arrangement that individual debtors meeting certain requirements must comply with under payment plan rules in order to adjust their debts and the terms of payment thereof.
- Consumer Debt– An individual or married couple that would otherwise desire to discharge debt in a Chapter 7 liquidation will be required to have a Chapter 13 or 11 payment plan if most of their debt is “consumer debt,” which does not include debt that is the result of typical negligence, such as automobile accidents caused by a debtor.
- Means Testing– The term denoting the criteria by which a debtor who would file a Chapter 7 bankruptcy may be required to instead enter into a Chapter 13 bankruptcy, with a payment plan, or a Chapter 11 bankruptcy, as applicable.
For example, an individual or married couple that might otherwise file a Chapter 13 bankruptcy will be required to file in Chapter 11 if they have more than $394,725 in unsecured debt or more than $1,184,200 in secured debt.
- Chapter 11 Bankruptcy– A reorganization bankruptcy that will typically apply for businesses, investment entities, and individuals having large amounts of indebtedness or otherwise not qualifying for a Chapter 13 bankruptcy.
- Prepackaged Chapter 11– A Chapter 11 bankruptcy where there is advance agreement between the debtor and most, if not all, creditors to allow for debt to be reduced in a bankruptcy proceeding in order to have the ability to avoid federal income tax on debt discharge or adjustment, and state law documentary, intangible and other transfer taxes that may not apply when transitions and transactions occur in bankruptcy.
- Debtor in Possession– A debtor that files bankruptcy and has the right to maintain ownership and control of assets and activities in a Chapter 11 bankruptcy.
- Bankruptcy Schedules – The schedules that must be filled out accurately under penalty of perjury and filed with the bankruptcy court for a debtor to file a bankruptcy proceeding.
- Involuntary Bankruptcy– A bankruptcy proceeding filed by creditors to force a debtor into a Chapter 7 or Chapter 11 bankruptcy liquidation. This must be done in good faith, after reasonable negotiations, will require three creditors to join in the petition if the debtor has twelve or more legitimate creditors.
- Exempt Assets – An asset that will not be accessible to creditors and may be retained by a debtor under state or federal law, such as homestead, IRAs, 401(k) plans and 529 plans where law permits.
- Non-Exempt Assets– Assets which are subject to creditor claims and become assets of the bankruptcy estate upon the filing of a bankruptcy.
- 730 Day or 180 Day Rule– A debtor will need to reside in the state where the bankruptcy is filed (to have the exemption laws of that state apply) at least 730 consecutive days before filing, or if not then the majority of days where the debtor has resided during the preceding 180 days will apply.
- Automatic Stay– The law which requires creditors to not take actions without court approval to collect or otherwise proceed against a debtor once a bankruptcy has been filed, unless or until the creditor has successfully filed to have the stay “lifted.”
- Adequate protection– Refers to the ability of a creditor to have protection of collateral where mortgage or security agreements exist and other requirements are satisfied.
- Suggestion of Bankruptcy– A document filed in a state court proceeding to indicate that one of the parties has filed bankruptcy, in order to stop or otherwise alter the state court proceeding.
- Attorney-Client & Work Product Privileges– The two common privileges which prevent a lawyer’s file and work product from being accessible to parties who are adverse to a client.
- Privilege Log– A schedule that must be disclosed when the attorney/client privilege is claimed to let the opponent know basic information about each item in the attorney’s file for which the privilege is claimed.
- Crime Fraud Exception– Federal and state laws which prevent the attorney/client privilege from being available if the conduct subject to the communication involved advice concerning the perpetration of a crime, defraudment, or possibly, in some cases, fraudulent transfer matters.
- Core Proceedings– Controversies that might normally be held in state court or non-bankruptcy federal court that become adjudicated in the bankruptcy court, which may include matters that would have otherwise been subject to arbitration requirements.
- Income from the Discharge of Indebtedness– As per Internal Revenue Code Section 108, a debtor may recognize taxable income when debt is discharged, which may be limited to the value of assets that will be owned after the discharge occurs, or which may not apply whatsoever if the discharge occurs in a bona fide bankruptcy proceeding.
