The Ninth Circuit’s Bankruptcy Appellate Panel has affirmed the decision of a California bankruptcy court that a qualified personal residence trust (QPRT) would not defeat a creditor of the settlor, largely because the QPRT was poorly drafted to begin with, and then was not updated to comply with later Treasury Regulations. Perhaps a bigger issue, though, is that the debtor should never have filed for bankruptcy on these facts to begin with.
Former lawyer Robert Ferrante owned a lavish waterfront home in Newport Beach, California. In 1994, he transferred the home to a qualified personal residence trust (QPRT), called the 518 Trust, and which had a 20-year term.
A QPRT is an estate technique to transfer a personal residence at a reduced gift and estate tax cost to the grantor. The grantor transfers a personal residence to the QPRT, retaining the right to use of the residence for a term of years. During this term, the grantor has the full and exclusive use of the home and is responsible for all expenses, and with limited exceptions no additional property can be transferred to the trust. At the end of the term, either the trust terminates and the trust property is distributed to the remainder beneficiaries, or the trust continues for the remainder beneficiaries, but the grantor no longer has the right to use the residence unless the grantor enters into an arm’s-length lease agreement. If the grantor dies before the end of the QPRT term, the trust property reverts to the grantor’s estate, with no estate tax savings.
There are a number of technical provisions and requirements QPRT instruments must meet. Among these are the provision that a QPRT ceases to be a QPRT if the residence ceases to be used or held as a personal residence of the term holder (usually the grantor), and the requirements that (1) within 30 days of the trust ceasing to qualify as a QPRT, the trustee must either (a) distribute the trust assets to the grantor, or (b) convert the trust to a grantor retained annuity trust (a GRAT – a trust from which the grantor receives an annuity payment at least annually); (2) the trust must prohibit the grantor from reacquiring the residence; and (3) the trust must prohibit additional contributions to the trust (with minor exceptions for maintenance costs and trust expenses).
In 2004, Ferrante was sued for a defaulted loan. The lender obtained a $2.4 million judgment, then filed a probate court action to declare the 518 Trust revocable and a sham to defeat Ferrante’s creditors.
Ferrante’s ex-wife successfully defended against the creditor’s claims on behalf of the Ferrante children, who were the remainder beneficiaries of the 518 Trust. The probate court dismissed the creditor’s case, and the California Court of Appeals affirmed. The Court of Appeals noted that the creditor had not sought Ferrante’s life estate or reversionary interest, and overruled the lender argument that an irrevocable trust can be deemed revocable based on the grantor’s subsequent conduct. Case over, thanks for reading!
Or maybe not.
A creditor in post-judgment litigation can fail numerous times, succeed only once, and collect. On the other hand, debtors must always succeed in their defense to avoid losing assets to a judgment creditor.
A debtor generally is never more vulnerable to lose to a large judgment creditor than in bankruptcy. Bankruptcy protection often comes at a substantial cost. Keep this in mind as we continue Ferrante’s story after filing for Chapter 7 bankruptcy in January 2010 in the Central District of California.
The bankruptcy trustee initiated an adversary proceeding against Ferrante and other interested parties, seeking an order revoking the QPRT to bring the residence into the bankruptcy estate. The QPRT trustee and the Ferrante children opposed the bankruptcy trustee.
The 518 Trust instrument included the following pertinent provisions:
Paragraph II: Irrevocability. This trust and all interests in it are irrevocable, and the grantor has no power to alter, amend, revoke, or terminate any trust provision or interest whether under this instrument or any statute or rule of law.
Paragraph III A.4.: Option to Purchase Residence. The Grantor shall have the option to acquire all or part of the Residence from the trust immediately prior to the expiration of the trust. The option price will be the then fair market value of the Residence then held by this Trust.
Paragraph III B. When the Trust Terminates. The Trust terminates only as provided in this paragraph:
- Cessation of Personal Residence Trust Status. Unless the Trustee makes a timely election under subparagraph III[C.], this trust shall terminate when it ceases to be a Qualified Personal Residence Trust (“QPRT”), and on such termination the Trustee shall distribute all of the trust assets to the Grantor….
- The date on which the Residence … ceases to be used or held for use as a personal residence shall be known as the “Cessation Date.”
Paragraph III C. Conversion to a Grantor Retained Annuity Trust. Within thirty (30) days from the date on which this trust would otherwise terminate under subparagraph III [B.3.], the Trustee may elect to convert the trust to a Grantor Retained Annuity Trust (“GRAT”)….
