North Carolina Wealth Law Counselor : North Carolina Estate Planning Lawyers & Attorneys for Asset Protection & Trust Administration in Greensboro, Raleigh & Winston-Salem NC

Two recent Tax Court decisions illustrate the danger (and cost) of not paying attention to the details when it comes to life insurance policies and taxes.  In each case the taxpayer failed to dot their i’s and cross their t’s, which created adverse estate tax consequences in one case and adverse income tax consequences in the other.

In the first case, Estate of Dwight T. Fujishima  et al v. Commissioner, TC Memo 2012-6, the decedent was the record owner of three life insurance policies.  The decedent was severely injured after which his mother cared for him in her home.  The decedent’s mother fed him, clothed him, and paid his bills with her own funds.  The Tax Court noted she did this gratuitously, without expectation of payment.

Following the decedent’s death on January 23, 2005 the decedent’s estate filed a Form 706 (United States Estate and Generation Skipping Transfer Tax Return).  On the return the estate listed two of the three policies as owned by the decedent (and therefore includible in the decedent’s estate for federal estate tax purposes), but listed a third policy issued by West Coast Life Insurance Co., with a death benefit of $1,037,973, as “disputed ownership” and did not include it in the value of the decedent’s estate.

At trial the decedent’s mother claimed that because she paid the premiums the policy was really owned by her.  The Tax Court flatly rejected this contention noting that the estate listed two other policies as owned by the decedent despite the fact that the decedent’s mother paid the premiums on those policies as well.  The Tax Court went on to state, “record ownership of the West Coast policy is the most persuasive evidence [of ownership of the policy]”.

Had Mr. Fujishima and his mother simply transferred ownership of the policy to Ms. Fujishima or to an Irrevocable Life Insurance Trust (”ILIT”), the value of the policy, $1,037,973, would NOT have been included in Mr. Fujishima’s estate for federal estate tax purposes.

In the second case, Yulia Feder v. Commissioner, TC Memo 2012-10, the petitioner purchased a Northwestern Mutual life insurance policy with a death benefit of $50,000.00 in 1982.  The policy required quarterly premiums of $73.00.  Petitioner paid the premiums as they became due until November 1987. Shortly afterward, Ms. Feder sent Northwestern Mutual a letter requesting cancellation of the policy and asked that all future communications be sent to her new address.

Apparently Northwestern Mutual never received the letter.  Instead of canceling the policy as requested, when Ms. Feder stopped making premium payments the automatic loan provision of the policy went into effect and Northwestern began advancing the premiums from cash value of the policy until the cash value was exhausted.  In 2007, when the cash value was exhausted, the policy lapsed for non-payment of premiums.  Northwestern used the policy’s cash value of $12,654 to pay off the premium loans of the same amount and issued Ms. Feder a 1099-R showing income of $5,625 (Cash value of $12,654 - premiums paid of $7,029 = taxable distribution of $5,625).

At trial the Tax Court noted that Ms. Feder failed to introduce a copy of the policy at issue.  Had she done so the court may have found that she complied with the notice provisions of the policy and given effect to the cancellation that Northwestern said it never received.

When it comes to life insurance and taxes,  pay attention to the details.  Life insurance is afforded generous income and estate tax treatment when handled in the right manner.  Further, a number of states protect the cash value  and  death benefits of life insurance policies from the claims of various creditors -if structured properly. In each case had those involved simply dotted their i’s and crossed their t’s, these issues would have never arisen.

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In North Carolina a creditor cannot reach the cash value or death benefit of a debtor’s life insurance policy on his or her own life provided the debtor’s spouse, children, or both are the beneficiaries of the policy.  This right is guaranteed under Article X, Section 5 of the North Carolina Constitution and is also found in under the state’s statutory exemption scheme at N.C. Gen. Stat. Sec. 1C-1601(a)(6). Because North Carolina is an opt-out state for bankruptcy purposes, which means a debtor filing bankruptcy in North Carolina must use the exemptions granted under North Carolina law.

