Protecting and Moving Wealth Forward—an Important Factor Is the Jurisdiction You Select

• Publication year: 2004
• Author: by Stephen E. Greer

PROTECTING AND MOVING WEALTH FORWARD—AN IMPORTANT FACTOR IS THE JURISDICTION YOU SELECT

by Stephen E. Greer^*

There is a dearth of literature to assist estate planners in comparing or contrasting state laws concerning the rights of creditors to reach assets in trust or other planning vehicles such as limited partnerships (LPs) or limited liability companies (LLCs). When a client has concerns about the ability of creditors to diminish the amount of wealth the client may be able to transfer to beneficiaries, selecting a jurisdiction other than California may be useful. This article compares and contrasts the laws of other states with California concerning protections against creditors. In Section I, the author considers the rights of the client's creditors under California law and the laws of states that can provide greater protection to the client. In Section II, the author discusses choice of law to protect against creditors of the client's beneficiaries.¹

I. PROTECTING YOUR CLIENT'S WEALTH AGAINST CREDITOR CLAIMS2

A. Limited Partnerships And Limited Liability Companies

For a variety of reasons, a client may be advised to establish an LP or LLC. When the client has a particular concern about creditors, the attorney should consider advising the client to organize the LP or LLC under the laws of a state other than California. While a creditor is generally able to obtain an order charging the LP or LLC interest with the debt under certain circumstances, the charging order itself would entitle the creditor only to distributions that the general partner or LLC manager may choose to make to partners or members. However, some states allow the creditor to foreclose on the charged LP or LLC interest, and to sell that interest.

Some commentators suggest that a state law that allows a creditor to foreclose on a charging order affords no real benefit to the creditor. Proponents of this argument cite Rev. Rul. 77-137,³ which states that a purchaser of a foreclosed partnership interest is considered a partner for federal tax purposes. On the other hand, state laws that allow foreclosure provide that the purchaser would be considered an assignee. An assignee is not protected by the fiduciary duties that the general partner/manager owes a partner/member. In addition, an assignee does not have the right to obtain information concerning the entity.⁴ Thus, one could argue that no one would want to be a purchaser at a foreclosure sale of the charged interest, because the purchaser would suffer the income tax consequences of being a member but not have any certainty that the LP or LLC would make distributions to satisfy this tax liability. The author has been unable to locate any IRS authority as to the tax treatment of a creditor who is not permitted to foreclose.⁵ In any event, the author believes that the adverse impact on the partner/member who may lose his or her interest in distributions is a sufficient basis for the attorney to consider advising the client to organize an LP or LLC in a state that does not permit foreclosure.

Attorneys should also consider whether state law allows a creditor with a charging order to force a judicial dissolution of the entity, and advise the client accordingly. In the following, the author discusses California law and the laws of other states regarding these issues.

1. California

Neither a California LP nor California LLC is a viable asset protection tool. California courts have allowed creditors to foreclose and sell the charged limited partnership interest.⁶ In addition, creditors have the statutory ability to foreclose a charged LLC interest.⁷ Finally, a California court can order the dissolution of an LP or LLC if it is not reasonably practicable to carry on the business in conformity with the LP or LLC agreement.⁸

2. Alaska

In 2000, the Alaska LP and LLC statutes were amended to make the charging order the "exclusive remedy that a judgment creditor may use to satisfy a judgment out of the judgment debtor's interest in the partnership or limited liability company, as the case may be."⁹ The statutes explicitly prohibit the foreclosure of an interest, which means the partner/member should at some time in the future be able to enjoy the economic benefit of his or her investment. A court cannot order the judicial dissolution of either a limited partnership or a limited liability company unless the court finds it is impossible for the entity to carry on the purpose of the enterprise.¹⁰ Note that while this provision further reduces a creditor's possible remedies against a partner or member, this same provision is an obstacle for a partner/member who wants the entity dissolved but cannot obtain the consent of the remaining partners/members.

