Is it a Transfer?

April 13, 2006

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To be found guilty of constructive fraud in a challenge of your asset transfers, you must not have gotten something of equal value in return for the transfer, as well as be insolvent at the time.

But the Uniform Fraudulent Transfers Act (UFTA) only applies if a "transfer" is made. The courts have made a distinction between a transfer made by an individual to himself (or a married couple to themselves), on the one hand, and a transfer from a husband to a husband and wife, on the other. The first situation does not involve a "transfer," as there is no change in ownership. Therefore, since there is no transfer, there can be no constructive fraud.

In contrast, a transfer of the second type does involve a transfer, as there is a change in ownership.

In the case in question, the husband inherited approximately $160,000 from his father. Immediately after receiving this inheritance, he used it to completely pay off two mortgages on his home, which he owned in tenancy by the entirety with his spouse.

The husband also individually owed more than $100,000 in unsecured debt. Accordingly, about 1-1/2 years after he paid off the mortgages, he filed an individual bankruptcy action. His wife was not a party to this action.

Under the law, a creditor of only one spouse cannot reach property owned in tenancy by the entirety, when only the debtor spouse files in bankruptcy.

However, the bankruptcy court found that the mortgage payoff was fraudulent, and entered a judgment against the husband and the wife in the amount of the $160,000.

According to the court, there was a transfer from one entity (the husband) to a different entity (the husband and wife). Had the payment been from joint funds, rather than from the husband's inheritance, there would have been no "transfer," and therefore no fraud.

As shown in the above example, one way to avoid a constructive fraud claim may be to ensure the transferor and transferee are one and the same. A payment on a mortgage secured by a jointly owned exempt home should come from joint funds, such as a joint checking account or a joint credit card.

In the example discussed above, the debtor received an inheritance, which is a source of funds attributable to only one spouse.

Had the debtor deposited the funds in the joint account, and left the funds in the account for a long period of time (the longer the better), so that the funds co-mingled with other joint funds in the account, it is possible that he would be considered to have converted the inheritance to joint funds, and thus the transaction would not have been a "transfer" according to the definition of the term adopted by the court in question.

In contrast to an inheritance are wages, which are usually deposited by a couple into a joint account on a regular basis and used to pay joint bills. These wages are likely to be considered joint funds much more rapidly than, say, an inheritance. Note that in the above example, the husband deposited the inheritance in a joint account for just a few days before paying off the mortgages. This was apparently insufficient to convert the funds to joint ownership, according to the court. This was probably due, in large part, to the unique character of an inheritance.

Thus, conversion of wages should not necessarily face the same outcome. However, it would be a mistake to pay down a mortgage on a jointly owned home from an account owned by only one spouse.

Work Smart

In short, the small business owner should follow this rule in making asset exemption transfers: A solely owned nonexempt asset should be converted to a solely owned exempt asset, while jointly owned nonexempt assets should be converted to jointly owned exempt assets. While not foolproof, this strategy helps to make the transfer resistant to challenge, on the grounds that it is not actually a "transfer" subject to the UFTA.

This strategy can be used to purchase an exempt asset (such as an exempt homestead), to pay down a mortgage when the exemption amount exceeds the home's value, or to encumber the home with another mortgage when the value of the home exceeds the homestead exemption.

In some cases, following this rule won't be practical. In the case of a newly married couple, for example, it would be expected that a residence owned by one spouse might by transferred into tenancy by the entirety. Here, to defeat a claim of constructive fraud, the transferor would need to ensure that he or she is not insolvent at the time of the transfer.

Note that, in cases involving fraud within one year of a bankruptcy filing, the court will not have to rely on the UFTA to invalidate a fraudulent act. In this situation, whether or not the fraud was in the form of a "transfer" will probably be irrelevant, because the transfer occurred within one year of filing a bankruptcy action. Where, however, the alleged fraud occurred before the one-year period, or the action is in state court, whether or not the fraud took the form of a transfer can affect the outcome.

The moral of the story is that caution must be exercised, especially in pre-bankruptcy exemption planning, because the debtor will usually be insolvent. In this situation, if you do not receive adequate consideration in return for the transfer, there is the possibility that the transfer will automatically be deemed fraudulent, regardless of intent, under the constructive fraud theory.

Warning

When a debtor is insolvent, a "gift" will always be deemed fraudulent under the constructive fraud theory. A gift is a transfer to another person or entity, where the transferor receives nothing (or something inadequate) in return.

The UFTA does not expressly define the term "adequate consideration." However, essentially the term means something of approximately equal value.