Damage control for professional liability.by Goldwasser, Dan L.
The threat of professional liability has become more ominous to CPAs with the recent downturn in the U.S. economy, as the number of suits brought each year against accountants is largely a function of the health of the national economy. Equally distressing is that such suits, on average, are resulting in larger monetary awards. These trends mean that in the next few years, many CPAs will likely be defendants in professional liability suits. The significance of these developments was recently underscored by the sudden demise of Laventhol & Horwath.
In the past, the accounting profession has sought to avoid litigation by adopting detailed written practice standards and quality control procedures. Although these measures have helped to improve the overall quality of practice among CPAs, they have done little to eliminate the nightmare of professional liability litigation, as the public's expectation of CPA performance has either kept pace or has increased at the same time.
The accountant's second line of defense traditionally has been to purchase professional liability insurance. Such insurance has been generally available in virtually unlimited amounts, covering every type of claim, save only those in which there were findings of intentional or fraudulent misconduct. Unfortunately, the cost of such insurance is currently four times higher than it was 10 years ago, with the result that many firms have decided to reduce, or even forego insurance coverage. Moreover, accountants are now forced to accept policies with sharply curtailed coverage. In addition, most professional liability policies provide that legal fees and other related costs of defending a claim are charged against the policy limits. Thus, accountants are not only faced with a rapidly increasing liability exposure, but also with diminished insurance protection.
Many CPA societies have sought to have their state legislatures adopt "privity" legislation limiting the scope of persons who can sue an accountant on a negligence standard. To date, Illinois, Kansas, Arkansas, and Utah have adopted such legislation. Others have sought similar protection from the courts. At present there are eight states that have adopted privity or near privity rules via the courts: New York, Colorado, Delaware, Idaho, Indiana, Nebraska, Nevada, and Pennsylvania. More recently, the AICPA has embarked upon a campaign to have states permit the practice of accountancy in "limited liability" corporations to further protect the assets of accounting firm owners from vicarious liability. These efforts alone, even if successful, will not completely remove the threat of personal liability and financial ruin that CPAs currently face.
The AICPA's Council has approved an amendment to Rule 505 of the Institute's Code of Professional Conduct, which, if adopted by the membership, will permit the practice of accountancy in business corporations. Typically, under state law shareholders of business corporations are shielded from personal liability resulting from the actions of others. The laws of most states, however, currently require professional firms to conduct their practices through either a partnership or a professional corporation. In contrast to shareholders in a business corporation, each member of a partnership is personally responsible for the liabilities of the partnership, regardless of their cause. A shareholder of a PC, on the other hand, is generally only responsible for liabilities of the firm if he or she directly caused those liabilities or "supervised" the persons whose actions gave rise to those liabilities.
Damage control consists of an organizational structure and operating procedures designed to minimize the impact of a given adversity. Perhaps the most vivid example of damage control is the design of naval warships that are equipped with armor plating and divided into numerous cells or water-tight compartments. In the event the ship is hit by a torpedo or bomb, the damage is minimized, as only those compartments directly affected by the ensuing explosion will be lost, allowing the remainder of the ship to function. It is this conceptual structure of an exterior shield and independent units that offers the best hope for an accounting firm to survive a liability claim in excess of its insurance coverage. In providing similar protection for accounting firms, there are numerous choices that can be made and these choices have ethical and practical ramifications.
The concept of dividing a professional practice into distinct parts also faces legal obstacles. For example, all states will ignore the separate existence of a corporate entity where legal formalities are not scrupulously observed or where the operations of the separate entities are so intertwined as to make them, in reality, a single enterprise. Also, the law will frequently nullify a transfer of assets from one legal entity to another if the transfer renders the transferor entity insolvent or is made to avoid claims of the transferor's creditors.
Despite these limitations, there are a number of damage control techniques that might be employed at the firm level. Most of these techniques, however, impose new operating burdens or entail other adverse consequences in addition to their legal problems and should only be undertaken after careful analysis.
INCORPORATING A PROFESSIONAL PRACTICE
All but three states (Kansas, Iowa, and Hawaii), have adopted laws permitting incorporation of professional practices. For example, Article 15 of the New York Business Corporation Law provides for incorporation of firms providing "professional services" which is defined as "any type of service to the public which may be lawfully rendered by a member of a profession within the purview of his profession." Notwithstanding such incorporation, the New York statute further provides that:
Each shareholder, employee or
agent of a professional corporation
shall be personally and fully liable and
accountable for any negligent or
wrongful act or misconduct committed
... while rendering professional
services on behalf of such corporation."
N.Y.B.C.L. Sec. 1505(a).