The bankruptcy trustee asserted three alternative arguments under which the residence should become part of the bankruptcy estate:
- By choosing to cease to use the residence as his personal residence, Ferrante could terminate the QPRT, making it de facto revocable by Ferrante, and, consequently, by the bankruptcy trustee;
- When Ferrante ceased to use the residence as his personal residence in March 2009 (when it was leased for two years exclusively to another individual, after which Ferrante moved back in), the QPRT terminated, and the trust property reverted to Ferrante because the QPRT trustee had not made a timely election to convert the QPRT to a GRAT; and
- The “buy-back” provision of Paragraph III A.4 violated applicable Treasury Regulations, causing the trust to cease to be a QPRT on March 24, 1998 (the date under the Treasury Regulations on or after which it would have been too late to initiate a trust reformation to eliminate the buy-back provision), and the trust property reverted to Ferrante because the QPRT trustee had not made a timely election to convert the QPRT to a GRAT.
The QPRT trustee and the remainder beneficiaries argued that none of the “terminating events” actually had occurred. They argued that Ferrante never exercised his buy-back right, that the 2009 lease had never gone into effect, and that Ferrante was required to have only the right to use the residence for at least 14 days each year.
They also argued that the Treasury Regulations concerning the buy-back provision had not been promulgated until 1997, some three years after the 518 Trust was settled and thus did not apply. Finally, they argued that whatever Ferrante did or could have done after the 1994 settlement of the QPRT could not render an irrevocable trust revocable under California law.
The bankruptcy court ruled in favor of the bankruptcy trustee.
First, the court held that the QPRT was revocable because Ferrante could terminate the QPRT status simply by ceasing to reside in the Newport Beach house. If Ferrante can revoke the QPRT, the Bankruptcy Trustee can revoke the QPRT.
Second, the bankruptcy court found that the “buy-back” provision violated the regulatory requirements for a QPRT, and caused the trust to be revocable or terminable.
Finally, the bankruptcy court ruled that because the bankruptcy trustee was not a party to the earlier Probate Court action holding the trust irrevocable, that decision was not binding upon the bankruptcy trustee.
Ferrante, the QPRT trustee, and the remainder beneficiaries moved for reconsideration, adding the argument that a completed gift could not be made to a QPRT unless it was irrevocable, and thus, the 518 Trust is irrevocable. They also argued that because the election to convert the QPRT to a GRAT was the right of the QPRT trustee, not Ferrante, he had no dominion or control over the 518 Trust, and thus, neither did the bankruptcy trustee. They contended that the regulations prohibiting the buy-back provision did not exist at the time he settled the 518 Trust and thus, did not apply, and could not cause termination of the QPRT. Even if the buy-back provision made the trust revocable, they argued, the 518 Trust would have converted to a GRAT on the trustee’s election to do so. Finally, they argued that the 518 Trust’s failure to comply with the 1997 regulations did not cause it to lose its QPRT status and terminate. They submitted a declaration of the attorney who drafted the 518 Trust stating that it was irrevocable and did not terminate if it deviated from QPRT laws.
The bankruptcy trustee argued that the 518 Trust, like all QPRTs created before or after the 1997 regulations, had to comply with the regulations. The regulations allowed for the modification of non-complying QPRTs, if a judicial or non-judicial (if allowed by state law) trust reformation was commenced within ninety days after December 23, 1997 and completed within a reasonable time. No action to modify the 518 Trust to comply with the 1997 regulations ever had commenced. As a result, the buy-back provision alone invalidated the 518 Trust’s QPRT status and caused it to terminate. The bankruptcy trustee further argued that the 518 Trust could not have been converted to a GRAT when it ceased to be a QPRT because its terms did not prohibits additional contributions to the trust.
The bankruptcy trustee asserted that Ferrante did not part with dominion and control, and thus Ferrante’s gift was incomplete under tax law, namely Treas. Regs. Sec. 25.2511–2(c), which provides that “a gift is incomplete in every instance in which a donor reserves the power to revest the beneficial title to the property in himself.” The bankruptcy trustee argued that Ferrante’s reserved power to buy back the residence or to cease to use the residence as his personal residence made the gift incomplete and rendered the 518 Trust revocable or terminable.
The bankruptcy court rejected Ferrante’s arguments. Ferrante appealed to the Bankruptcy Appellate Panel (“BAP”) of the Ninth Circuit Court of Appeals.
The BAP upheld the bankruptcy court. The BAP additionally held that even if the 1997 Treasury Regulations didn’t apply to the QPRT when it was formed in 1994, they applied going forward from 1997, and the QPRT failed because it failed to comply (before or after) with the 1997 Treasury Regulations. Thus:
[T]he 518 Trust provides that the “trust shall terminate when it ceases to be a [QPRT], and on such termination the Trustee shall distribute all of the trust assets to the Grantor.” Although… the 518 Trust provides that within thirty days of the trust’s termination the trustee may elect to convert it to a GRAT, this was not done. Thus, the 518 Trust terminated in 1998 and its terms required distribution of the trust assets, including the 518 Property, to Debtor at that time. As a result, these assets are property of Debtor’s bankruptcy estate. Sec. 541(a)(7). We reject Debtor’s argument that failing to comply with QPRT regulations did nothing to change the fact that Debtor transferred a completed and irrevocable gift of property to the 518 Trust in 1994.