- Fraudulent Transfer– A transfer which may cause loss of the ability to receive a bankruptcy discharge, if it has occurred within one year before the debtor files bankruptcy, or which may be set aside or subject a transferee to liability if it has occurred within two years before the filing of bankruptcy under the federal Bankruptcy Code, or for whatever longer period of time may apply under state law.
- Doctrine of Successor Liability– State law which provides that the successor owner of a business or investment arrangement will be responsible for the liabilities of the previous owner if there is a commonality of related ownership, business identity, customers, and business assets. A bankruptcy court approved sale can avoid imposition of the doctrine.
- Assignment for the Benefit of Creditors (ABC) – A statutory state law proceeding where the local court will oversee the sale or distribution of corporate assets and payment of expenses and liabilities so that creditors are fairly treated, and officers, directors and managers of the debtor entity can avoid liability for fiduciary duties owed to creditors if the ABC plan is approved and carried out. An ABC plan does not discharge debtors in most states or avoid application of the Doctrine of Successor Liability.
- Executory Contract– A contract between the debtor and third parties that may be binding upon the trustee in bankruptcy or debtor in possession, because there are contractual obligations on the part of both the debtor and the third party. This can be very important in the following situations:
(1) Where the debtor owns LLC member or limited partnership interests and wishes to limit the creditor to having charging order protection in a jurisdiction that provides for this to be the sole remedy. A Limited Partnership Agreement or Operating Agreement may be executory when each partner or member has an obligation to make capital contributions, provide significant services, guarantee indebtedness, or carry out other material responsibilities.
(2) A trustee in bankruptcy or debtor in possession may “reject” a non-executory contract, and thus not have legal responsibility, other than as to the damages that might be sued for by the other party. For example, a trustee may choose not to pay a promissory note or to continue with an Operating Agreement where the payee or other party has no affirmative obligations. On the other hand, an Operating Agreement where both the debtor and third parties have affirmative obligations to make capital calls, provide management services, and to guarantee obligations should be characterized as an executory contract, making charging order protection possible, if applicable under state law.
- Opting In or Outing-Out– Debtors residing in states that allow the choice between having the state law or the federal law of creditor exempt assets may “opt-in” or “opt-out” of the federal exemptions.
- Tenancy by the Entireties– A special status of property owned by a married couple which may be immune from the creditors of either spouse under state law. It is possible that debtors living in a non-tenancy by the entireties state will be able to protect assets held as tenants by the entireties in a state where this is recognized. This specifically includes real estate and has been held to include tangible personal assets by at least one Florida case. Tenancy by the entireties may protect homestead property even where it would not otherwise be protected because of the homestead protection exceptions that were passed in 2005.
- U.S. Trustee’s Office– A federal criminal enforcement agency officed in Bankruptcy Court buildings which provides investigative and prosecutorial services with respect to bankruptcy fraud, monitoring, and associated matters, as more thoroughly described in Footnote 1 below.
- Contempt of Court– An equitable remedy that may be applied by a bankruptcy judge to force a debtor to go to jail in order to induce conduct with respect to making assets available to the trustee in bankruptcy under circumstances where the debtor is believed to have control over the assets or a third party in possession of the assets, or has inappropriately created an impossibility with respect thereto.
- Homestead Protection Exceptions– At present, a homestead exceeding $160,375 in value (or $320,750 for a married couple in bankruptcy if owned jointly), and otherwise exempted under state homestead creditor protection law, will be accessible to the trustee in bankruptcy to the extent of such excess net value if one of the following exceptions applies: (1) the home was acquired or its equity value was enhanced by one or more “fraudulent transfers” within ten years of a bankruptcy being filed, with the exception to apply to the extent of equity attributable to such fraudulent transfers; (2) the homestead was acquired less than 1,215 days before bankruptcy is filed; or (3) one of the “bad conduct” exceptions under Bankruptcy Code Section 550(a)(1). See the case of Martinez v. Hutton (In re Harwell), 628 F.3d 1312, 1314 (11th Cir. 2010) discussed in the materials that follow.
- Stripdown– Where a mortgage or other collateralized loan is reduced in a Chapter 11 or 13 bankruptcy to the value of the collateral. The excess indebtedness becomes unsecured, and a payment plan must provide for satisfaction of the collateralized debt over time – commonly five years with interest based upon a 30 month amortization schedule.
