Bankruptcy Exemptions Law
Note: This post is an outline of a few topics and is not intended to be exhaustive or a substitute for research or legal advice regarding bankruptcy.
A basic understanding of bankruptcy exemptions law and its purposes is essential to analyzing its benefits and its complications. Bankruptcy exemptions allow debtors to retain certain assets free of claims of creditors. At the time of filing bankruptcy, a debtor must surrender all property interests to the bankruptcy estate. ((11 U.S.C. § 541(a)(1).)) Because the bankruptcy estate does not reach exempt assets, unsecured creditors cannot obtain exempt assets. However, secured creditors may collect their security interests in exempt assets. The debtor retains what remains after paying off any security interest in the exempt property. Therefore, the choices made in the years prior to filing bankruptcy determine a debtor’s exemptions.
Although bankruptcy is typically a matter of federal law, exemption statutes rest in state law. ((11 U.S.C. § 522(b)(2).)) The Bankruptcy Code provides uniform federal property exemptions while allowing states to opt-out. ((Elizabeth Warren, Jay L. Westbrook, Katherine Porter & John A.E. Pottow, The Law of Debtors and Creditors: Text, Cases, and Problems 80 (7th ed. 2014).)) The opt-out provision “granted to each state legislature the option to determine if those subject to that state’s laws would be able to choose the federal exemptions.” ((Lawrence R. Ahern, III & Nancy Fraas MacLean, Bankr. Exemption Manual § 4:1 (West 2017).)) A total of thirty-five opt-out states require individuals to follow state exemption laws. ((Warren et al., supra note 3, at 80.)) States that chose not to opt-out permit the choice of either federal or state exemptions, but do not allow the combination of both federal and state exemptions. ((Id. at 88.))
The Bankruptcy Code’s exemption list includes the following maximum values: $3,775 in one vehicle, ((11 U.S.C. § 522(d)(2).)) $1,600 in jewelry “held primarily for personal, family, or household use[,]” ((11 U.S.C. § 522(d)(4).)) $12,625 in household furnishing held for personal, family, or household use, not to exceed $600 in any single items, ((11 U.S.C. § 522(d)(3).)) $23,675 in a home, which is construed broadly to include residences such as a boat, ((Lawrence R. Ahern, III & Nancy Fraas MacLean, Bankr. Exemption Manual § 5:2 (2017).)) $1,283,025 in tax exempt retirement accounts, $2,375 in “tools of trade,” ((11 U.S.C. § 522(d)(5).)) $12,625 “in any accrued dividend or interest under, or loan value of, any unmatured life insurance contract owned by the debtor under which the insured is the debtor or an individual of whom the debtor is a dependent,” ((§ 522(d)(8).)) and the so-called “wildcard” exemption that exempts up to $1,250 in any property plus up to $11,850 in any unused amount of a homestead exemption in any property. ((Lawrence R. Ahern, III & Nancy Fraas MacLean, Bankr. Exemption Manual, § 5:6 (West 2017).)) The Bankruptcy Code exempts all of the following: “professionally prescribed health aids,” ((11 U.S.C. § 522(d)(9).)) a right to receive compensation for specific injuries, ((11 U.S.C. § 522(d)(11).)) benefits such as “social security, unemployment compensation, or public assistance benefits, veteran’s benefits, disability, illness, or unemployment benefits, alimony, support, or separate maintenance (but only to the extent reasonably necessary for the support of the debtor and any dependents of the debtor), and benefits under a certain stock bonus, pension, profit sharing, annuity or similar plan based on illness, disability, death, age or length of service,” ((Lawrence R. Ahern, III & Nancy Fraas MacLean, Bankr. Exemption Manual § 5:11 (West 2017) (quoting H.R. Rep. No. 595, 95th Cong., 1st Sess. 362 (1977), reprinted in 1978 U.S. Code Cong. & Ad. News, 5787, 6318).)) and an unmatured life insurance policy other than a credit life insurance policy. ((11 U.S.C. § 522(d)(7).))
