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Fraudulent Conveyance to Avoid or Hinder Creditors

Fraudulent Conveyance to Avoid or Hinder Creditors

By Robert M. Swaim, E.A.
2009

Think you can avoid paying damages in a lawsuit by holding property and other assets in the names of your relatives, friends or business entities that you own? Think again.

Under the law of fraudulent conveyance a transfer made by a debtor is fraud perpetrated against the creditor whether the claims of the creditor were made before or after the transfer if the debtor made the transfer in either of the following ways:

1. with actual intent to hinder, delay, or defraud any creditor, or

2. without receiving a reasonably equivalent value in exchange for the transfer of the asset and if either of the following applies:

(a) the debtor was engaged or was about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or

(b) the debtor intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they came due.

For example, we can all reason ably expect to owe income tax in the future. We are worried that one day the government could seize our property for back taxes so we set up trusts for our children or spouse or parents to hold our assets We may now believe that the property is safely beyond the reach of the IRS in future years should we ever fall behind in paying our taxes. WRONG! And you can substitute the name of any creditor in place of the IRS in the example here, same rules apply.

No effort to hinder or delay creditors is more severely condemned by the law than an attempt by a debtor to place his property where he can still enjoy it and at the same time require his creditors to remain unsatisfied. Direct evidence of a party’s fraudulent intent is not required in court because it is impossible to look into a debtor’s mind for the purpose of ascertaining his intent, the court must consider the circumstances surrounding the fraudulent transfer to determine intent from what the debtor does or fails to do.

The court will look for badges of fraud which are circumstances so frequently attending fraudulent transfers that an inference of fraud arises from them. The following acts are considered strong evidence that you have committed fraud in transferring or attempting to hide assets to prevent losing them to pay a debt you owe:

1. whether the transfer was to an insider (i.e. relative, friend, etc.);

2. Whether the debtor retained possession or control of the property transferred after the transfer. Meaning that you really own it in all but legal title.

3. Whether the transfer was concealed or done “secretly” or whether it was disclosed and done openly in the “sunshine”;

4. Whether before the transfer was made or the obligation was incurred, the debtor had been sued or threatened with a suit. Whether you knew, or should have known, that you were going to incur a debt.

5. Whether substantially all of the debtor’s assets have been transferred to related parties to hide the true ownership.

6. Whether the debtor absconded;

7. Whether the debtor attempted to hide assets or remove them to a place where they could not be found.

8. Whether the dollar value the debtor received from the related party that he transferred the assets to approximated FMV. In such a case your relative simply becomes your nominee or “straw man” (i.e. “selling” the assets to your child for a very low price or selling at a fair price but taking a note in lieu of cash payment knowing the note will never be paid or “gifting the assets – which by the way triggers the federal gift tax);

9. Whether the transfer of assets caused the debtor to become insolvent shortly after the transfer of assets was made.

10. Whether the transfer occurred shortly before or shortly after a substantial debt was incurred;

Although badges of fraud are not conclusive and are more or less strong or weak according to their nature and the number occurring in the same case, a concurrence of several badges will always make out a strong case against the debtor.

If the creditor is able to prove a sufficient number of badges, the burden of proof then falls on the debtor to prove that the transfer was not fraudulent.

The doctrine of “economic substance over legal form” applies here. No matter that you have all the legal documents prepared with the i’s dotted and the t’s crossed, this will not protect your assets if your actions and intent fail the badges of fraud test. The court will look to the reality, not the legal fiction, of what really is going on with those properties. If you continue to use, control, benefit from, and enjoy the properties then you are in fact still the legal owner, no matter whose name is on the deed.

If you hold these properties in business entities, i.e. corporations for LLC’s, then you must strictly observe the formality of the “corporate veil” and never pierce it if you expect to benefit from the limited liability statutes of state law. Otherwise, your company will be deemed to be your “alter ego” or “nominee” and this means that the entity is not the real owner but rather it is you. You will lose it all in court.

If you undertake to protect your assets be sure that your attorney is well versed in the statute of frauds and fraudulent conveyances.

Robert Swaim holds a Masters in Accounting and is an Enrolled Agent in Charleston, SC. He works with real estate investors for tax returns, audit defense and other IRS problems. He can be contacted at 843-722-5264 or This e-mail address is being protected from spambots. You need JavaScript enabled to view it .

Income from Cancellation of Debt

INCOME FROM CANCELLATION OF INDEBTEDNESS

by Robert Swaim, Accountant and Enrolled Agent
2009

During a March 18 IRS phone forum on cancellation of indebtedness income, Anne Freeman, IRS chief of review, gave an overview of Code Sec. 108's cancellation of indebtedness income resulting from foreclosures and short sales where the lender has to “eat” a portion of the unpaid mortgage, with a focus on applicable exceptions to the general rule that mortgage forgiveness by the lender results in taxable income to the borrower.

