In my previous post, we learned that doing a solvency analysis is crucial to staying on the right side of UFTA. But what is solvency? Under N.J.S.A. 25:2-23:
A debtor is insolvent if the sum of the debtor’s debts [after any purported transfer of assets] is greater than all of the debtor’s assets, at a fair valuation.
That seemingly simple definition can cause a host of issues. This post will review a few of them.
Under the above definition, we can reduce solvency to math. Assets – Debts = Net Worth. If Net Worth is negative after any transfer of assets into an asset protection vehicle, we have insolvency. Our analysis, then, must start with the definition of “assets” and “debts”.
Under N.J.S.A. 25:2-21:
“Asset” means property of a debtor, but the term does not include:
a. Property to the extent it is encumbered by a valid lien;
b. Property to the extent it is generally exempt under nonbankruptcy law; or
c. An interest in property held in tenancy by the entireties to the extent it is not subject to process by a creditor holding a claim against only one tenant.
An asset is pretty much anything we would include in the normal definition of the word, with a few exceptions. The most notable exception is that “assets” do not include assets which creditors cannot attach. [This is what is meant in subsection b above.] In New Jersey, this would mean that both IRAs and 401(k)s, for example, are not “assets” for purposes of UFTA solvency. Another of the exceptions is property held as “tenancy by the entireties”. That exception will be discussed in a future post.
Also note that property is not an asset to the extent is is encumbered by a valid lien (subsection a above). Taken together with N.J.S.A. 25:2-23(e), this means that if you have a house worth $250,000 with a $200,000 mortgage, the house counts as a $50,000 asset and the mortgage doesn’t count as a debt. On the other hand, if you have a $200,000 house with a $250,000 mortgage, the house isn’t an asset at all, and the mortgage counts as a $50,000 debt.
Moving onto defining “debts”, under N.J.S.A. 25:2-21:
“Debt” means liability on a claim.
“Claim” means a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.
In short, a debt is anything you owe anyone. It is also anything you might owe someone in the future should a specific set of circumstances arise. The latter is what UFTA calls a “contingent” claim and is one of the trickiest parts an UFTA solvency analysis.
Based on the definition above including “contingent” claims, in an UFTA solvency analysis, do we need to include all amounts of money which we could possibly end up owing anyone? The answer to that must be no, otherwise almost no one would be solvent under UFTA. So how do we deal with contingent claims then?
Probably the most common type of “contingent” claim under UFTA is a personal guarantee. Most small business owners are forced to give personal guarantees all the time in order to obtain loans for their businesses. The normal scenario starts with XYZ Corp wanting a loan from Bank. Bank agrees to grant the loan, but requires that John Doe (owner of XYZ Corp) give a personal guarantee on the loan. This means that if XYZ Corp defaults on the loan, Bank can sue John to recover what is is owed.
When John Doe meets with an asset protection attorney, does XYZ’s loan have to be considered in a personal solvency analysis for John? Under the definitions of “debt” and “claim” under N.J.S.A. 25:2-21, the clear answer is yes. Does John then need to record the full value of the loan as a “debt” in his solvency analysis? The answer to that is no, and that is the key to this discussion.
In a fraudulent transfer solvency analysis, the value of a personal guarantee or other contingent claim is reduced by the probability that the debtor won’t become responsible for the liability. [Remember, John Doe only becomes responsible for the debt if XYZ Corp defaults.] See, e.g., In the Matter of Xonics Photochemical Inc., 841 F.2d. 198 (1988). This means that in our John Doe example above, John’s personal guarantee might have very little or no value as a debt in his solvency analysis if XYZ is a healthy company and unlikely to default on its loan. In this regard, the UFTA seems to defer to Generally Accepted Accounting Principles in determining the value of the debt.
This brings me to the final point of this post. Many times my clients are perplexed as to why I have them obtain a Statement of Financial Condition prepared by an independent CPA shortly after our first meeting. The reason I do this is to protect against a future UFTA attack. Remember that UFTA solvency analysis is done as a snapshot at the time the transfers into asset protection vehicles are made. Solvency at the time of creditor attack is irrelevant. Therefore, a CPA-prepared financial statement which was completed at the time of the transfers will provide good evidence of solvency should a creditor raise the issue years later. Not all assets and debts on the statement will be considered assets and debts for UFTA (as described above), but it will be easy for a court to adjust for those exceptions. This places a creditor trying to argue insolvency into the position of having to discredit the Statement of Financial Condition, which may be difficult since it will be likely be given a good amount of weight when prepared by a licensed independent CPA.
The independent CPA will also have valued all contingent liabilities on the statement as of the time of transfer, meaning again that a creditor will be stuck trying to discredit those valuations years after the fact should it try to bring an insolvency argument. This isn’t impossible for a creditor to do, but again the Statement of Financial Condition will be likely be given a good amount of weight by a court when prepared by a licensed CPA.
My upcoming plan for the blog is to do a few more posts on UFTA, and then move on to some new topics. If you have any questions about UFTA or asset protection in general, don’t hesitate to contact me.
TAX ADVICE DISCLAIMER: Any tax advice contained in this communication (including attachments) was not intended or written to be used, and it cannot be used, by you for the purpose of (1) avoiding any penalty that may be imposed by the Internal Revenue Service or (2) promoting, marketing, or recommending to another party any transaction or matter addressed herein.
NOT LEGAL ADVICE. Everything posted here is for educational purposes only, and is not to be construed as legal advice. Do not take any action, postpone any action, or decline to take any proposed action based on this information without first engaging the representation of me or another qualified attorney. Nothing posted on Twitter or on any website shall be construed in any way as legal advice.
DISCLAIMER: I am an attorney and a CPA, however I am neither your attorney nor your CPA, and therefore no communications between us are covered by attorney-client or accountant-client privilege unless you possess a signed document which states that I currently represent you as an attorney or a CPA. In the case that such a document exists, the existence or waiver of attorney-client privilege or accountant-client privilege shall be controlled by the signed fee agreement or engagement letter.