August 2011 - Vandrew Law | NJ Estate Planning, Wills, Trusts, Asset Protection

UFTA III: Solvency and the Importance of a CPA-Prepared Statement of Financial Condition

This is my third post in a series on UFTA. Running afoul of UFTA will bust any asset protection plan, so familiarity with it is crucial. You can read my first two posts about UFTA here and here.

In my previous post, we learned that doing a solvency analysis is crucial to staying on the right side of UFTA. But what is solvency? Under N.J.S.A. 25:2-23:

A debtor is insolvent if the sum of the debtor's debts [after any purported transfer of assets] is greater than all of the debtor's assets, at a fair valuation.

That seemingly simple definition can cause a host of issues. This post will review a few of them.

Under the above definition, we can reduce solvency to math. Assets - Debts = Net Worth. If Net Worth is negative after any transfer of assets into an asset protection vehicle, we have insolvency. Our analysis, then, must start with the definition of "assets" and "debts".

Under N.J.S.A. 25:2-21:

"Asset" means property of a debtor, but the term does not include:

a. Property to the extent it is encumbered by a valid lien;

b. Property to the extent it is generally exempt under nonbankruptcy law; or

c. An interest in property held in tenancy by the entireties to the extent it is not subject to process by a creditor holding a claim against only one tenant.

An asset is pretty much anything we would include in the normal definition of the word, with a few exceptions. The most notable exception is that "assets" do not include assets which creditors cannot attach. [This is what is meant in subsection b above.] In New Jersey, this would mean that both IRAs and 401(k)s, for example, are not "assets" for purposes of UFTA solvency. Another of the exceptions is property held as "tenancy by the entireties". That exception will be discussed in a future post.

Also note that property is not an asset to the extent is is encumbered by a valid lien (subsection a above). Taken together with N.J.S.A. 25:2-23(e), this means that if you have a house worth $250,000 with a $200,000 mortgage, the house counts as a $50,000 asset and the mortgage doesn't count as a debt. On the other hand, if you have a $200,000 house with a $250,000 mortgage, the house isn't an asset at all, and the mortgage counts as a $50,000 debt.

Moving onto defining "debts", under N.J.S.A. 25:2-21:

"Debt" means liability on a claim.

"Claim" means a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.

In short, a debt is anything you owe anyone. It is also anything you might owe someone in the future should a specific set of circumstances arise. The latter is what UFTA calls a "contingent" claim and is one of the trickiest parts an UFTA solvency analysis.

Based on the definition above including "contingent" claims, in an UFTA solvency analysis, do we need to include all amounts of money which we could possibly end up owing anyone? The answer to that must be no, otherwise almost no one would be solvent under UFTA. So how do we deal with contingent claims then?

Probably the most common type of "contingent" claim under UFTA is a personal guarantee. Most small business owners are forced to give personal guarantees all the time in order to obtain loans for their businesses. The normal scenario starts with XYZ Corp wanting a loan from Bank. Bank agrees to grant the loan, but requires that John Doe (owner of XYZ Corp) give a personal guarantee on the loan. This means that if XYZ Corp defaults on the loan, Bank can sue John to recover what is is owed.

When John Doe meets with an asset protection attorney, does XYZ's loan have to be considered in a personal solvency analysis for John? Under the definitions of "debt" and "claim" under N.J.S.A. 25:2-21, the clear answer is yes. Does John then need to record the full value of the loan as a "debt" in his solvency analysis? The answer to that is no, and that is the key to this discussion.

In a fraudulent transfer solvency analysis, the value of a personal guarantee or other contingent claim is reduced by the probability that the debtor won't become responsible for the liability. [Remember, John Doe only becomes responsible for the debt if XYZ Corp defaults.] See, e.g., In the Matter of Xonics Photochemical Inc., 841 F.2d. 198 (1988). This means that in our John Doe example above, John's personal guarantee might have very little or no value as a debt in his solvency analysis if XYZ is a healthy company and unlikely to default on its loan. In this regard, the UFTA seems to defer to Generally Accepted Accounting Principles in determining the value of the debt.