A recent bankruptcy case from the Eastern District of North Carolina, In re: Shawn Foster and Nancy Foster, United States Bankruptcy Court, Eastern District of North Carolina; Case No. 11-02711-8-JRL, illustrates the danger of a common estate planning technique of designating a client’s revocable trust as the beneficiary of the client’s life insurance policy.  In Foster the debtor owned several life insurance policies, each of which had accumulated some cash value.  Several years prior to filing bankruptcy Mr. and Mrs. Foster executed estate planning documents that included a revocable living trust (”RLT”).  The Fosters’ RLTs were designated as the beneficiary of various life insurance policies the Fosters owned.  As is common with many estate plans, the surviving spouse and children were the beneficiaries of the RLTs. Likewise as with many RLTs, the trust authorized the trustee to pay the Fosters’ burial expenses, death taxes, and unsecured creditors of their estates.

When they filed bankruptcy the Fosters listed the life insurance policies as exempt assets, relying on the provisions of the North Carolina Constitution and North Carolina’s exemption statutes.  The bankruptcy trustee objected to the exemption for the life insurance policies arguing that because the trusts, not the spouse and children, were the beneficiaries of the life insurance polices, the exemption did not apply even though the surviving spouse and children were the beneficiaries of the trust.  The bankruptcy trustee also argued that even if the court could look through the trust to see the real beneficiaries, i.e. the surviving spouse and children, because the trust permitted the trustee to pay the Fosters’ burial expenses, death taxes, and creditors of their estates, the life insurance policies were not for the sole benefit of the surviving spouse and children as required by North Carolina’s constitution.

The court ruled that naming the trust as a beneficiary instead of the spouse and children did not “categorically violate the terms of Article X, Section  5, so long as the trust complies with the purposes of the underlying exemption.” The court went on to hold, “where a trust authorizes payments to unsecured creditors of the decedent…such a trust exceeds the boundaries of “sole use and benefit” contemplated by” Article X, Section 5 of the North Carolina Constitution.” As a result, the Fosters lost approximately $32,000.00 to creditors in bankruptcy that they would otherwise been able to keep except for the faulty trust language.

In light of the Foster decision, advisors should review their current RLT provisions and modify the language to crave out life insurance from those assets that could be used to pay estate expenses.  Better yet,  create an Irrevocable Life Insurance Trust (”ILIT”), which is a type of trust specifically designed to hold life insurance policies.  Had the Fosters done so, they would not have lost $32,000.00 to their creditors.

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Though the result was preordained, the United States Court of Appeals for the Eleventh Circuit issued its decision in FTC v. Olmstead.  At issue in Olmstead was whether Florida law allowed a court to order a judgment-debtor to surrender all "right, title, and interest" in the judgment-debtor's single-member LLC to satisfy the claims of a judgment-creditor.  The Florida Supreme Court, in a 4-2 decision with a harshly worded dissent, ruled that a court does indeed have such power.

In a previous post, I discussed the Florida Supreme Court's decision in Olmstead v. FTC.  Briefly, in Olmstead the defendant argued that because Florida's LLC Act made no distinction between single-member and multi-member LLCs, a charging order was the sole remedy of a judgment-creditor.  Drawing an analogy to stock in corporations, which the dissent in Olmstead argued was incorrect, the Florida Supreme Court held that F.S.A. Section 608.433(4) does not establish the exclusive remedy for judgment-creditors of single-member LLCs.  Instead the Florida Supreme Court held that judgment-creditors of single-member LLCs also have the right to levy upon and sell through an execution sale, a member's interest in a single-member LLC pursuant to F.S.A. Section 56.061-even though that statute deals with stock in corporations, not membership interests in LLCs.

The Eleventh Circuit noted:

Where an LLC has only one member, no need exists to protect the interests of other members by restricting judgment-creditors to a charging-order remedy.

As flawed as the statutory interpretation behind the Florida Supreme Court's decision in Olmstead v. FTC may be, because that decision has now been adopted in a published decision of the Eleventh Circuit Court of Appeals, courts in other states with similar LLC acts, such as North Carolina, will likely look to FTC v. Olmstead for guidance.  As a result, where limiting a judgment-creditor's remedy solely to a charging order is an important planning consideration, caution would dictate steering clear of single-member LLCs.

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Confusion and chaos.  That's what the Florida Supreme Court created in Olmstead v. F.T.C. In Olmstead the Florida Supreme Court, in a 4-2 decision with a scathing dissent, ruled that Florida law allows a court to order a judgment debtor to surrender all right, title, and interest in the debtor's single-member limited liability company (SMLLC) to satisfy an outstanding judgment.  The court went on to note that the charging order provision set forth in Florida Statute Sec. 608.433(4) was, on its face, a nonexclusive remedy and that the statute "does not in any way suggest that the charging order remedy is an exclusive remedy."