Thus, we conclude the bankruptcy court did not err in granting partial summary adjudication to Trustee on the basis that the 518 Trust failed to comply with QPRT regulations. Because we are able to affirm the MSJ Order on that basis, we need not address Appellants’ other argument that the bankruptcy court erred in ruling that the 518 Trust is, and QPRTs in general are, revocable trusts as a matter of law.
Adios, luxurious $7.5 million home on an exclusive island in the Newport Beach harbor.
The 518 Trust was an atypical and flawed QPRT from the start. However, this case reminds us that a trust is not a “fire and forget” strategy, but rather a legal structure to be maintained throughout its lifetime, just like any complex tool. The 518 Trust died in early 1998 when no one thought to update it to comply with the 1997 QPRT regulations.
This case also illustrates that there can be a significant relationship between creditor-debtor law and tax law. Creditor-debtor concerns sometimes negate tax benefits, and sometimes, tax benefits weaken asset protection. We see this more frequently in cases where protections for IRAs or qualified retirement plan accounts do not apply where the account was disqualified for tax purposes. Generally speaking, the more likely a plan will fail for tax purposes, the more likely it also will fail for asset protection purposes.
We cannot simply dismiss the Ferrante case as one of a flawed QPRT and move along. QPRTs are not the grand asset protection tools some planners market them to be. Beyond the potential for flawed drafting and the failure of a QPRT trustee to act timely to convert a QPRT to a GRAT, other potential weaknesses include:
- Fraudulent Transfer — Because a QPRT must be settled by a gift of the home, if the creditor can prove either that the grantor meant to defeat the rights of creditors (including future creditors) or was insolvent when the transfer was made, the transfer to the QPRT is susceptible to being set aside as a fraudulent transfer. The good news is that the typical Statute of Limitations for a fraudulent transfer is four years (up to seven years in California), so if you can get past that period, this concern probably goes away.
- Self-Settled Trust — At least as to the grantor’s right to use in the residence and to receive annuity payments if the QPRT is converted to a GRAT, a QPRT is to some significant degree a self-settled trust. A transfer to a QPRT may be viewed as a transfer to a “self-settled trust or similar device” invoking the ten-year clawback provision of Bankruptcy Code section 548(e).
- Alter Ego — Since the grantor retains effective control of the home, a QPRT might be deemed to be the alter ego of the grantor, a theory that is increasingly applied to trusts (see, e.g., the Schwarzkopf case). Indeed, the bankruptcy court in Ferrante specifically mentioned that an alter ego challenge to the QPRT might be effective, but the court did not need to resolve that issue since it ruled in favor of the bankruptcy trustee on other grounds.
Every asset protection strategy has its flaws, and the only thing we know about those who claim to have a 100%-effective asset protection strategy is that they are 100%-wrong. Despite the personal assets being accessed by the Bankruptcy Trustee in this case, QPRTs should still work very well for many people as an estate planning device, particularly for those at low risk for lawsuits. Generally, however, QPRTs are not particularly strong asset protection vehicles, and should not be used primarily for that purpose. Use them as they are meant to be used, and don’t misuse them for something else.
Once again, we’ve seen a debtor’s ostensibly foolproof strategy fail in bankruptcy. It’s not likely that Ferrante protected more than $7.5 million in assets in his Chapter 7 bankruptcy case, so the voluntary bankruptcy filing seems to have been a big mistake. Prior to his bankruptcy, the California Probate Court had ruled in his favor, so creditors were stuck not having access to the QPRT assets. Only by filing for bankruptcy did he re-open the door to give creditors another shot at the luxury home, and this time they (via the bankruptcy trustee) scored a bullseye.
Estate planning, particularly asset-protection-oriented estate planning, often mixes poorly with bankruptcy. A debtor who has engaged in significant planning should consider voluntary bankruptcy cautiously, and only in consultation with expert estate planning and bankruptcy attorneys. Yet, it seems like every month we read another decision involving a debtor who only made things worse for himself by filing for bankruptcy.
Apparently, $7.5 million worse in Ferrante’s case.
HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!
TECHNICAL EDITOR: DUNCAN OSBORNE
LISI Asset Protection Planning Newsletter #310, (November 3, 2015) at http://www.LeimbergServices.com Copyright 2015 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited – Without Express Written Permission.
Ferrante v. Casey (In re Ferrante), 2015 WL 5064087 (BAP 9th Cir., Unpublished Slip Opinion, Aug. 26, 2015). Full Opinion at http://goo.gl/iUB381
Reproduced Courtesy Leimberg Information Services, Inc. (LISI).