Creditor Protection Strategies in the ‘New Normal’

Take-Away: As we counsel clients with how to maintain their sanity during the COVID-19 ‘lock-down’ and their sudden loss of 25% of their wealth, knowing that they are overwhelmed by anxiety and tend to compartmentalization of their problems they may act out of impulse. That is where we come in to control those impulses. We need to be mindful of creditor protection strategies if a client ultimately faces their worst-case scenario with lawsuits or even bankruptcy.  The message here is pretty simple: spend what’s exposed, save what’s protected.

Creditor Protection in Michigan: Michigan, like most states, has an extensive (albeit hard to read) statute that exempts certain types of property from creditor claims. However, Michigan’s statute is greatly outdated; for example, it exempts chickens, goats, horses, and many other items of property that most households no longer deem essential (or even own.)

Tools of Trade: However, tools of a tradesman are protected.

Homestead: A limited amount of a homestead’s equity is also protected. Some states, like Florida, exempt substantially more of a home’s equity than does Michigan, which is tied to a low dollar amount.

Retirement Accounts: The Michigan Exempt Property statute provides for almost (but not quite) total protection for: (i) IRA account balances; (ii) qualified plan account balances, e.g. 401(k) accounts; You will recall, however, that back in 2013 the U.S. Supreme Court held that assets held in an inherited IRA are not protected in bankruptcy, and Michigan has yet to amend its Exempt Property statute to extend protection to inherited IRAs (although a small number of states have extended creditor protection to inherited IRAs.) In short, inherited IRA accounts are fair-game for creditors in Michigan.

529 Accounts:  529 accounts are exempt, regardless of the value of the account;

Insurance Contracts: The cash surrender value of a life insurance policy is exempt, regardless of the amount, if the insured’s family members are named as the beneficiaries of the policy. Tax sheltered annuity values are also, as a generalization, protected. In light of the amount of wealth still held in IRAs, qualified plan accounts, 529 accounts and life insurance contracts, those assets should be the last be be used to maintain a household during this crisis.

Federal Bankruptcy: The purpose of bankruptcy is to give a debtor a fresh start, by eliminating debts while permitting the debtor to retain many exempt assets. Normally the debtor’s property is controlled by the bankruptcy trustee. [11 U.S.C. 541.] A stay order is entered by the Bankruptcy Court that prohibits a creditor from pursuing collection actions against the debtor’s pending bankruptcy. Like Michigan’s Exempt Property statute, many assets are classified as exempt in bankrutpcy. Perhaps the most notable exempt asset is that a person can file for bankruptcy and still retain roughly $1.2 million in an IRA and an unlimited amount in a qualifed plan account, e.g. 401(k) account.

Caution: While an adjudication in bankruptcy truly does give the debtor a fresh start, it is important to remember that converting non-exempt assets to exempt assets within one year of the debtor filing for bankruptcy may be classified as a fraudulent transfer, which may provide grounds for the Bankruptcy Court to deny any discharge of debt and a dismissal of the debtor’s petition for bankruptcy.

Chapter 7: A petition for Chapter 7 Bankruptcy liquidates non-protected assets of the debtor. Debts are discharged, usually with no payment plan, if the debt is mostly ‘business debt’ (in contast to consumer debt.)

Chapter 11: A petition for Chapter 11 Bankruptcy is intended to result in a reorganization applied to (i) businesses and (ii) individuals with large amounts of debts who do not qualify for a Chapter 13 Bankruptcy. The repayment plan approved by the Bankruptcy Court can either be for full or partial repayment which is based on the debtor’s ability to pay the non-discharged debts under the proposed plan.

Discharge of Indebtedness as Taxable Income:  If there is an advance agreement between the debtor and creditors to reduce the debt outstanding, or permit the debts’ repayment over time, approved by the Bankrutpcy Court, the debt discharged in the process of negotiation and settlement will normally be income-tax free for the debtor. [IRC 108.]

Small Business Reoganization Act of 2019: This Act, passed a year ago (talk about being timely!) amended subchapter V, which makes the Bankruptcy Code more debtor friendly. It was further amended by the CARES Act, effective April 1, 2020. Initially the Act eliminated a former requirement of the law that any class or classes of unsecured creditors would have to vote on a debtor’s proposed plan of reorganization before the Bankruptcy Court could approve the reduction or restructuring of debt. In addition, any secured creditors of the debtor will be required to subject to the bankruptcy plan or reorganization approved by the Court, which generally provides that a secured creditor’s claim cannot exceed the value of the collateral that secures the debt on the date that a Chapter 11 Bankruptcy Peition is filed. The CARES Act raised the amount of debt a small business debtor can have while filing Chapter 11 to $7.5 million.

Chapter 13: This provision of the Bankruptcy Code is intended to result in a payment plan arrangement that an individual debtor, who meet eligibility requirements, comply with the payment plan rules. This usually results in a 3 to 5 year repayment plan that is funded by the debtor’s disposable income. In short, the debtor can retain many of his/her assets in a Chapter 13 proceeding. To be eligible for filing a Chapter 13 Bankruptcy peition, the debtor may have unsecured debt of less than $419,275 and secured debt of less than $1,251,850.

Practical (and Fairly Obvious) Tips: When counseling clients who are faced with their financial devastation (real or perceived) some obvious points should be made:

1. Hold onto cash, as long as possible, to deal with the unexpected. We do not know how long this crisis is going to last, so holding onto cash as long as possible makes sense.
2. As noted in the Take-Away, spend what is exposed and save what is protected. While the CARES Act liberalized the ability to borrow from a qualified plan account, that should be a source of ‘last-resort’ funds, since the loan will have to be repaid, and qualified p While the CARES Act also waived the 10% penalty for an early distribution, the distribution itself is still taxable income that triggers the payment of income tax.
3. Cut personal spending. Several different sources have conducted studies that indicate that happiness and contentment is increasedwith annual income up to a certain level, which is about $135,000 per household, but it does not go up further even when income jumps.
4. Adult toys, like sports cars, boats and airplanes need to be jettisoned. Their value just dropped dramatically with the market meltdown. Waiting for the market to ‘return’ before these adult ‘toys’ are liquidated simply means that they have to be maintained until the market ‘returns’ (your guess is as good as mine.) Maybe selling these items at a loss, while painful, may still make sense if the net sales proceeds can sustain a family while preserving other exempt assets.