Olmstead correctly pointed out that the Florida statute made no distinction between a SMLLC and a multi-member limited liability company.  As the dissent in Olmstead observed, because the statute makes no distinction between SMLLCs and multi-member LLCs, the court's ruling arguably applies with equal force to both SMLLCs and multi-member LLCs, so that a charging order is at best a nonexclusive remedy for multi-member LLCs as well, and "render[s] assets of all LLCs vulnerable."

In its simplest form, a charging order is an order from the court directing an entity to pay over to the judgment creditor any monies or property that the judgment debotor would have received, if and when the judgment debtor becomes entitled to a distribution.  A charging order typically remains in effect until the judgment is satisfied in full.

Charging orders originated in England when Parliament enacted the Partnership Act of 1890.  Prior to that time, a creditor who had a judgment against a partner of a partnership on a claim wholly unrelated to the partnership could seize partnership assets to satisfy the judgment.  This wreaked havoc on partnerships because partners were powerless to prevent judgment creditors from interjecting themselves into the partnership's business. 

Both the Uniform Partnership Act and Uniform Limited Partnership Act in the United States borrowed the charging order concept from England's Partnership Act of 1890.  When states enacted laws permitting limited liability companies, the charging order concept was carried through to LLCs.   With the possible exception of certain Nevada corporations, corporations and their shareholders do not have similar protections.

As the different states enacted legislation allowing for the creation of LLCs, some states, such as Alaska, Nevada, North Carolina (see below), North Dakota, South Dakota, and Texas to name a few, provided that a charging order is the sole remedy of a judgment creditor.  Other states, such as California, Colorado, South Carolina, Utah, and West Virginia, permit a judgment creditor to foreclose on member's interest in a LLC.  Until Olmstead, many Florida practitioners would have said a charging order was the sole remedy under Florida law. 

While the Olmstead decision created much confusion and consternation among the Florida bar, its effects extend well beyond Florida.  Many states' LLC statutes contain language similar to Fla. Stat. 608.433(4). For instance, N.C.G.S. Sec. 57C-5-03 is almost identical to Fla. Stat. Sec. 608.433(4), and makes no distinction between SMLLCs and multi-member LLCs. Although the  North Carolina Court of Appeals in Herring v. Keasler  held that a judgment creditor could not seize and sell the judgment debtor's membership interests in several LLCs, and instead the judgment creditor's "only remedy is to have those interests charged with payment of the judgment under N.C. Gen. Stat. § 57C-5-03," the judgment debtor in Herring only owned a 20% interest in the LLCs at issue.  

Like Florida before Olmstead, North Carolina appellate courts, as well as appellate courts in a number of other states with similar LLC statutes, have yet to address this issue.  While North Carolina's statute seems plain enough on its face - it should apply equally to SMLLCs and multi-member LLCs - Olmstead illustrates the risks of making any such assumption absent legislative or judicial clarification.  Until then, multi-member LLCs provide the safest course of action for charging order protection.

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In SEC v. Solow, the Securities and Exchange Commission ("SEC") charged Jamie Solow, a stock broker, with a fraudulent trading scheme involving inverse floating rate collateralized mortgage obligations. The case was tried to a jury , which returned a verdict in the SEC's favor on all seven counts. The final judgment found Mr. Solow liable for $2,646,485.99, plus prejudgment interest of $778,302.91, plus a civil penalty of $2,646,485.99.

During the four months between the date the trial ended and the date the final judgment was entered, Mrs. Solow retained a firm that specialized in Cook Islands trusts. Pursuant to the plan they created, the Solows, among other things, stripped approximately 6.5 million dollars in equity from two Florida properties, one of which they owned as tenants-by-the-entirety, and the other of which was owned by a corporation of which Mrs. Solow was the sole shareholder.

Following the entry of the final judgment Mr. Solow made three payments totaling $2,639.24 to the Court so the SEC sought to hold him in contempt. In response Mr. Solow argued:

1. The properties from which the equity was stripped were exempt from creditors' claims because the properties were held as tenants-by-the-entirety with his wife and, therefore, could never be reached by his creditors (a good argument)
2. He had no ability to make the trustee of the Cook Islands trust pay the judgment (a bad argument)
3. As a result of the Court's order he could no longer be a stock broker and, therefore, could not earn money to pay the judgment (an ugly argument)

After reviewing other securities fraud cases in which the defendant sought to shelter assets in an offshore trust, notably In re Lawrence and SEC v. Bilzerian, the Court noted, " where assets are held in an offshore trust, the 'burden of proving impossibility as a defense to a contempt charge will be especially high.'" 

