Bankrupt Debtor’s Asset Transfers Failed to Shield Assets from Creditors

March 30, 2007 | Roger McEowen


When a person is tumbling into financial trouble, a common planning technique is to try to maximize the amount of property that can be held exempt from creditors if bankruptcy is filed. The U.S. legal system has a long history of allowing debtors to hold specified items of property exempt from creditors (unless the exemption is waived). This, in effect, gives debtors a “head start” in becoming reestablished after suffering economic reverses. Typically, one of the largest and most important exemptions is for the homestead. Other exemptions exist for “tools of the trade” and retirement accounts. Because of the availability of exemptions, debtors may be tempted to convert non-exempt property (such as cash) into exempt assets before filing bankruptcy. There is no general prohibition on such conversions, but courts closely examine attempted conversions with respect to the adequacy of the purchase price and the bargaining of the parties involved. If the primary purpose of the move is to hinder, delay or defraud creditors, the conversion can be challenged. The propriety of asset transfers made just before bankruptcy filing was at issue in this case.

The debtor’s business was not doing well and couldn’t pay its debts. The debtor had personally guaranteed the business’s debts, so the debtor was on the hook for the liabilities. In 2005, a creditor went after the debtor to recover on the $1.3 million personal guarantee. Before filing bankruptcy, the debtor used $8,000 of non-exempt funds to establish Roth IRAs for his wife and himself. Later in 2005, the debtor used another $11,500 of non-exempt funds to pay down a note secured by a mortgage on his primary residence. That same day, the debtor filed a Chapter 7 bankruptcy petition and claimed his IRA and equity in the house as exempt assets under the Minnesota exemption statute. Before all of this happened, the debtor, in 2004, established two education savings accounts (I.R.C. §529 plans) for his children. The debtor claimed that the education accounts were either not property of the bankruptcy estate or were exempt. The bankruptcy trustee objected to the homestead and IRA exemptions and also claimed that the education accounts were property of the bankruptcy estate. The bankruptcy court agreed.

On appeal, the court affirmed. The court first noted that the debtor had filed bankruptcy three days before new bankruptcy rules went into effect. Under the new rules, at least some of the education savings accounts would not have been included in the bankruptcy estate. But, those rules had not yet gone into effect at the time the bankruptcy petition was filed. Under the prior rules, education savings accounts were not specifically excluded from the debtor’s bankruptcy estate. So, the appellate court held that it was reasonable for the trial court to determine that those accounts were included in the bankruptcy estate.

As for the homestead exemption, the new rules went into effect before the debtor filed bankruptcy. Under those rules, to the extent the homestead exemption was obtained through fraudulent conversion of non-exempt assets during the 10-year period before filing, the exemption is reduced by the amount attributable to the fraud.  So, the issue was whether the use of funds to pay down home mortgage indebtedness was fraudulent. That was a closer question that depended on all of the facts surrounding the transfer – debtors simply don’t have the blanket ability to use non-exempt resources to pay down debt on the residence. Here, the court noted that the evidence pointed to fraud. The debtor’s business was going down the drain at the time of the transfer, the debtor was insolvent, a creditor had taken legal action against the debtor on the personal guarantee and the transfer was made earlier the same day the debtor filed bankruptcy.

Concerning the IRAs, the court also upheld the trial court’s findings that their creation was tainted with fraud. Specifically, the court noted that the IRAs were acquired only a few months before the bankruptcy filing and were the first time that the debtor had ever acquired IRAs, even though he had been advised to start utilizing IRAs on prior occasions. The court also didn’t believe the debtor’s testimony that he purchased the IRAs as a retirement planning device because he was only 37 years old at the time, and had never done any retirement planning before.

Bottom line - non-exempt assets can be converted into exempt assets, but there better be a good reason to do so and it is helpful if it is part of the debtor’s overall estate, business and financial plan. Addison v. Seaver, No. 06-6060MN, 2007 Bankr. LEXIS 972 (BAP 8th Cir. Mar. 30, 2007).