3. Nevada

In Tupper v. Kroc,¹¹ the Nevada Supreme Court affirmed a denial of a motion to set aside a court-ordered sale of a charged partnership interest. The Nevada Supreme Court held that the Nevada statute authorized the trial court to make all orders and directions as the case required. The Nevada statutes were subsequently amended, both with respect to limited partnerships and limited liability companies, making the charging order the exclusive remedy available to a creditor.¹² A Nevada court can order the dissolution of a limited partnership and limited liability company if the court determines it is not reasonably practicable to carry on the business in conformity with the partnership or limited liability company agreement.¹³

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4. Other States

In Rhode Island a creditor may obtain a charging order against an LP or LLC interest and there is no statute that prevents a court from ordering a foreclosure of the charged interest.¹⁴ Nonetheless, there are no reported decisions where a Rhode Island court has ordered a foreclosure of a charged interest. A Rhode Island court may decree the dissolution of a limited partnership and limited liability company if it is not reasonably practicable to carry on the business in conformity with the partnership/limited liability company agreement.¹⁵

In South Dakota and Utah, a charging order may be placed against an LP or LLC interest giving a creditor the rights of an assignee.¹⁶ Although there are no reported decisions where a South Dakota or Utah court has ordered a foreclosure sale of an LP interest, there is also no statute precluding a court from ordering a foreclosure. On the other hand, a court does have statutory authority to order the foreclosure sale of a charged LLC interest.¹⁷ This fact must be taken into account in determining what a court might do when presented with the question of its authority to foreclose a charged LP interest. A South Dakota or Utah court may decree the dissolution of an LP interest if it is not reasonably practicable to carry on the business in conformity with the partnership agreement.¹⁸ A South Dakota court may also decree the dissolution of an LLC upon application by a transferee of a member's interest or upon entry of a charging order and a determination that it would be equitable to wind up the business.¹⁹

5. Summary

If one of the objectives in forming the limited partnership or limited liability company is creditor protection, then Alaska and Nevada are the preferred jurisdictions. Of the states surveyed, these two have specific legislation that makes the charging order the exclusive remedy of a creditor. Nevada makes it easier for a local court to dissolve the entity than does Alaska.

B. Self-Settled Trusts

Historically, states were hostile to permitting self-settled trusts from serving as asset protection vehicles, and California does not protect the assets of such trusts from creditors. On the other hand, Delaware, Nevada, Rhode Island and Utah have shown greater tolerance for the use of such trusts to protect against claims by creditors. The discussion that follows compares the strengths and weaknesses of the states that protect self-settled trusts. Because of its unique features, Oklahoma's recently enacted "Family Wealth Preservation Trust Act" is discussed separately. The reader should note, however, that even these jurisdictions will not shield the assets of a self-settled trust from transfers that are determined to be "fraudulent conveyances."

1. Setting Aside Transfers To Self-Settled Trusts As Fraudulent Conveyances

Delaware, Nevada, Rhode Island and Utah have all adopted the Uniform Fraudulent Transfer Act (UFTA).²⁰ The UFTA classifies creditors as present creditors and future creditors. Present creditors include those whose obligations are not fully matured, e.g., holders of unliquidated, unmatured, and contingent claims.²¹ Under the UFTA present creditors can set aside a transfer when:

• The transferor had actual intent to "hinder, delay or defraud" any creditor.²² The creditor can set aside a transfer based on "constructive fraud" as opposed to "actual fraud": actual intent can be inferred by any of 11 separately listed "badges of fraud," (this rule also applies to future creditors); or
• when the debtor did not receive back reasonably equivalent value; and
• the debtor was engaged or about to be engaged in an undercapitalized business²³ (this rule also applies to future creditors);
• the debtor intended to incur debt beyond his or her ability to pay²⁴ (this rule also applies to future creditors);
• the debtor was insolvent at the time of the transfer or became insolvent;²⁵ or
• a transfer was made to an insider for an antecedent debt where the debtor was insolvent at the time and the insider knew the debtor was insolvent.²⁶

As noted above, a creditor in Delaware, Nevada, Rhode Island and Utah can have the transfer in trust set aside if the creditor proves the debtor intended to "hinder" or "delay" satisfaction of the debt. In other words, it is not necessary to prove an intent to "defraud." A self-settled trust by its very nature, however, is meant to "hinder or delay" a creditor. The problem caused by the overly broad language contained in the UFTA that describes an "actual fraud case" as one...