Veterans' Benefits and Bankruptcy

 

Don’t Do That!  (Part 1)

 

Panic is a normal reaction when a creditor threatens legal action to collect a debt.  If your house or car is paid off, or you have a large amount of cash in your bank account, those assets could be especially vulnerable to creditor collection activity. 

The Bankruptcy Code, and every U.S. state, has a series of “exemptions,” a dollar-amount limit on the value of assets that will be protected from creditors.  If the value of your assets exceed the amount of those exemptions, they might be at risk.  (Here’s a quick example: Assume you own a home valued at $150,000, with no mortgage.  Your state allows a $43,000 “exemption” in your homestead.  A creditor or bankruptcy trustee could force the sale of your home, pay you the first $43,000 in proceeds, and use the rest to pay your creditors!)  Bankruptcy can often protect assets when their value exceeds the exemption limit, but that usually requires the ability to use future income to pay the value of the asset or the debt over time.  For those who are “land rich, cash poor,” bankruptcy may not offer a feasible solution. 

Fraudulent Transfers: In such a situation, the first instinct might be to transfer ownership of the asset to someone else: A quick "lateral" to a spouse or relative, or a trusted friend.  If you “take it out of your name,” that puts the asset beyond the reach of creditors, right?  Unfortunately, no.  That has been tried before, and the law has had an answer to that for more than 400 years.  In 1601, the infamous English “Star Chamber” ruled that certain “badges of fraud” applied when property was given to someone else under circumstances that suggested the transfer was made to avoid paying a judgment.  Those badges of fraud are now codified in U.S. state and federal law.  Even selling the asset to a friend or relative won’t work unless the sale is for fair market value.  A sale for less than fair value is considered “constructive fraud.”  Here, “constructive” means that the intent to commit fraud doesn’t need to be proven – if the sale is for less than fair value, the math speaks for itself.  These fraudulent transfers can be avoided or undone (by bringing a legal action against the person who received the property… an awkward situation for everyone involved as we’ll see in a moment), and leaving you right back where you started. 

The Garrett Case: A recent example comes from the case of In re Garrett in the Bankruptcy Court for the Eastern District of Tennessee.  Brian Garrett’s troubles began when he became ill and had to stop working.  He had a close family network who took care of him for almost two years while he applied for Social Security benefits.  He eventually received a substantial amount of Social Security lump-sum payments, as well as a $15,000 personal injury settlement from an automobile accident.  Brian withdrew $25,000 from those settlements and gave it to his mother, Cheryl.  Six months later, Brian filed a Chapter 7 bankruptcy case to obtain relief from medical bills that he incurred during his illness.

When the Chapter 7 Trustee appointed to Garrett’s case found out about the $25,000 transfer she sued Cheryl.  The Trustee argued that Brian’s payment to Cheryl was a fraudulent transfer, as well as something called a “preference.” 

Preferences: A “preference” is another method that allows bankruptcy trustees to avoid certain transfers, in this case repayments to creditors that would allow those creditors to receive more than others in the eventual bankruptcy case.  The logic is that bankruptcy should be a fair and orderly process where all creditors are treated the same.  Paying certain people back more is “preferential treatment” that tips the scales unfairly, and those payments can be avoided just like the fraudulent transfers could be.  In this case, Brian couldn’t argue that he gave the money to his mother to repay her because that would have been a preference.  In any event, in the Garrett case Brian didn’t list any of his family members as creditors, and the Bankruptcy Court held that there was no actual debt or legal obligation, just a feeling of moral responsibility to pay back family members who supported him.

The Bankruptcy Court in Garrett then concluded that Brian’s gift was a fraudulent transfer because Brian did not receive fair value.  Even though his family supported him during his illness, the Court reasoned that fair value needs to be viewed from the perspective of other creditors.  The Court said that fulfillment of a moral belief or duty was not “reasonably equivalent value” for the money transferred. 

Brian and Cheryl had two other arguments:

• First, Cheryl argued that of the $25,000 Brian gave her, she kept only $4,000 and paid the rest to other family members who also supported Brian.  Regardless, the Bankruptcy Court held that Cheryl could be liable for repaying the entire amount.  That’s because the Bankruptcy Code allows the Trustee to sue Cheryl and/or the family members in order to recover the full amount! 

• Second, Brian argued that some of the money should be “exempt” because it was from Social Security proceeds that are 100% protected under federal law.  The Court agreed with Brian and decided that, to the extent the money he gave Cheryl could be traced to the lump-sum Social Security payments, those funds were protected.  That required a complicated tracing analysis, after which the Court concluded that of the amounts Cheryl received, $14,890.14 was not traceable to Social Security and was instead from the personal injury settlement.  Brian again argued that under Tennessee law up to $7,500 in personal injury money would be “exempt” and protected from creditors.  But since personal injury proceeds are characterized differently from Social Security, the Court reached a different conclusion as to those funds and declined to accept a “no harm, no foul” argument: Cheryl had to return $14,890.14 to the Trustee, to be split up and paid to Brian’s creditors. 

Brian’s well-meaning transfer was an unqualified disaster.  The payment to Cheryl prompted the Trustee to bring a lawsuit against both Cheryl and Brian’s father, resulting in an undisclosed amount of legal fees to defend the action.  The lawsuit involved evidence and testimony about payments to at least four other family members.  At the end of the day, even though Cheryl testified she kept only $4,000 of the money, the Court ordered her to pay back almost $15,000.  Had Brian hung onto the money he could have kept all but about $7,390.14 because he could have utilized the personal injury exemption to protect another $7,500 in proceeds.  That $7,500 was ultimately lost to his creditors. 

There are legal ways to protect your assets from creditors with careful planning.  Any transfer or sale of valuable property when creditors are pursuing collection requires careful consideration, with the review and advice of a knowledgeable attorney.  (And any time you are considering the transfer or sale of property it’s a good idea to get the opinion of a tax professional, as well.)  If you’re thinking about a quick handoff of your property to a trusted friend or relative in order to thwart creditors…Don’t Do That! 

Creditors make bad decisions, too, and we’ll look at a very bad decision in the next blog post.  Until then, be happy, be safe, and spend wisely.  The 7thirteen is a blog written by Jeff Narmore, focusing on consumer bankruptcy issues.  Visit my website at narmorelawoffice.com for more information.  Narmore Law Office LLC is a debt relief agency and helps people file for relief under the United States Bankruptcy Code.