This brings me to the final point of this post. Many times my clients are perplexed as to why I have them obtain a Statement of Financial Condition prepared by an independent CPA shortly after our first meeting. The reason I do this is to protect against a future UFTA attack. Remember that UFTA solvency analysis is done as a snapshot at the time the transfers into asset protection vehicles are made. Solvency at the time of creditor attack is irrelevant. Therefore, a CPA-prepared financial statement which was completed at the time of the transfers will provide good evidence of solvency should a creditor raise the issue years later. Not all assets and debts on the statement will be considered assets and debts for UFTA (as described above), but it will be easy for a court to adjust for those exceptions. This places a creditor trying to argue insolvency into the position of having to discredit the Statement of Financial Condition, which may be difficult since it will be likely be given a good amount of weight when prepared by a licensed independent CPA.

The independent CPA will also have valued all contingent liabilities on the statement as of the time of transfer, meaning again that a creditor will be stuck trying to discredit those valuations years after the fact should it try to bring an insolvency argument. This isn't impossible for a creditor to do, but again the Statement of Financial Condition will be likely be given a good amount of weight by a court when prepared by a licensed CPA.

My upcoming plan for the blog is to do a few more posts on UFTA, and then move on to some new topics. If you have any questions about UFTA or asset protection in general, don't hesitate to contact me.

TAX ADVICE DISCLAIMER: Any tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

NOT LEGAL ADVICE. Everything posted here is for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of me or another qualified attorney. Nothing posted on Twitter or on any website shall be construed in any way as legal advice.

DISCLAIMER: I am an attorney and a CPA, however I am neither your attorney nor your CPA, and therefore no communications between us are covered by attorney-client or accountant-client privilege unless you possess a signed document which states that I currently represent you as an attorney or a CPA. In the case that such a document exists, the existence or waiver of attorney-client privilege or accountant-client privilege shall be controlled by the signed fee agreement or engagement letter.

About the Author

Return to Law Offices of Jeff Vandrew Jr, Attorney-CPA Homepage

UFTA Part II: Reasonably Equivalent Value and its Application to LPs and LLCs

This is the second post in a series on the Uniform Fraudulent Transfer Act and its applicability to asset protection planning. To read the first post in the series, click here.

Now that we have reviewed the basics of UFTA, we can move on to defining "reasonably equivalent value" for purposes of UFTA. If you remember, not receiving reasonably equivalent value is one of the components of both actual and constructive fraud.

We get very little information on the definition of "value" from the statute itself. Only one section of the statute addresses it, N.J.S.A. 25:2-24:

a. Value is given for a transfer or an obligation if, in exchange for the transfer or obligation, property is transferred or an antecedent debt is secured or satisfied, but value does not include an unperformed promise made otherwise than in the ordinary course of the promisor's business to furnish support to the debtor or another person.

b. For the purposes of subsection b. of R.S. 25:2-25 and R.S. 25:2-27, a person gives a reasonably equivalent value if the person acquires an interest of the debtor in an asset pursuant to a regularly conducted, noncollusive foreclosure sale or execution of a power of sale for the acquisition or disposition of the interest of the debtor upon default under a mortgage, deed of trust, or security agreement.

c. A transfer is made for present value if the exchange between the debtor and the transferee is intended by them to be contemporaneous and is in fact substantially contemporaneous.

As you can see, that section doesn't help much. It tells us that someone who bought an asset in a foreclosure sale has given reasonably equivalent value despite the price he may have paid. It also tells us that the value received by the debtor in a transfer is the value of what was transferred to the debtor or the amount of debt discharged in the transfer. The latter would have been obvious even without this statutory provision.

