Are You Really Sure You Are Solvent?

Legal Methods of Asset Protection

Are You Really Sure You Are Solvent?

An Example Of A Solvency Analysis
The Critical Importance Of A Solvency Analysis
A Definition of "Insolvent"
A Suggested Solvency Analysis Checklist

All of the books I've read about asset protection emphasize the importance of solvency in being able to make transfers of assets to exempt forms or to entities that remove the assets from the reach of future creditors.

None of these books really get into the meat of the question,

"How Do You Compute Solvency or Insolvency?"

As I reread my various books on Asset Protection in the context of fraudulent conveyances and the solvency defense for claims of constructive fraud, it became apparent that measuring solvency in the context of the bankruptcy/creditor exemptions is vastly different from measuring solvency in terms of generally accepted accounting principles.

The more I read, the more obvious it became that a person could be totally solvent under traditional methods of computing assets, liabilities and net worth, while being seriously insolvent after eliminating all exempt assets and after including all contingent debts.

It seems to me that this is a seriously undefined issue in the context of asset protection planning. So, I'm "rushing in where wise men fear to tread" and I've attempted to provide an explanation of how to adjust traditional financial data for a solvency analysis.

Asset protection planning, estate planning and even some family income tax planning methods usually involve the transfer of ownership of various assets to other family members by gift. If you want to be sure that your transfers will protect those assets from the claims of your creditors in the event that you might be sued, then you need be sure that you are solvent at the time you make the transfers. Where asset protection is your primary concern, your lawyer or financial planner is likely to insist that he or she conduct an insolvency analysis for you. Many of the articles about asset protection in professional journals are now warning legal and financial advisors that they could be held accountable for helping a client to commit a fraud against the client's creditors.

If you make transfers that render you insolvent or unable to meet your obligations, then the courts may give your creditors the right to recover any property from the transferee where there is a lack of fair value given in exchange for the property.

An Example Of A Solvency Analysis

While you may think that you couldn't possibly be insolvent, an insolvency analysis might result in a huge surprise. For example, assume you have $3 million in assets and only $1 million in current debts. You are thinking of putting $1 million of your net worth in an asset protection plan that will include a domestic trust, some gifts to your spouse and some gifts to your children. When your advisor gathers the data for a solvency analysis, you remember that you have $500,000 of contingent liabilities on some loan guarantees that you made for your son. If you live in Texas, your homestead is exempt from the claims of creditors for a residence on land of up to one acre in a city. Your home equity amounts to $250,000. In addition, your pension fund assets of $750,000 are exempt. Another $500,000 of your assets are in a partnership, which are exempt under the laws of most states, including Texas.

Insolvency Analysis
Property Type	Traditional Method	Solvency Format

Home Equity	$250,000	None
Pension Assets	$750,000	None
Partnership Equity	$500,000	None
Other Assets	$1,500,000	$1,500,000
Total Assets	$3,000,000	$1,500,000

Actual Debts	$1,000,000	$1,000,000
Contingent Debts		$500,000
Total Debts	$1,000,000	$1,500,000

Net Worth	$2,000,000	None

Based on this simplified example, any other assets that are transferred to family members or irrevocable trusts could be treated as a fraudulent conveyance by the courts and would be subject to recovery by the courts within the applicable statute of limitations.

If you make transfers to an offshore trust, it might be more difficult for the creditors to get to that money, but then the courts might not be willing to grant you any relief in bankruptcy if you should be sued. The claim would then be hanging over your head for many years to come and if the assets were brought back, they would be available to satisfy the claims of any waiting creditors.

The Critical Importance Of A Solvency Analysis

If a creditor can prove that there was an actual intent to hinder, delay or defraud the creditor, then that is a fraudulent conveyance, even if the taxpayer is solvent. But intent is very difficult to prove, so the courts most often look for "badges of fraud" to establish "constructive fraud". These badges of fraud include a lack of adequate consideration and any one of the following three elements.

Insolvency, or
unreasonably small capital, or
an intent to incur debts that could not be paid.

The unreasonably small capital element generally applies to a business type of bankruptcy. However, if a transfer is made without adequate consideration for estate planning or asset protection purposes and the transferor has a business that is left without adequate capital, then a creditor could attempt to use this element rather than the insolvency element. Thus, where a business is involved, solvency is not enough.

The business must also be left with sufficient capital to meet its obligations as they become due and the debtor must be reasonably able to foresee that a lack of working capital could result in not being able to meet any claims that might become due. In addition, this element gives standing to future creditors, where the solvency element doesn't. As a practical matter, if the debtor is solvent and can demonstrate a reasonable belief that existing resources and future cash flow would permit the debtor to meet all known or foreseeable obligations, then it should be very difficult for a creditor to prevail on a claim of insufficient capital.

As for the element of intentionally incurring debts beyond the ability of the debtor to pay those debts, this element goes back to the difficulty of proving intent. So long as the transferor can show that he attempted to retain sufficient assets to meet his obligations, it should be extremely difficult for a creditor to prevail on this element of constructive fraud.

Thus, the measure of solvency becomes a critical element in any asset protection plan. It also needs to be considered in connection with any estate planning or family income tax planning. So long as you are solvent, as defined below, and so long as you can show that you have a reasonable basis to believe that you can fulfill your future obligations, then your asset protection or estate planning transfers should hold up to a challenge

A Suggested Solvency Analysis Checklist

How do these diverse rules apply to the process of computing solvency? I haven't been able to find any clear explanation of how to measure solvency so as to be reasonably sure that your asset protection or estate planning strategies will hold up, so I'm gong to stick my neck out and attempt to prepare one based on my reading of the legal issues discussed above. (My analysis of how to measure solvency is based on hundreds of hours of research and it is only available to paid subscribers to my on-line Wealth Protection Library.)

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NOTICE: This Information is intended only for educational purposes and may be regarded as controversial by some legal experts. Readers should consult with a qualified professional who is familiar with their specific financial and tax circumstances before adopting any ideas that are discussed in this article.

About the author:

Vernon Jacobs is a CPA who works as a tax author and consultant. He can be reached by phone at (913) 362-9667.

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