Debtor's Late Transfer To Tenancy By The Entireties Fails In Paulsen
Article 2023 Illinois Asset TBE Art231211DebtorsLateTransferTenancyByEntiretiesTBEFailsPaulsen
Tenancy by the entireties (known as TBE) is a form of property where husband and wife own property jointly, but on the death of one the entire interest automatically passes to the other (called the right of survivorship). The TBE form of property is recognized by half the states, and those states add an additional feature which is that if property is held in TBE, then the property is not exposed to a creditor of only one spouse. Only if a creditor holds a judgment against both husband and wife can the creditor get past the TBE protection and enforce the judgment against the property. All this makes property held in TBE an easy and effective asset protection vehicle: A couple can re-title their property in TBE, which costs little to do, and suddenly it is protected from all creditors except those of both spouses, and situations where both spouses become liable for something — in which case TBE would not provide any creditor protection — are pretty rare.
The voidable transaction laws in fact give special treatment to property that is held in TBE. Such property is excluded from the definition of "asset" in the Uniform Fraudulent Transfers Act (UFTAFTA) and Uniform Voidable Transactions Act (UVTA), which means that property held in TBE is effectively immune from being fraudulently transferred — you couldn't fraudulently transfer TBE property even if you wanted to.
But what about property that was not held in TBE but instead was transferred into TBE? Well, that's a different story entirely, and one that we will explore in the interesting opinion of Paulsen v. Olsen, 2023 WL 8019393 (N.D.Ill., Nov. 20, 2023), issued by the U.S. District Court for the Northern District of Illinois.
James and Kathleen Paulsen were a married couple who had owned their home Ringwood, Illinois, sine 1974. The home was owned the Paulsens in joint tenancy, which is perhaps the most common way American property is held by more than a single owner. A joint tenancy is different than TBE, however, since TBE property is effectively protected from the creditors of just one of the spouses, whereas a debtor's joint tenancy interest may be subject to execution by creditors. Note that a pair of owners (not necessarily married) could hold property as a joint tenancy with right of survivorship, which is very similar to TBE except the joint property would still be subject to creditor claims. Some might suggest that the real difference between joint tenancy and TBE, other than the built-in creditor protection, is that TBE is exclusive to married couples whereas joint tenancy can involve two more unrelated owners.
James and his son owned and operated a paving company, and took out a loan for $345,000 from McHenry Savings Bank to finance the business. The assets of the business collateralized the loan, which was made in 2014. Within a couple of years, however, the business of the paving company dwindled and James started selling off the equipment of the paving company to make payments on the loan and also certain property tax payments — even though that equipment has been pledged to McHenry Savings Bank to secure the loan in the first place. Eventually, in 2018, McHenry Savings Bank sued James and his son for breach of contract and by 2019 had obtained a judgment against them personally for almost $350,000.
Earlier in 2019, in January, James and his son met with an attorney, James Magee, who held himself out to them as being both a bankruptcy and asset protection attorney. Days later, and with Magee's assistance, James and Kathleen Paulsen transferred their residence to a trust in which Paulsen's held their interests as TBE. At this point in time, James owed McHenry Savings Bank more than the principal amount of the loan, the liability on the loan having been accelerated.
Three days after this conversion of title was completed, Magee entered his appearance to represent the Paulsens against McHenry Savings Bank.
A couple of days later, on January 24, 2019, James and Kathleen submitted a financial statement to McHenry Savings Bank which stated that James owned three life insurance policies naming Kathleen as the beneficiary, plus the couple had about $8,500 cash available. The financial statement also showed the Paulsens' commercial property, which had been purchased for $345,000 but was listed as having no current market value, and the Paulsens' residence which was valued at $275,000 but James stated that he only had a 50% interest in TBE. The only liabilities were the almost $340,000 now owed to McHenry Savings Bank and some minor credit card debt of about $3,000.
