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By Deborah M. Beers, Esq.
Buchanan Ingersoll & Rooney, PC, Washington, DC
In In re Mortensen,1 we have what appears to be one of the first decisions to consider whether an individual may use a state's - in this case Alaska's2 - self-settled asset protection spendthrift trust statute as a shield in a federal bankruptcy proceeding. On the facts set forth below, the bankruptcy court determined that he could not, a decision that may have broader implications depending on whether the case was decided solely on its "bad" facts, or on a broader reading of the federal bankruptcy Code.3
Facts. In 1994, Thomas Mortensen and his former wife purchased 1.25 acres of remote, unimproved real property located near Seldovia, Alaska for $50,000 cash. The Mortensens divorced in 1998, and Mortensen received his former wife's interest in the property. On February 1, 2005, Mortensen transferred the property to a self-settled trust called the "Mortensen Seldovia Trust (An Alaska Asset Preservation Trust)." Mortensen drafted the documents himself, using a template he had found and then had the trust document reviewed by an attorney.
The express purpose of the trust was "to maximize the protection of the trust estate or estates from creditors' claims of the Grantor or any beneficiary and to minimize all wealth transfer taxes." The trust beneficiaries were Mortensen and his descendants. Mortensen had three children at the time the trust was created.
Mortensen designated two individuals, his brother and a personal friend, to serve as trustees. His mother was named as a "trust protector," and had the power to remove and appoint successor trustees and designate a successor trust protector. She could not designate herself as a trustee, however. The trustees and Mortensen's mother were all named defendants in the bankruptcy proceeding.
The trust was registered on February 1, 2005. As required by AS §34.40.110(j), Mortensen also submitted an affidavit which stated that: (1) he was the owner of the property being placed into the trust, (2) he was financially solvent, (3) he had no intent to defraud creditors by creating the trust, (4) no court actions or administrative proceedings were pending or threatened against him, (5) he was not required to pay child support and was not in default on any child support obligation, (6) he was not contemplating filing for bankruptcy relief, and (7) the trust property was not derived from unlawful activities.
The Seldovia property was worth roughly $60,000 when it was transferred to the trust in 2005. Mortensen's mother sent him checks totaling $100,000 after the transfer in exchange for his transfer of the property to the trust "because she wanted to preserve [the property] for her grandchildren." Eighty thousand of the $100,000 was transferred to the trust.
Mortensen's financial condition deteriorated after the establishment of the trust. His income was sporadic. He used the cash he received from his mother and his credit cards to make speculative investments in the stock market and to pay living expenses. His credit card debt ballooned after the trust was created. In 2005, total credit card debt ranged from $50,000 to $85,000. When he filed his petition under Chapter 7 of the Bankruptcy Code on August 18, 2009, Mortensen had over $250,000 in credit card debt. The $100,000 he received from his mother had been lost as the result of bad investments.
Mortensen did not list his interest in the Seldovia Trust as an asset in the schedules to the petition, but he did disclose the creation of the trust on his statement of financial affairs. His monthly expenses exceeded his monthly income. However, in its decision, summarized below, the court determined that Mortensen was solvent when he created the trust, as required under the Alaska statute.
Decision . Kenneth Battley, the bankruptcy trustee, sought judgment against Mortensen under 11 USC §548(e),4 which contains a 10-year limitation period for setting aside a fraudulent transfer. Section 548(e) provides:
(e)(1) In addition to any transfer that the trustee may otherwise avoid, the trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if -
(A) such transfer was made to a self-settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.
Section 548(e) was added to the Bankruptcy Code in 2005, as part of the Bankruptcy Abuse Prevention and Consumer Protection Act. Its purpose was to close "the self-settled trusts loophole" and was directed at the [then] five states that permitted such trusts, including Alaska. Its main function, per the court, "is to provide the [bankruptcy] estate representative with an extended reachback period for certain types of transfers."
Mortensen's trust, established in accordance with Alaska law, satisfied the first three subsections of §548(e) - the Seldovia property was transferred to a self-settled trust, Mortensen made the transfer, and he was a beneficiary of the trust. The determinative issue in the case was thus whether Mortensen transferred the Seldovia property to the trust "with actual intent to hinder, delay, or defraud" his creditors.