- Cramdown– Where a judge has required creditors to be owed less monies, or under different payment terms, notwithstanding the creditor’s objection thereto.
- Concealment– The felony of misleading the bankruptcy court and creditors by having substantive ownerships and benefit from assets that are not reported as assets of the debtor on a bankruptcy schedule.
- Core Proceedings– These are legal adversary proceedings where the Bankruptcy Court holds trials and makes determinations that would normally occur in state or federal court if the debtor were not in bankruptcy.
- Non-Core Proceedings– Litigation occurring outside of Bankruptcy Court that involves a debtor and may impact the outcome of a bankruptcy proceeding.
- Adversary Proceedings– Proceedings similar to separate litigation within the bankruptcy case that is adjudicated by the Bankruptcy Court as if this were separate litigation outside of bankruptcy.
Possible Advantages of Filing a Bankruptcy
by Alan Gassman, Al Gomez, Mike Markham, and Adriana Choi
Possible advantages of having disputes adjudicated in a court of bankruptcy:
- Bankruptcy judges are said by many to favor debtors, and bankruptcy courts are a “court of equity” with powers that a typical state court of law will not have. Courts of equity are able to provide remedies beyond ordering the payment of money, as further discussed below.
- Justice will often be much quicker and more severe given the ability of a bankruptcy court to navigate quickly, and without a jury. Federal bankruptcy courts will commonly be less congested and more able to push a matter along to completion at trial than a state court. Disputes may be adjudicated by the bankruptcy court without a jury, and bankruptcy judges tend to push disputes through trial in the bankruptcy court without delay, and may favor a debtor whose business is attempting to survive the bankruptcy process in a Chapter 11.
- Creditor lawyers and creditors in general are often reluctant to hire specialized counsel to pursue claims in bankruptcy court. Many creditors simply “give up” when a debtor files for bankruptcy.
- The ability to appeal a matter to a federal District Court, and then a federal Circuit Court of Appeals, can result in less political and more accurate and analytical results than a state court action.
- The average bankruptcy court judge may be far superior than the average state court judge, and there will typically be less local politics since the judge is appointed for a fourteen year term and will not need to run for re-election or be “popular” among the lawyers and others in the community. Often the bankruptcy court is further away from the “hometown situation” of the debtor than state court would be.
- Creditor lawyers may not be adept at representing creditors in bankruptcy, and creditors may have a sour track record with bankruptcy court judges.
- Traditionally, bankruptcy courts can only issue final orders on matters which arise from “core” proceedings listed under 28 U.S.C. §157(b). Non-core issues are those which may affect a bankruptcy proceeding; however, only exist under state law, such as a tort or breach of contract. Thus, bankruptcy judges may only issue advisory opinions on non-core matters.
This would be a reason to file bankruptcy earlier rather than later, because the criteria for determination of whether a dispute should be adjudicated in the court is that the court must determine whether to enforce an otherwise valid arbitration clause or to refuse enforcement and decide the underlying dispute. The court’s discretion depends on the nature and origin of the dispute, and whether arbitration will adversely affect the bankruptcy case.
- For a Chapter 7 bankruptcy, there can be finality to debt that is discharged, and any disputes associated therewith.
- There is immediate protection against a creditor’s collection efforts and wage garnishment from the date of filing under the “automatic stay.”
- Debtors who reside in non-tenancy by the entireties states may have tenancy by the entireties assets located in other states that will be protected in bankruptcy, but not otherwise.
- The clawback rights that some creditors will have against others in Ponzi schemes or where there have been preferential transfers.
- Elimination of the “one year after discovery” time given to a creditor under many state fraudulent transfer statutes when the “longer of four years or one year from discovery” rule applies. This will be applicable in many other states that have adopted the Uniform Fraudulent Transfer Act.
- 13. A lease obligation of a debtor tenant may be limited to past due amounts plus only the greater of (1) one year from the time of filing; or (2) 15% of the post-filing term of the lease, but no longer than three years of future lease obligations. This may relieve guarantors who are in bankruptcy of lease obligations beyond the one year after filing.
- A debtor that is an employer may eliminate any damages that would be attributable to obligations beyond one year after the filing under the employment agreement.
