Factor Liability Insurance into Insolvency Tests

April 13, 2006

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Selecting the types and levels of insurance is vitally important to a small business owner seeking to avoid day-to-day liability risks. So an owner should follow some general insurance guidelines if he or she wants to take full advantage of the protections purchased.

But what some small business owners may not realize is that insurance can offer protection beyond the scope of its apparent coverage by helping to avoid challenges to transfers of assets.

The Uniform Fraudulent Transfers Act (UFTA) outlaws transfers consummated thorough constructive fraud or actual fraud.

Constructive fraud exists when a transfer is made that makes the transferor insolvent, and the transferor receives less that full value in return. "Insolvent" means either that the transferor's liabilities exceed his assets (the balance sheet test) or that the transferor is unable to pay his debts as they come due (the cash flow test). If the two conditions apply, the transfer is automatically deemed fraudulent.

With actual fraud, the transfer's intent is the key issue. It must be proved that the transferor intended to defraud creditors through the transfer. However, even here insolvency is important, as it is one factor bearing on intent.

Moreover, distributions from a limited liability company (LLC) or a corporation to an owner on account of his ownership interest (i.e., distributions of earnings or dividends, or ownership redemptions) are also subject to a constructive fraud test. Generally, these distributions are deemed fraudulent if they are made at a time that the business entity is insolvent.

So how do insurance liability limits relate to insolvency? The limits of a liability insurance policy can be deemed to be an "asset" under the balance sheet test and a future receipt of capital in the cash flow test. The result then can be that the transferor has a positive balance sheet (assets exceed liabilities) and a positive cash flow (cash receipts exceed cash payments) position, and thus is not insolvent. Accordingly, the transfer would not be deemed fraudulent.

One important catch, though: The insurance liability limits will be factored in only if the creditor challenging the transfer as fraudulent is someone who could benefit from the policy.

Let's say a physician, a sole proprietor, is successfully sued for malpractice and a judgment of $100,000 is rendered. The physician, upon receiving notice of the lawsuit, transfers $800,000 to his children as a gift.

The transfer leaves the physician with assets of $20,000 and liabilities (including the court judgment) of $400,000.

The physician is insolvent under the balance sheet test ($400,000 of liabilities exceeds $20,000 of assets). Thus, the $800,000 transfer to the children would be deemed fraudulent.

Now, however, let's say the physician carried an E&O (Error & Omission) policy, which is a type of liability insurance for professionals, with a policy limit of $800,000. The physician is solvent before and after the transfer (assets of $20,000 plus $800,000, or $820,000, exceed liabilities of $400,000). Therefore, the transfer of $800,000 to the children is valid.