The Court went on to point out that because disgorgement is an equitable remedy, a federal district court is not bound by state exemption laws. Instead it "has broad discretion in fashioning the equitable remedy of a disgorgement order...and will not be guided by state law where its effect is to make a liable party judgment proof." The Court noted that Mr.Solow created the impossibility by transferring the assets to the Cook Islands trust and, therefore, the defense of impossibility was unavailable. As a result the Court ordered Mr. Solow to be jailed until he satisfied the disgorgement order.

If offshore trusts are so great, what went wrong?

1. Hiding ill-gotten gains is never a goal of asset protection.  The  majority of "bad" asset protection cases are those in which the defendant is attempting to secret ill-gotten gains or avoid paying a federal tax liability.
2. The best asset protection plans, implemented for lawful reasons, are those implemented well before there are any claims on the horizon.
3. It is often said, "It is okay to be a pig, but all hogs get slaughtered." It is worth consideration whether if, had the Solows done nothing, the court would have forced the sale of their home.

Whether and when to use an offshore trust depends on the particular client's unique facts and circumstances.  As with all other planning techniques, the best plans are implemented well prior to the existence of any threatened or actual claims. Finally, legitimate asset protection planning never involves sheltering ill-gotten gains.

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Until recently, the answer would have been a fuzzy, "Uh maybe.  I don't know." 

Now the answer is a resounding YES.      

Withdrawals from an IRA account are exempt--regardless of how the judgment debtor chooses to use the withdrawal or the age at which the debtor makes the withdrawal (i.e. premature distributions before age 591/2).

In Kinlaw v. Harris the North Carolina Court of Appeals ruled that a defendant may withdraw funds from an IRA and use those funds "in the same manner as if there were no judgment against the Defendant."  Thus the funds representing the judgment debtor's withdrawal from his IRA remained exempt.

An "exempt" asset is one that cannot be seized by a creditor to satisfy a judgment.  The type and amount of assets that are exempt from creditors' claims varies by state. Some states do not exempt IRAs at all.  Others, like California, only exempt IRAs to the extent reasonably necessary to support the debtor and his family.

The Kimball court noted that the tax consequences, if any, of the withdrawal had no bearing on whether the withdrawal was exempt.  In this case the withdrawal was from a traditional IRA, so the debtor had to pay ordinary income tax and, because the debtor was under age 59and 1/2, an early withdrawal penalty of 10% of the amount of the withdrawal. 

Had the debtor's IRA been a Roth IRA, which is funded with after-tax dollars, not a traditional IRA, which is funded with pre-tax dollars, subject to certain timing conditions, the debtor could have withdrawn the amount of his contribution without any penalty and free of any additional income tax. 

This is a new and important asset protection planning tool.  Under North Carolina law, IRAs are exempt from creditors' claims without regard to whether the IRA is necessary to support the debtor's family.  Plus, unlike some states' exemptions as well as the federal bankruptcy exemptions, North Carolina DOES NOT LIMIT the exemption to a particular dollar amount.  Instead, any amount in an IRA (traditional or Roth) is exempt. Now, any withdrawal from an IRA is exempt as well.

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Is your Irrevocable Life Insurance Trust ("ILIT") funded by a universal life policy more than five years old? 

If so, your ILIT could go from a safe vehicle to leverage and shift wealth on a potentially estate and income tax free basis to a ticking time bomb that may implode when you need it the most. If your ILIT holds a universal life policy, now is a good time to dust off the policy and ask the carrier for a new illustration based on current assumptions. 

Here's why. Universal life policies are interest sensitive products, which means the illustrations the carrier gave when the policy was taken out were based on the prevailing interest rate environment at that time. In the early years of a universal life policy, the actual cost of insurance is for  far less than the premium and the insurance company invests the difference. The insurance company is betting it can make enough in the early years of the policy so that it can make up for the increased cost of insurance in the later years of the policy.

If the investment does not perform as the illustration shows, i.e. the internal rate of return on the investment is less than projected, the policy will terminate unless the owner infuses additional cash. If your universal life policy is older than five years, the interest rate assumptions contained in the illustration given when the policy was issued are probably unrealistically high, which means your policy is on a road to self-destruction.