Mortensen argued that the trust language ("to maximize the protection of the trust estate or estates from creditors' claims of the Grantor or any beneficiary and to minimize all wealth transfer taxes.") could not be used to determine intent because Alaska law expressly prohibits it. Under Alaska law, "a settlor's expressed intention to protect trust assets from a beneficiary's potential future creditors is not evidence of an intent to defraud."5
Although, ordinarily, it is state law, rather than the Bankruptcy Code, which creates and defines a debtor's interest in property, the court in Mortensen determined that "[h]ere, Congress has codified a federal interest which requires a different result." In 2005, when §548(e) was enacted, only five states allowed their citizens to establish self-settled trusts. Section 548(e) was enacted to close this "self-settled trust loophole." The court noted:
It would be a very odd result for a court interpreting a federal statute aimed at closing a loophole to apply the state law that permits it. I conclude that a settlor's expressed intention to protect assets placed into a self-settled trust from a beneficiary's potential future creditors can be evidence of an intent to defraud. In this bankruptcy proceeding, [Alaska law] cannot compel a different conclusion. (Emphasis supplied.)
Had the opinion stopped there, the court would essentially have ruled that the establishment of an asset protection trust in and of itself is per se evidence of an intent to defraud. However, the opinion noted that "there is additional evidence which demonstrates that Mortensen's transfer of the Seldovia property to the trust was made with the intent to hinder, delay and defraud present and future creditors."
First, Mortensen was coming off some very lean years at the time he created the trust in 2005. His earnings over the preceding four years averaged just $11,644 annually. He had burned through a $100,000 annuity which he had cashed out in 2000. He had also accumulated credit card debt of between $49,711 to $85,000 at the time the trust was created. He was experiencing `financial carnage' from his divorce. Comparing his low income to his estimated overhead of $5,000 per month (or $60,000 per year), Mortensen was well `under water' when he sought to put the Seldovia property out of reach of his creditors by placing it in the trust.
Further, while not technically insolvent, Mortensen had substantial credit card debt when he established the trust, which he did not attempt to pay off with the $100,000 that he received from his mother, $80,000 of which was transferred to the trust and subsequently lost in speculative investments. The court therefore concluded that the transfer of the Seldovia property and the placement of $80,000 into the trust constituted "persuasive evidence of an intent to hinder, delay and defraud present and future creditors." The transfer of the Seldovia property therefore was set aside (avoided).
On motion for reconsideration, the court again emphasized that it was not ruling that the mere establishment of a self-settled asset protection trust is sufficient to avoid a transfer in bankruptcy. It reiterated that, "[i]n this case, I found that the trust's express purpose could provide evidence of fraudulent intent. However, it was not the only evidence upon which I based my decision."
Conclusion . Mortensen is important in part because there are so few - if any - decided cases involving challenges to self-settled asset protection trusts. As a result, practitioners have had to make recommendations on the efficacy of such trusts without substantive precedent on which to rely. However, there are some lessons to be learned from Mortensen that can strengthen such trusts against attempts to set aside transfers in bankruptcy.
First, the trust should not recite, as Mortensen's did, that its purpose was to protect assets from creditors.
Second, a subsidiary purpose (such as estate planning) will not be enough to save the trust if the primary purpose is asset protection. Third, no settlor should transfer substantially all of his or her net worth to such a trust, especially at a time when, although technically solvent, the settlor has substantial debts. Fourth, it should be noted that Mortensen voluntarily sought the protection of the bankruptcy statutes. It is not clear that Mortensen would apply in a case where the settlor avoids bankruptcy. Finally, this is just one case. Given the increasing use of self-settled trusts, there will be others, and the result may be different, especially on better facts.
This commentary also will appear in the March 2012 issue of the Tax Management Estates, Gifts and Trusts Journal. For more information, in the Tax Management Portfolios, see Rothschild and Rubin, 810 T.M., Asset Protection Planning, and in Tax Practice Series, see ¶6350, Estate Planning.
1 Slip Copy, 2011 WL 5025249 (Bankr. D. Alaska 5/26/11) (Original Memorandum); Slip Copy, 2011 WL 5025252 (Bankr. D. Alaska 7/8/11) (Memorandum Denying Motion for Reconsideration).
2 AS §34.40.110.
3 11 USC §548(e).
4 Battley also argued that Mortensen was insolvent at the time of the creation of the trust, but the court found that this was not the case.
5 AS §34.40.110(b)(1).
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