State exemption statutes vary significantly by jurisdiction. Texas, a non-opt-out state, is acknowledged for its liberal approach to exemptions, which includes an unlimited homestead exemption. Texas law exempts the following: $50,000 for single households or $100,000 for two person households for any personal property (other than a home), ((Tex. Prop. Code Ann. § 42.001(a)(1) (West 2015).)) unlimited value in a home, ((§ 41.001.)) all insurance cash value, ((In re Borchers, 192 B.R. 698 (Bankr. W.D. Tex. 1996).)) tax exempt retirement accounts “to the maximum extent permitted by law,” ((§ 42.0021.)) all current wages, “professionally prescribed health aids,” alimony and additional support, and one religious book. ((§ 42.001(b).)) Other states’ exemptions are fairly restrained. For example, Michigan is a non-opt-out state, which means that debtors must choose between the state or federal exemption scheme. But unlike Texas, Michigan does not have a blanket exemption for personal property. Instead, Michigan specifies each article of exempt property, which includes the following maximum values: $3,525 in a vehicle, $650 in a religious pew, $2,550 in crops and farm animal feed, $650 in household pets, $650 in a computer, $2550 in tools of the debtor’s trade, $38,225 or $57,350 if the debtor or a dependent is over 65 years of old or disabled in a homestead. ((See State of Michigan Dept. of Treasury, Property Debtor In Bankruptcy May Exempt From Levy Or Sale Inflation Adjusted Amounts, https://www.michigan.gov/documents/treasury/Notice_BankruptcyExemptions2017_550393_7.pdf (last visited Jan 8, 2017).)) In addition, Michigan law exempts all of the following: a life insurance policy (if the contract contains such a provision), tax exempt retirement accounts “as permitted by section 522(b)(2) of the bankruptcy code,” “family pictures,” accoutrements, clothes (excluding furs), cemeteries, tombs, burial rights, and “professionally prescribed health aids.” ((Mich. Comp. Laws § 600.5451(a).))
Exemption Planning and its Limitations
Given the variability of exemption laws, in a non-opt-out state such as Michigan, it is necessary to determine which exemption structure maximizes a debtor’s exemptions. For many years, the credit industry asserted that debtors who could pay their debts were abusing exemption laws. ((Warren et al., supra note 3, at 233.)) In response to active lobbying efforts, Congress passed property exemption reforms via the Bankruptcy Abuse Prevention and Reform Act of 2005 (“BAPCPA”). ((Id. at 106.)) While signing the bill, President George W. Bush echoed the credit industry: “too many people have abused the bankruptcy laws. They’ve walked away from debts even when they had the ability to repay them.” ((Id. at 317.)) The opportunity for mischief inevitably presents itself as a result of the variety of state property exemptions. One may assume that property exemptions are easily taken advantage of, but this belief does not tell the full story.
BAPCPA introduced several limitations on exemptions. As described above, the variation in exemption laws between states is so tremendous that some debtors move to a state to receive that state’s exemptions. Section 522(b)(3) was a response to this concern. Section 522(b)(3) requires debtors to reside in a state for 730 days before filing bankruptcy to be able to use the new state’s exemption laws. If a debtor has not lived in one state for 730 days, section 522(b)(3) provides that the state in which the debtor spent most of the 180 days preceding the 730 days before filing bankruptcy will be the state where the debtor resides for purposes of exemption laws.
Congress introduced several monetary caps on exemptions in response to the threat of fraudulent use of exemptions. Section 522(o) reduces the debtor’s homestead exemption by the value of “any property that the debtor disposed of in the 10-year period” before the petition that is attributable to an “intent to hinder, delay, or defraud a creditor.” This provision is rarely invoked because proving a debtor’s intent is a cumbersome evidentiary burden. Section 522(p) caps homestead exemptions at $160,375 for debtors who have moved within 1,215 days before bankruptcy, which seems to disfavor newly wealthy debtors. Section 522(q) provides a homestead exemption cap of $160,375 for debtors convicted of a felony, securities fraud, racketeering, and other criminal acts. Also, section 522(n) caps retirement account exemptions at $1,283,025.