- In some cases, a debtor may (but the law is unclear) be able to have the Bankruptcy Court eliminate a non-competition covenant that would otherwise be enforceable, such as by an ex-employer, or a purchaser of a debtor’s business.
- The lawyers and professionals representing the debtor going forward will typically be paid first from available assets.
By Martin Shenkman
Florida’s governor vetoed bills to permit wills to be signed by e-signatures. What about using e-signatures now on Crummey notices? That would save incredible time and hassle for many taxpayers, and there is no requirement for them to be signed (although many advisers recommend it). Besides it might get hordes of folks to address Crummey powers that get so frustrated they give up. What about annual minutes for an entity or consents for the various fiduciaries of an irrevocable trust? Too often these matters are never documented and if e-signatures confirm important actions that too may be far better than no documentation at all. Consider the challenges to LLCs and trusts above. Perhaps periodic web meetings corroborated with e-signed minutes might be a positive step to deflect challenges for ignoring entity formalities.
■ Health Care Costs. The average 65- year-old healthy couple will spend $400,000+ on health care during their remaining lifetimes. What about a couple where one or both have health issues? At $400,000 the uber-wealthy won’t have to worry, but for the mere wealthy who are already pushing the envelope on prudent spending, that figure could sink their financial ship.
■ Is it a loan? A creative taxpayer tried to characterize distributions from a closely held business as loans. After all, if he treated the amounts as compensation he’d have to pay tax. The court wasn’t impressed and gave a checklist of factors to consider when determining if something is a loan (fish or fowl?). While everyone should know these factors, it seems that so many taxpayers trip over loan characterization that a refresher course is worthwhile:
■ Ability to repay.
■ Existence of a debt instrument.
■ Security for the repayment.
■ Interest being paid.
■ A fixed maturity date.
■ Repayment schedule.
■ Records of the parties confirming the transfer was a loan.
■ Conduct of the parties corroborating loan treatment.
■ Whether the borrower actually made payments on the note.
■ Whether the lender had demanded repayment.
■ Agent confusion. A growing and potentially nettlesome issue is how aging folks appoint people to help them with financial matters. The lack of coordination of how this is addressed could create considerable conflict. Consider each of the positions or appointments: safe deposit box alternate signer, bank account titles, agent under power of attorney, successor trustee on a revocable trust, trusted contact person on a brokerage account under FINRA Rule 4512, Social Security Representative Payee, agent to make funeral arrangements, and more…
Richard Connolly’s World
Insurance advisor Richard Connolly of Ward & Connolly in Columbus, Ohio often shares pertinent articles found in well-known publications such as The Wall Street Journal, Barron’s, and The New York Times. Each issue, we feature some of Richard’s recommendations with links to the articles.
The attached article from Forbes reports:
It’s official. For 2018, the estate and gift tax exemption is $5.6 million per individual, up from $5.49 million in 2017. That means an individual can leave $5.6 million to heirs and pay no federal estate or gift tax. A married couple will be able to shield north of $11 million ($11.2 million) from federal estate and gift taxes. And the annual gift exclusion amount is $15,000 for 2018—up from $14,000 where it’s been stuck since 2013.
To View the Full Article Click Here
Humor! (Or lack thereof!)
In The News with Ron Ross
HAVE YOU HEARD THE RADIO AD FOR “THE HURRICANE LAWYER”?
Don’t be fooled. The hurricane has no legal standing in the state of Florida. Sure, its’ lawyer talks a good game, and the hurricane may in fact have suffered damages, poking its’ eye as it passed over the Keys. But whoever badly you may feel for the poor hurricane, however eloquent the attorney, remember, that hurricane was trespassing. Just like a burglar who put his eye out when he was stealing your candelabra, don’t let his sad story, or the fact that the hurricane only had one eye to begin with encourage you to settle.
Everyone who mattered in France was there
From Louis XVI to Robespierre
Walking the white carpet to share their passion
For the very latest in couture fashion
The interviewers asked about their Givenchy
Dior, Cardin, and the best in Par-ee
When all the court has passed, the king and queen
Met the real hero, the guillotine
They still looked fashionable without a head
But now to be safe, fashion show carpets are red