The IRS is currently working on an update to Publication 4681, which explains the federal tax treatment of canceled debts, foreclosures, repossessions and abandonments, said Freeman. You can print a copy of this booklet from the IRS web site, www.irs.gov.

Cancellation of Debt Under Code Sec. 108

Code Sec. 108 generally excludes from gross income discharges of indebtedness (also known as "COD" income) IF:

(1) the discharge occurs in a title 11 bankruptcy case,

(2) the discharge occurs when the taxpayer is insolvent,

(3) the indebtedness is "qualified farm indebtedness," or

(4) the indebtedness is "qualified real property business indebtedness."

In addition, as a temporary relief provision during the current housing crisis, discharged qualified principal residence indebtedness (QPRI) is excluded for discharges on or after January 1, 2007, and before January 1, 2013. Exclusions from income are allowed under Code Sec. 108 in an order of priority.

Definition of “Qualified Real Property Business Indebtedness”:

Taxpayers, other than C corporations, are permitted to exclude income attributable to cancellation of qualified real property business indebtedness. This exclusion does not apply to qualified farm debt, which is covered by a separate exclusion discussed above. In order to be considered "qualified" the real property business indebtedness must have been incurred or assumed before January 1, 1993, in connection with realty used in a trade or business that secures the debt. For indebtedness incurred on or after that date to qualify for the exclusion, it must be either qualified acquisition indebtedness, which is indebtedness incurred or assumed to "acquire, construct, reconstruct, or substantially improve... ." the property securing the debt, or indebtedness obtained to refinance, but not add to, pre-1993 qualified real property business indebtedness.

Additionally, taxpayers must make an election to exclude forgiveness of indebtedness income attributable to qualified real property business indebtedness. The election is made by checking the box on line 1d of Form 982 and filing it along with the taxpayer's federal tax return. Taxpayers who file a timely return who are eligible to make the election but fail to do so may still make the election by filing an amended return within six months of the original due date, excluding extensions, with the notation "Filed pursuant to Section 301.9100-2" written on the amended return. Once a proper election is made, it may not be revoked unless permission to do so is obtained from the IRS.

EXAMPLE: In 1989, Wayne Smith purchased rental property, which he used in his business, for $15 million. He financed the acquisition with a $12 million nonrecourse mortgage. The current fair market value of the property has dropped to $8 million, a figure well below both its original cost and the amount of the outstanding nonrecourse debt. The holder of the nonrecourse debt has agreed to release the mortgage in exchange for a cash payment of $7 million. The adjusted basis of the property is $9.5 million, with $2 million allocable to the basis of the land and the remaining $7.5 million allocable to the depreciable building.

The existing $12 million nonrecourse debt would be satisfied with only $7 million in cash, leading to a $5 million discount that would ordinarily be a taxable discharge of indebtedness income. The qualified real property business indebtedness requirements are met. If Smith makes a Code Sec. 108(c) election, current recognition of part of this income could be avoided. The amount of discharge of indebtedness income that Smith can elect to exclude is limited to $4 million (the outstanding principal amount of debt determined immediately before the discharge ($12 million) minus the fair market value of the real property securing the debt ($8 million)) ( Code Sec. 108(c)(2)(A)). The second, overall limit on the amount of the exclusion is the total amount of the adjusted bases of all the taxpayer's depreciable real property held immediately before the discharge. Here, Smith owns the one item of depreciable real property, and its $7.5 million adjusted basis exceeds the $4 million of discharge of indebtedness income. Discharge of indebtedness income will be recognized in the amount of $1 million.

The basis of Smith's depreciable real property is reduced by the amount of excluded discharge of indebtedness income --resulting in a basis of $3.5 million ($7.5 million - $4 million). The basis is reduced at the beginning of the tax year following the year in which the discharge occurred.

Taxpayers are allowed the qualified real property business indebtedness exclusion only to the extent that the outstanding principal amount of real property business debt, reduced by the amount of any reduction in that debt that qualifies for the insolvency exclusion, exceeds the fair market value of the property securing the debt. If there is additional business debt secured by the real property, the fair market value of the property must first be reduced by the amount of that additional indebtedness in making the calculation. Additionally, there is an overall limitation which prohibits taxpayers from excluding qualified real property business indebtedness in excess of the adjusted bases of the qualified depreciable realty held immediately before the cancellation, (exclusive of any such property acquired in contemplation of the debt cancellation).