Very shortly after that, in February of 2019, the Paulsens sold the commercial property to a close friend, Barry Lederer, for $275,000 but contingent upon Lederer securing $220,000 in financing and some other conditions. Moving forward to June 2019, Lederer deposited $53,000 for the purchase into an escrow arrangement where the moneys where held in the account of the Paulsen's daughter-in-law Michelle Paulsen. However, Lederer was not able to obtain the financing, while the Paulsens did not meet one of the other conditions of the sale, which was to provide an environmental inspection report. In August 2019, Lederer's attorney demanded the $53,000 be paid back to Lederer, but this did not happen.
Instead, James filed for bankruptcy on October 29, 2019. In his bankruptcy schedules, James claimed that his residence was 100% exempt as TBE and that his only source of income was from Social Security which is also exempt. A bankruptcy trustee, Joseph Olsen, was then appointed to marshal the assets of James.
Olsen sued the Paulsens to recover James' one-half interest in the residence and sought to set aside the transfers which ended up with the residence titled in TBE. Under Illinois law, a transfer into TBE can be set aside if it can be proven that the sole intent of the debtor was to avoid the payment of debts. After a three-day trial, the bankruptcy court did not find the Paulsens' testimony about why they made the transfers into TBE to be credible and held in favor of Olsen by way of avoiding those transfers. The Paulsens then appealed the bankruptcy court's decision to the U.S. District Court for the Northern District of Illinois, which entered the Memorandum Opinion And Order that we shall now examine.
The district court first looked at the text of the Illinois TBE law as it relates to creditors:
"Any real property, or any beneficial interest in a land trust, held in tenancy by the entirety shall not be liable to be sold upon judgment … against only one of the tenants, except if the property was transferred into tenancy by the entirety with the sole intent to avoid the payment of debts existing at the time of the transfer beyond the transferor's ability to pay those debts as they become due."
The salient issue was thus whether James' sole intent in engaging in the transfers was to defeat the rights of his creditors. On this point, James complained on appeal that the bankruptcy court should not have looked to the so-called "badges of fraud" in the Illinois Uniform Fraudulent Transfer Act (UFTA) as evidence of this intent. The reason is that the UFTA will void a transfer if any part of a debtor's intent is to cheat creditors, i.e., a secondary purpose to cheat creditors would suffice, but with the Illinois TBE statute that intent must exclusively be to cheat creditors. This was an interesting argument, but not so interesting that the district court bit off on it. Instead, the district court simply noted that the same factors could be used just as well to establish sole intent.
The Paulsens next argued that there was not any evidence that James had an intent to defeat his creditors when the property was titled in TBE. The problem with this argument was that there was actually plenty of evidence on this point, including the timing of the transfers since James and his son had just been sued by McHenry Savings Bank when James re-titled his property into TBE. Further, the Paulsens also claimed that James had the ability to pay McHenry Savings Bank, but his 2019 financing statement given to the bank demonstrated precisely the opposite.
Finally, the Paulsens argued that James did not re-title his share of the residence into TBE to cheat his creditors, but rather his purpose was for estate planning. As it so often does, this argument went nowhere, with the district court agreeing with the bankruptcy court that these claims by the Paulsens were "little more than after-the-fact concoctions" made for the purpose of avoiding the "sole intent" language of the Illinois statute.
The district court in the end affirmed the judgment of the bankruptcy court to set aside James' re-titling of his his share of the residence into TBE.
ANALYSIS
This case stands as yet another example of planning that was never going to work under the circumstances, meaning well after a creditor's claim had arisen. But why anybody thought that it might work is easy to explain by the 5Ds: Desperate Debtors Do Desperate Deeds. In this case, the deed was into TBE.
A fraudulent transfer is where a debtor transfers title to an asset to some third-person transferee. The debtor's goal is to cease to hold title to the asset so that the asset cannot be subject to execution and sale to satisfy the judgment. By contrast, a fraudulent conversion is where the debtor continues to hold title to the asset, but the asset has been converted from an asset that is available to creditors (known as a non-exempt asset) into an asset that falls within some statutory creditor exemption and thus becomes an exempt asset.