A careful review of the illustration may show when the policy will implode due to these increased costs. But remember, that implosion date was determined based on the interest rate environment at the time the policy was issued. If the insurance company's return on investment is less than expected, the implosion will happened sooner, not later.

The good news is that in most cases the ticking time bomb can be diffused, sometimes on a tax neutral basis. It all starts with requesting a new illustration based on current assumptions, which the insurance company must provide upon request free of charge at least once a year. The new illustration based on current assumptions will show the new implosion date (date the policy lapses based on current assumptions).

With this information, you may be able to diffuse your bomb before it goes off and leaves nothing behind.

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In a recent decision, the normally unfriendly United States Tax Court ruled in favor of a taxpayer in a family limited partnership ("FLP") case. 

In Estate of Shurtz (.pdf), the Tax Court ruled that despite somewhat lax observations of the corporate formalities, a FLP was nevertheless formed for legitimate non-tax reasons and that the formation was a bona fide sale for full and adequate consideration.  The Tax Court held that asset protection and protection of the family business is a legitimate non-tax purpose. 

While the Shurtz' FLP followed ordinary formation procedures, the FLP:

• failed to open a checking account for at least 4 months
• made disproportionate distributions
• did not keep normal partnership records (accountant's records served as the paper trail to document capital accounts and other transactions). 

Nevertheless, the court ruled there was a bona fide sale for full and adequate consideration.  Reviewing the factors set out in Bongard (.pdf), a 2005 Tax Court case, the Shurtz Court noted:

1. The contributors received interests in the FLP proportionate to the ownership interest each contributed. The Shurtz engaged an accountant to calculate the value of a 1-percent general partnership interest in the FLP based on the value of the total property being contributed. The Shurtz each contributed property equal to the value of a 1-percent general partnership interest and the 98-percent limited partnership interest.
    
2. The respective assets contributed were properly credited to each partner's respective capital account.
    
3. Distributions from the FLP required a negative adjustment in the distributee partner's capital account.
    
4. Asset protection and protection of a family business is a legitimate and significant non-tax business reason for the establishment of the FLP.

For these reasons, the Tax Court was satisfied that the formation of the FLP and the contribution of property to the FLP were carried out in the way that ordinary parties to a business transaction would do business with each other. Consequently, the Tax Court ruled that the transfer of property to the FLP was made for adequate and full consideration.

FLPs, which include family limited liability companies, present a great opportunity to pass family wealth to future generations at discounted values, while at the same time providing significant asset protection features to preserve and protect a family's accumulated wealth.  However, the window of opportunity for passing wealth at discounted values may be closing soon.

The most recent proposal sent over by the White House substantially restricts valuation discounts.  If the legislation is passed in its current form, any entities formed and funded after the effective date of the legislation will lose valuable opportunities for discounting.  Once closed, the window may remain closed forever.

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North Carolina law exempts contributions to 529 plans from the reach of creditors. Recently a bankruptcy court called 529 plan exemptions into question, ruling that a grandparent's $40,000 contribution to a 529 plan owned by their child could be seized by the child's creditors in bankruptcy. 

In In re Bourguignon (.pdf), the debtor's mother contributed 40k to the 529 plan the debtor set up for the debtor's kids about two weeks prior to the debtor filing bankruptcy. The entire 40k was reached by the bankruptcy court and used to pay the debtor's creditors, leaving NO MONEY to pay for college!

As the court noted, it is the timing, not the source of the funds that determines whether it is property of the estate. The Bourguignon court explains why 529 plans enjoy only limited protection under bankruptcy law. Note the court's analysis is under 11 USC 541, which is property of the estate, not the exemptions and opt out provisions under 11 USC 522.

North Carolina is known as an "opt-out" state, which means North Carolina residents who file bankruptcy must use the exemptions provided by North Carolina law, not the federal bankruptcy exemptions. Under North Carolina law, only $25,000.00 of a 529 plan are exempt from the account owner's creditors. No amounts placed in a 529 plan within the 12 months preceding bankruptcy are exempt.

The asset protection issue could be solved simply by having a trust or llc be the account owner of the 529 plan. Where there are actual or anticipated large gifts to a 529 plan, it would be wise to set up a trust or llc to protect all funds within the 529 plan from creditors, not just the amounts protected under the Bankruptcy Code and North Carolina law.

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