Generally, taxpayers must reduce certain tax attributes to the extent that income from the discharge of indebtedness is excluded from gross income under Code Sec. 108. Tax attributes reduced under this provision include the adjusted basis of properties, net operating losses, passive activity losses and credit carryovers. In many cases Code Sec. 108 operates to defer, rather than eliminate, income from discharge of indebtedness, Freeman explained.

Bankruptcy and Insolvency Exceptions

Freeman discussed three major exclusions from gross income for: (1) bankruptcy, (2) insolvency (your net worth is negative), and (3) a qualified principal residence. She clarified that the bankruptcy exclusion for Title 11 bankruptcies "takes precedence over any other exclusion under Code Sec. 108." Freeman further noted that "because no dollar limit is associated with it [the bankruptcy exclusion], you wouldn't need another exclusion to apply."

Insolvency is the second exclusion in order of priority. However, unlike under the bankruptcy exclusion, dollar limits apply, Freeman clarified. The "concept is much easier than the calculation," according to Freeman. She revealed that the IRS is in the process of creating an insolvency worksheet to "help with the calculation." Very simply: If the debt forgiven is $75,000 and your net worth is NEGATIVE $37,000, then $38,000 [$75,000 - $37,000] of the debt forgiveness is taxable and $37,000 [$75,000 - $38,000] is not taxable.

The extent to which the taxpayer is insolvent for purposes of the exclusion is calculated by subtracting the fair market value (FMV) of total assets immediately before the discharge from the total amount of liabilities immediately before the discharge. Freeman noted that "accrued liabilities, like accrued real estate taxes and assets generally beyond the reach of creditors" must also be included in the calculation.

Case Study - Single Person

Rick is a single person with no immediate family. After hearing a discussion I did on stacking Limited Liability Companies (LLCs), he wanted to know what he could do as a single person. At the time he owned seven properties. Three had almost no equity. One had over $60,000 equity and the other three varied from $25,000 to $30,000 in equity.

Rick was fully exposed to the liabilities created by ownership as well as management. He indicated he was actively seeking more property. His objective was to acquire roughly 12 properties in the near future. He did not want to risk all he had worked for in one frivolous lawsuit.

First, he needed to insulate himself from the management liability. Management seems to be even a stronger lightening rod that property ownership. By separating management from ownership, any payment for management by the owner becomes earned income. To provide a liability shield and mitigate the tax issues, an S corporation can be used. Plus a corporation provides additional tax-advantaged fringe benefits every entrepreneur should consider. In certain situations a C corporation could be used, but the S corporation suited Rick the best.

The S corporation would contract (important to have a written contract) with the owner. Such a contract should be tailored for the special situation where you control both the owner and the S corporation (such as the one in the Corporate Fortress and LLC & Partnership courses). More than one owner has been tripped up in court when it is pointed out that the S corporation management company had not performed as the realtor-provided management contract required, such as escrows, monthly reporting and payments, etc.

Rick expressed a little concern that in his state management companies must hold a realtor license to manage property for others. He correctly pointed out that the S corporation is doing just this since (if run properly) it is separate and distinct from its owner. This is also true in my state.

However, you need to read the law and the consequences. In most cases, this is a “no harm, no foul” situation since you as the owner of the property or the owner of the entity that owns property, are unlikely to sue the management company that you also own. If this concerned Rick, he could structure the relationship with the S corporation such that it leased the properties from him or the entity that owns properties with the right to sublease.

Now, we turn to actual ownership of the properties. Rick could use single-member LLCs to segregate liabilities between the properties. Maybe put all three of the low equity properties in one which he in turn owns.

Depending on his paranoia level, he may place each of the ther properties in its own single-member LLC since each as significant equity. This would provide a liability shield under state law to protect Rick from a liability accruing to the owner of each property.

He would still be protected from the liability for the three properties in the one LLC, but all of the properties could be exposed to a liability occurring on any one. Since there is almost no equity in any of the three, this is not a big trade-off.

But Rick understands that single-member LLCs are not very effective under the “Charging Order” doctrine. Also, single-member LLCs are by default transparent for tax purposes. By using a multi-member LLC, he can get the benefit of the charging order protection and have a separate, low-profile tax return for the LLC. It will not change the taxes he owes as the net numbers will K-1 to his personal return.

But he needs a second member. That can be his S corporation as a 1-5% owner. He may also decide that the S corporation will be the manager of the multi-member LLC. The single-member LLCs would then be owned by the multi-member LLC and in turn the single-member LLCs own the properties.

If land trusts are used, they would simply own the property and in turn be owned by the single-member LLCs.

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