We are then left to court decisions to further flesh out the definition of "value" received by a debtor. The definition was clarified somewhat by the court in In re Chadwick, 2011 Google Scholar 12438110022790024933 (Bkrpt. E.D. Ten. 2011):

[T]he proper focus is on the net effect of the transfers on the debtor's estate, the funds available to unsecured creditors. As long as the unsecured creditors are no worse off because the debtor... has received an amount reasonably equivalent to what it paid, no fraudulent transfer has occurred.

Quoting In re Congrove, No. 04-8049, 2005 WL 2089856, at*3, 330 B.R. 880 (B.A.P. 6th Cir. 2005).

In other words, when we're trying to value what was received by a debtor in exchange for one of his assets, we use the value to a creditor of what was received, not its value to the debtor himself. For example, if a debtor transfers $100,000 to an IRA in exchange for a $100,000 interest in that IRA, despite the dollar values being the same the debtor has not received any value. This is because an IRA is protected from creditors under New Jersey law and therefore has a zero value to a creditor. For UFTA purposes, the debtor has transferred $100,000 for $0.

"Reasonably equivalent" is likewise not defined by UFTA. To stay on the safe side of UFTA, I therefore recommend assuming "reasonably equivalent value" means fair market value. Based on plain meaning, I can't see any definition of reasonably equivalent value ever being greater than fair market value.

So what does all of this mean in practical terms? It means that when we are planning, if we make a transfer into a protected structure we almost certainly haven't received reasonably equivalent value. This does NOT mean we can't make the transfer. It simply means that we can't make the transfer if the value of the transferred asset exceeds the degree to which the debtor is solvent. [We also, as with any transfer, must avoid violating the other provisions of UFTA not relating to solvency.] The mathematical calculation to determine "the degree to which a debtor is solvent" will be covered in my next post in a week or so.

The principles above have especially interesting application to LLCs and LPs used for asset protection (as described in an earlier post). Some practitioners have argued that if a debtor transfers $100,000 into an LLC valued at $200,000, and the debtor receives a 50% interest, he has received reasonably equivalent value. I disagree. As discussed above, the value received is computed as the value to a creditor, not to the debtor. Because the LLC interest is charging order protected (at least in most states), its value is very low to a creditor. A willing buyer wouldn't likely pay a willing seller anything for a charging order, and for that reason I believe there is no reasonably equivalent value. Further, if such a transfer were held to be for reasonably equivalent value, UFTA would become ineffective as a statute, which could not have been the intent of the legislature. Many will say this is a very conservative interpretation of UFTA, but it is better to be conservative than to have an asset protection plan broken because the debtor got greedy.

To emphasize, this does not mean that we can't make transfers to LLCs for asset protection purposes. It simply means that we need to do a solvency analysis before we do. Solvency will be addressed in my next post in a week or so.

UFTA sounds complicated, and it is. Staying on the right side of UFTA is one of the reasons engaging a competent attorney for asset protection planning is so important. If you're interested in an asset protection plan that won't violate the provisions of UFTA, contact me.

About the Author

Return to Law Offices of Jeff Vandrew Jr, Attorney-CPA Homepage

UFTA: The First Post in a Series

One of the most important things in formulating an asset protection plan is avoiding a "fraudulent transfer". If an asset protection plan includes a "fraudulent transfer", it can be undone by a court very easily. This of course begs the question of how a fraudulent transfer is defined. Assuming you don't live in New York, Virginia, Maryland, Kentucky, South Carolina, Louisiana or Alaska, the concept of fraudulent transfer is defined by your State's enacted version of the Uniform Fraudulent Transfer Act, or UFTA. This post will look at the basic definition of a fraudulent transfer under UFTA and will preview a series of upcoming posts delving into UFTA a little more in depth. For illustration purposes, we will use the UFTA statute as enacted in New Jersey (NJUFTA), but most if not all of the concepts we will discuss apply in any of the 43 UFTA states.

Under NJUFTA, there are two types of fraud: actual and constructive. In defining the two, it is easier to define constructive fraud first as it is the far more common type of fraudulent transfer.

