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Yerushalmi - Old And Cold QPRT Stands Up To Alter Ego Challenge In Bankruptcy Adversary Proceeding

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In 1995, Husband (our Debtor) and Wife funded a QPRT with their residence. The QPRT had a term of 23 years. Husband and Wife were the Trustees of the QPRT, but not the beneficiaries -- the beneficiaries were their children, including a son with special needs.

For those of you who might be wondering what a QPRT is, the Court described it this way:

It is this Court's understanding that an individual—a grantor—might transfer real property to a QPRT in order to reduce the size of their taxable estate. ** * If structured properly, the QPRT will freeze the value of the grantor's residence at the time he or she creates the trust and result in estate tax savings if the property increases in value. During the term of the QPRT, the grantor retains the exclusive rent-free use, possession and enjoyment of the residence and pays all ordinary and recurring expenses such as real estate taxes, insurance and minor repairs. At the expiration of the trust term the grantor must relinquish possession of the residence or pay rent to the trust.

In order to realize the tax benefits of the QPRT, the grantor must outlive the term of the trust. If the grantor dies before the trust term expires, the value of the property at the date of death will be included in the grantor's estate and be subject to estate taxes. If the grantor outlives the term of the trust, the property passes to the beneficiary, in this case the Yerushalmi Family Trust, at the end of the term. At that point, the grantor may lease the residence back from the beneficiary at fair market rent, thereby allowing the grantor to continue living in the house.

In 1998, Husband became embroiled in a partnership dispute with one of his law partners, which resulted in litigation that lasted over a decade. Eventually, in 2011, after an appeal and a remand to re-calculate damages, a judgment for $600,000 was entered against Husband in the partnership dispute.

In 2002, Husband and Wife divorced. The following year, Husband was ordered to pay all the expenses of the residence including mortgage payments, taxes, utilities, insurance and the like.

In 2007, Husband filed for Chapter 11 bankruptcy, and listed the residence on his bankruptcy schedules as having a value of $5.2 million with an outstanding mortgage of $407,000.

The Bankruptcy Trustee filed an adversary action against Husband and Wife in 2009, against Husband individually and against both Husband and Wife as Trustees of the QPRT. This action sought to unwind, as a fraudulent transfer, both the original conveyance of the residence to the QPRT and Husband's subsequent payments of the numerous expenses of the property.

The Statute of Limitations for a fraudulent transfer action having long run, the Husband filed a motion to dismiss those claims and eventually the Trustee withdrew them entirely.

Instead, the Trustee amended his Complaint to seek a declaratory judgment that the QPRT was the alter ego of the Husband and therefore the assets of the QPRT were property of the Bankruptcy Estate.

The Bankruptcy Trustee's alter ego claim was based on these allegations:

• the Debtor "controlled and dominated all aspects of the QPRT" since its creation;

• the real property owned by the QPRT was purchased with the Debtor's own funds;

• the QPRT never established its own checking account;

• the QPRT did not maintain books and records;

• the Debtor's wife, ". . . acted at all times as the nominee of the Debtor with respect to the QPRT";

• "the Debtor used his control of the [QPRT] to conceal his assets and to engage in fraudulent conveyances to shield funds from the reach of his creditors";

Husband moved to dismiss the alter ego claim on the grounds that the Bankruptcy Trustee lacked standing to bring such a claim, but for technical reasons related to the Bankruptcy Code that are not germane to our discussion here, the Court rejected that defense and held that the Trustee had standing.

Husband also moved to dismiss the alter ego claim by arguing that the Statute of Limitations had long run on the alter ego claim. But the Court correctly pointed out that there effectively is no Statute of Limitations for the property of the bankruptcy estate to be marshaled by the Bankruptcy Trustee, and thus rejected that defense as well.

That takes us to the merits of the alter ego action.

The Court noted that under New York law "estate planning trusts generally are susceptible to attack if used for a fraudulent purpose." However, the Court refused to find such a fraudulent purpose as to this QPRT:

The facts of this case do not show that this Debtor exercised complete domination over the trust, or even if he did, that he used that domination to commit a fraud or wrong.

The important facts, in the view of the Court, were that the residence:

was transferred into the QPRT in 1996 at a time when the Debtor had significant assets and disposable income. * * * The Trustee has not presented the Court with evidence of any litigation or threatened litigation which may have prompted the Debtor to improperly shield his assets from creditors at the time the QPRT was formed.

The Bankruptcy Trust, however, had also argued that the Husband's actions after the QPRT was formed -- such as living in the house and paying expenses -- were evidence that the QPRT was simply Husband's alter ego.  But the Court rejected this as well:

While it is true the Debtor retained the use and enjoyment of the Great Neck Residence after it was transferred to the QPRT and continued to pay all expenses associated with the [] Residence, those facts are consistent with the requirements of a valid QPRT. The grantor of a qualified personal residence trust retains the right to live at the residence rent free but has to pay all costs associated with the residence for the duration of the trust term—in this case until 2018.

And thus the Court concluded:

Based on the undisputed facts, the Court finds the Debtor did not engage in any conduct or enter into any transaction that would be inconsistent with the QPRT's ownership of the property, and the Trustee has failed to prove that the Debtor exercised complete domination over the trust, or even if he did, that he used that domination to commit a fraud or wrong.

Upon that finding, the Court granted summary judgment against the Bankruptcy Trustee, and he lost and the QPRT stood up to his attack.

QPRTs Are A Safe And Effective Asset Protection Tool, Most Of The Time

Despite the fact that a lot of QPRTs have been formed over the years, there have been scant few cases that have addressed them in the creditor-debtor context. This Opinion goes a long way to validate the asset protection benefits of a timely and properly formed QPRT.

I say "timely" because if the QPRT had been formed after Husband became embroiled in his partnership dispute, then the Bankruptcy Trustee could have brought a fraudulent transfer action and had a much greater chance of prevailing. Because a QPRT typically involves a gift of the residence to the QPRT and a gift is inherently without any "reasonably equivalent value", such transfers are inherently susceptible to fraudulent transfer actions.

But while alter ego claims effectively have no Statute of Limitations because the claim is that the property is that of the debtor's bankruptcy estate, fraudulent transfer action do have relatively short limitations periods (generally four years from the date of transfer, or one year from when the transfer could have reasonably been discovered).

Thus, QPRTs can be a very effective asset protection tool so long as the residence is conveyed into the QPRT at a time when the grantor is solvent and has no significant creditor claims on the horizon -- in aviation parlance, when the skies are "severe clear". But, as with pretty much every other asset protection strategy short of pure exemption planning, if there are creditor thunderclouds on the horizon, all bets are off.

In re Yerushalmi, 2012 WL 5839938 (Bkrtcy.E.D.N.Y., Slip Copy, Nov. 19, 2012). Full Opinion at http://goo.gl/HlM8k

This Article at http://onforb.es/XarN1c and http://goo.gl/yziwM