Unlimited Homestead Exemption
The homestead exemption pertains to a debtor’s domicile. Generally, the approach to the exemption of an asset parallels the importance of the asset. ((The World Bank, Report on the Treatment of the Insolvency of Natural Persons 137 (2013).)) The homestead exemptions reflect this standard because the home is typically the most important and expensive asset possessed by debtors. As such, the unlimited homestead exemption has been legally untouchable in Texas, which fought hard in Congress to prevent BAPCPA from abolishing unlimited homestead exemptions. ((See Warren et al., supra note 3, at 106.)) Currently, six states provide an unlimited homestead exemption. ((The Texas Pol. Project, https://texaspolitics.utexas.edu/archive/html/cons/features/0406_01/homestead.html (last visited Jan 4., 2018).)). But Texas’ unlimited homestead exemption is the most generous in the country because a Texas home is exempt from all unsecured creditors if the homestead is not larger than ten acres in a city or two-hundred acres in a rural area. ((Tex. Prop. Code Ann. § 41.002 (West 2015).)) Unlimited homestead exemptions have drawn criticism because of the ostensible risk that debtors, in the apprehension of bankruptcy, will put all their non-exempt assets into a wholly exempt homestead. However, this criticism has not gone unchallenged. Many European countries seek to model their bankruptcy systems after that of the United States in the belief that the United States’ generous bankruptcy laws are partially responsible for its economic success. ((See John Armour, Personal Bankruptcy Law and Entrepreneurship, Credit Slips (Oct. 3, 2007, 5:55 AM), http://www.creditslips.org/creditslips/2007/10/personal-bankru.html.)) Economists have studied the relationship between unlimited homestead exemptions and entrepreneurship. ((Warren et al., supra note 3, at 125.)) They found that states with unlimited homestead exemptions had a 35% higher rate of small business ownership. ((Id.)) In other words, an unlimited homestead exemption is arguably beneficial to society because it provides reinvigoration and reinsertion of debtors into the economy. ((See generally The World Bank, supra note 29, at 38.))
Trusts and Retirement Accounts
Congress and the states agree on one major principle: retirement accounts and trusts need special protection from creditors. Section 541, which governs what comprises property of the estate, protects the debtor’s interest in a trust “that is enforceable under applicable nonbankruptcy law” as well as tax exempt retirement accounts. Though BAPCPA set hard limits on property exemptions, it introduced special treatment for retirement accounts and certain trusts if they are “enforceable under applicable nonbankruptcy law.” ((11 U.S.C. § 541.)) Trusts separate the holding and control of assets from their ownership. ((Warren et al., supra note 3, at 121.)) In thirteen states, self-settled trusts allow one to retain both the benefit and control of assets, with legal title conveyed to a third-party to shield the assets from creditors. ((Id.)) Domestic trusts, in theory, allow debtors to stiff their creditors, but in reality, this rarely occurs because not only do debtors rarely think ahead but BAPCPA sterilized self-settled trusts through section 548(e)(1). ((Id.)) Section 548(e)(1) provides that an intentional transfer of property to a “self-settled trust or similar device” made within ten years before bankruptcy is voidable. Section 548(e)(1) caused the domestic self-settled trust to become less attractive to wealthy individuals. Currently, individuals typically prefer offshore trusts that have proven to be impenetrable. ((Id.)) Offshore trusts are so untouchable largely because the countries in which the trusts are set up do not recognize foreign court orders. ((Id.)) The Cook Islands, in particular, is notorious for creating trusts for wealthy individuals. ((Id.)) Trusts in the Cook Islands are perhaps the most formidable manner in which to retain assets because, under Cook Islands law, foreign court orders upon trusts are required to be disregarded. ((Id.)) As a result, enterprising asset protection firms have boasted that “simply put, to date there has never been a situation where an offshore asset protection trust has been broken and where the money in such a trust has been forced to return to the U.S. and returned to a creditor.” ((Id. at 123.))