Constructive fraud is defined by N.J.S.A. 25:2-27:

a. A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation. b. A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time, and the insider had reasonable cause to believe that the debtor was insolvent.

In short, constructive fraud hinges on insolvency. If you avoid both transfers into asset protection vehicles that make you insolvent and transfers that take place while you are already insolvent, you have for the most part avoided constructive fraud. The key to this entire statute, then, is the definition of "insolvent". Under N.J.S.A. 25:2-23(a), "a debtor is insolvent if the sum of the debtor's debts is greater than all of the debtor's assets, at a fair valuation".

In other words, in the simplest example, a debtor whose only asset is $10,000 in cash and whose only liability is a $1,000 credit card bill should not transfer more than $9,000 into an asset protection structure, otherwise he has committed a constructive fraud. Very few debtors will find themselves with such a simple analysis of solvency, and for that reason I will be doing a post very soon entirely on solvency analysis under UFTA, so stay tuned for more details.

Actual fraud, on the other hand, is defined by N.J.S.A. 25:2-25:

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: a. With actual intent to hinder, delay, or defraud any creditor of the debtor; or b. Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor: (1) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or (2) Intended to incur, or believed or reasonably should have believed that the debtor would incur, debts beyond the debtor's ability to pay as they become due.

In short, actual fraud is the more egregious and less common type of fraudulent transfer. This is because it requires actual intent to defraud the creditor. Most of the time when a court finds someone has committed actual fraud, that person was clearly up to no good. Since proving actual intent is nearly impossible, courts are permitted to infer it from presence of the "badges of fraud", which are enumerated in N.J.S.A. 25:2-26:

a. The transfer or obligation was to an insider; b. The debtor retained possession or control of the property transferred after the transfer; c. The transfer or obligation was disclosed or concealed; d. Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit; e. The transfer was of substantially all the debtor's assets; f. The debtor absconded; g. The debtor removed or concealed assets; h. The value of the consideration received by the debtor was [not] reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred; i. The debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred; j. The transfer occurred shortly before or shortly after a substantial debt was incurred; and k. The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.

The presence of one or two of the badges of fraud in your transfer usually isn't quite enough to prove actual intent. However, the more badges present, the more likely it is that a court will find actual intent. It is also important to note that some badges, like insolvency, tend to carry more weight than others in a court's analysis.

You will also notice that one of the badges is our old friend we met when analyzing constructive fraud -- insolvency. For this reason, usually when someone has committed actual fraud, they have also committed constructive fraud. The reverse is not usually true.

Not all fraudulent transfers are equal. Creditors whose claims arose prior to any potentially fraudulent transfer can attack the transfer on either actual or constructive grounds, however creditors whose claims arose after the potentially fraudulent transfer must prove an actual fraud.

In the coming weeks, I will flesh out this analysis further with posts on defining solvency, defining "reasonably equivalent value", and the importance of CPA-prepared financial statements. In the meantime, if you are interested in an asset protection plan that doesn't run afoul of UFTA, contact me.

TAX ADVICE DISCLAIMER: Any tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
NOT LEGAL ADVICE. Everything posted here is for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of me or another qualified attorney. Nothing posted on Twitter or on any website shall be construed in any way as legal advice.
DISCLAIMER: I am an attorney and a CPA, however I am neither your attorney nor your CPA, and therefore no communications between us are covered by attorney-client or accountant-client privilege unless you possess a signed document which states that I currently represent you as an attorney or a CPA. In the case that such a document exists, the existence or waiver of attorney-client privilege or accountant-client privilege shall be controlled by the signed fee agreement or engagement letter.

Blog of the Law Offices of Jeff Vandrew Jr, Attorney-CPA

UFTA III: Solvency and the Importance of a CPA-Prepared Statement of Financial Condition

UFTA Part II: Reasonably Equivalent Value and its Application to LPs and LLCs

UFTA: The First Post in a Series