While a few states have fraudulent conversion statutes that set aside non-exempt to exempt transfers, the fraudulent transfer laws can usually operate to this purpose. Here, Olsen as the bankruptcy trustee could have challenged on fraudulent transfer grounds James' transfer to the new trust and then the subsequent transfer back to James in TBE. There was no need, however, for Olsen to go this alternative route as the Illinois statute operated to unwind TBE conversions such as the one here.
Re-titling property into TBE can be an effective asset protection strategy if two conditions prevail: First, the transfer occurs before any claims arise; and, second, both spouses don't both get sued for something. As this case demonstrates, it does not work for cases where a creditor's claim has already materialized.
A last word here about the Paulsens' attempt to argue the estate planning defense, which is that James didn't intend to cheat McHenry Savings Bank at all, but that was simply a by-product of his estate planning. As usual, that defense didn't fly here either simply because of the timing of the transfers. This is one of those things which often sounds good in some attorney's conference room, but it sounds silly in court and judges almost never buy it. Simply put, because of James' debt to McHenry Savings Bank in comparison to his assets, James effectively had no estate to plan for and both the bankruptcy and district courts here saw right through this argument.
But that doesn't stop folks from trying. Like moths to the flame.
AI Article Synopsis
♦ This case, Paulsen v. Olsen, serves as a stark reminder that tenancy by the entirety (TBE), while a powerful asset protection tool, is not a foolproof shield against creditors, especially when used after a claim has arisen. Here's a breakdown of the key takeaways: 1. TBE is not a magic bullet for pre-existing debt: The Paulsens attempted to shield their home from McHenry Savings Bank's judgment by transferring it into TBE. However, the court found that this transfer was done with the "sole intent to avoid the payment of debts" and therefore voided the transaction. This case highlights the crucial distinction between using TBE for asset protection before a creditor's claim arises and using it after a claim has materialized. 2. Timing is everything: The court emphasized the timing of the transfer, noting that it occurred shortly after McHenry Savings Bank sued James and his son. This timing strongly suggested that the transfer was motivated by a desire to avoid the bank's claim. This underscores the importance of implementing asset protection strategies proactively, before any potential creditors come knocking. 3. "Badges of fraud" can be used to prove intent: The Paulsens argued that the court should not consider "badges of fraud" (factors that suggest fraudulent intent) under the Illinois TBE statute. However, the court rejected this argument, stating that these factors could be used to establish "sole intent" to avoid debt. This means that even if a debtor claims a different motive for the transfer, the court can still consider factors like timing, the debtor's financial situation, and the relationship between the parties to determine if the true intent was to defraud creditors. 4. Estate planning defense is often ineffective: The Paulsens attempted to argue that the transfer into TBE was for estate planning purposes. However, the court saw through this argument, finding it to be an "after-the-fact concoction" to avoid the "sole intent" requirement. This demonstrates that courts are often skeptical of estate planning defenses when the timing of the transfer suggests a motive to avoid creditors. 5. Fraudulent conversion vs. fraudulent transfer: The article explains the difference between fraudulent conversion (converting non-exempt assets into exempt assets) and fraudulent transfer (transferring assets to a third party). While the trustee could have challenged the transfer on fraudulent transfer grounds, the Illinois TBE statute provided a more direct route to unwind the conversion. 6. TBE can be an effective asset protection tool, but only when used strategically: The article acknowledges that TBE can be a valuable asset protection strategy, but only when used before any claims arise and when both spouses are not subject to the same creditor's claim. This case serves as a cautionary tale for those who attempt to use TBE as a last-minute solution to avoid creditors. In conclusion, Paulsen v. Olsen provides a valuable lesson for anyone considering using TBE for asset protection. While TBE can be a powerful tool, it is not a magic bullet. It is crucial to implement asset protection strategies proactively and to understand the potential limitations of TBE in the context of pre-existing debt. ♦