As stated above, retirement accounts are exempt from the reach of creditors up to a cap of $1,283,025. ((11 U.S.C. § 522(n) (2012).)) However, a judge has the discretion to waive this cap in the interests of justice. ((Id.)) The relationship between trusts, retirement accounts, and bankruptcy is controversial given the vast amounts of value that debtors may have in these assets. ((The World Bank, supra note 28, at 83.)) Consequently, the simple use of retirement accounts together with trusts allows one, in theory, to avoid formal bankruptcy and keep one’s assets, including assets that would otherwise be nonexempt. ((See Nathalie Martin, The Myth of the Non-Bankruptcy Exemptions, Credit Slips (May 28, 2008, 3:06 PM), http://www.creditslips.org/creditslips/2008/05/the-myth-of-the.html.)) The fact that thirteen states have formally legalized domestic asset protection trusts reinforces this theory. ((See Warren et al., supra note 3, at 121 (noting that Alaska, Delaware, Hawaii, Missouri, Nevada, New Hampshire, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, and Wyoming have legalized asset protection trusts).)) Further, many of those states permit establishing trusts for out-of-state residents. ((Id.)) As a result, a debtor in any state can transfer her or his property to a domestic trust. More importantly, a debtor may set up an impervious Cook Islands trust. It is important to recognize that a retirement account itself is exempt, but a distribution from a retirement account is not exempt. Retirement account distributions are not exempt because an exempt account no longer protects them. However, a discharge frees all retirement account distributions from claims of creditors. Therefore, debtors should first receive a discharge before taking any distributions. As such, if executed correctly, a debtor can have no assets within reach of creditors. Note that this activity takes place against a backdrop of judicial scrutiny.
Relationship Between Federal and State Law Exemptions
The law of bankruptcy exemptions is in need of a comprehensive rethinking. Unfortunately, no such rethinking has occurred. While some legislators oppose bankruptcy law’s variety of state-specific laws, others believe it is beneficial because the states are in the best position to know which property is vital to debtors. The relationship between federal and state exemption law reflects a widespread difference of opinion concerning the proper value of exemptions. Consequently, Congress decided to give the hot potato of exemption values to the states. The result is that the BAPCPA reforms provide more opportunity for wealthy debtors to engage in exemption planning but create new hurdles for economically challenged debtors who do not have the resources to use retirement accounts and trusts. ((See Jason J. Kilborn, Still Chasing Chimeras but Finally Slaying Some Dragons in the Quest for Consumer Bankruptcy Reform, 25 Loy. Consumer L. Rev. 1, 2 (2012).)) States ought to exercise their power to set exemption values because many exemption statutes are woefully out of date. Empirical evidence has suggested that generous bankruptcy laws improve the economy and benefit society and economically challenged people in many ways. ((See generally Jason Kilborn, Quantifying the Benefits of the Fresh Start, Credit Slips (Apr. 6, 2015, 11:16 AM), http://www.creditslips.org/creditslips/2015/04/quantifying-the-benefits-of-the-fresh-start.html.)) For example, empirical evidence demonstrated that access to bankruptcy protection led to increased annual earnings, increased rate of self-employment, decreased death rates by 2%, increased aspiration to work, and a reduction in stress. ((Id.)) Not only have some studies suggested that a fraction of debtors abuse the exemption laws but property exemptions may improve the economy by giving debtors the confidence and tools necessary to be economically productive. Although chiefly limited to wealthy individuals, bankruptcy planning is alive and well after the 2005 reforms aimed to prevent abuse. The current state of bankruptcy exemptions law leaves scholars to question why Congress placed seemingly arbitrary hard caps on only newly acquired wealth and why it afforded less protection for debtors who happen to move frequently. ((See John Pottow, The Unconstitutionality of 11 U.S.C. 522(p), Credit Slips (June 30, 2007, 3:50 PM), http://www.creditslips.org/creditslips/2007/06/the-unconstitut.html.).)) Is the current situation of bankruptcy exemptions law fair, or is it merely a product of wealthy individuals serving the interests of wealthy individuals?