Even if a firm only maintains offices within one state, problems may arise if it provides services in neighboring states through persons licensed to practice in those states. For example, although Connecticut may license a New York accounting firm to service its Connecticut clients, Connecticut in all likelihood will not permit that provides immunity from personal liability beyond that authorized in the Connecticut statute. For this reason, it may also be necessary to form a separate Connecticut corporation even though Connecticut permits incorporation and even though the firm does not have a Connecticut office. The creation of separate entities in each state naturally will increase the firm's administrative and possibly its tax burdens.
While approximately half of the states have statutes that are similar to those of New York or Connecticut, seven states permit professionals to incorporate their practices so as to take advantage of tax benefits accruing to corporations (most of which are now also available to partnerships) without diminishing the liability exposure of firm members. For example, Sec. 58.185(2)(c) of the Oregon PC statute provides:
"Shareholders shall be jointly and
severally liable with all other shareholders
of the corporation for the
negligent or wrongful acts or misconduct
of any shareholder, or by a person
under the direct supervision and
control of any shareholder."
Arizona, West Virginia, and Wisconsin have adopted similar provisions.
Other state statutes provide limited liability to firm shareholders, provided the firm maintains adequate capital or insurance. For example, Sec. 12-2-131 of the Colorado statute provides:
"All shareholders of the PC shall be
jointly and severally liable for all acts,
errors, and omissions of the employees
of the corporation except during
periods of time when the corporation
maintains in good standing professional
Louisiana, Pennsylvania, Rhode Island, South Dakota, and Wisconsin have adopted similar provisions.
Little Attention from Courts
PC statutes sheltering professionals from personal liability have received little attention in the courts. Accordingly, the extent to which they offer protection against personal liability is unclear. Moreover, if the action giving rise to a claim is effected in another state, or by the citizens of another state, and the case is brought in that state, it is highly likely that the laws of that state will be applied. Therefore, the shareholders of the defendant professional corporation may be held personally liable regardless of their firm's incorporation and regardless of their not having participated in the alleged wrongful actions. Thus, the protection offered by incorporation may not be as significant as envisioned by the statutes.
Aside from the lack of uniformity of the various PC statutes, there is an added problem in that they do not currently contemplate multi-state practice. Indeed, unlike professional partnerships that can consist of professionals licensed in two or more states, most PC statutes at present only permit professionals who are licensed in the state of incorporation to be shareholders. While this may not preclude a majority of accounting firms from incorporating, it does restrict larger firms. This problem, combined with the residency requirements imposed by some states, greatly limits PCs as damage control devices.
For firms operating in more than one state, incorporation presents other complications. in the event an accounting firm has offices outside its state of incorporation, it should seek to incorporate the offices in states that permit PCs and to form separate partnerships in states not permitting PCs. The formation of such separate entities raises questions as to how profits are to be shared among the various offices because no PC statute presently permits a professional corporation to be a member of a PC. One possible solution to this problem is to have the parent professional corporation receive payments from the firm's out-of-state offices for management, administrative and/or training services supplied by the home office. As discussed later, even this format presents a potential liability. Moreover, it would also violate fee-splitting prohibitions which have been adopted in some states.
Nonparticipant in an Engagement
Even as to those accounting firms practicing almost exclusively in one state with a strong PC statute, the benefits of incorporation may still be illusory. This is because limited liability under the better PC statutes is only afforded to those shareholders who neither committed the wrongful acts nor supervised the person or persons who committed them. Unfortunately, there is no legislative history and no judicial interpretations that discuss what is meant by "supervision" in this context. For example, would the "managing partner" or the members of the firm's "executive committee" be personally liable on the theory that they are responsible for the actions of all of the firm's employees? On the same theory, would the head of the firm's audit department be liable even if he or she had no direct contact with an audit engagement that went awry? Moreover, would the answer to those questions be different if a technical or business aspect of the engagement had been considered by any of those persons?
Similar questions may be raised with respect to persons on the firm's review staff. Such persons, while actively involved in an engagement, often play a limited role, such as reviewing the firm's report for its apparent compliance with GAAP, rather than reviewing - much less supervising - the manner in which the engagement was carried out. Nevertheless, their actual participation in the engagement certainly makes them more likely prospects for incurring personal liability than those persons with administrative responsibilities.
Further complicating this issue are provisions in the audit literature and the AICPA's Code of Professional Conduct ET Sec. 9, paragraph .02(2), that tend to make a CPA firm owner ethically responsible for the actions of other owners. It is conceivable that such provisions could be used to argue that every owner has a duty of supervision over every engagement undertaken by the firm, thereby completely nullifying the protection offered by the PC statutes.
Although there is currently no clear basis for determining which members of an accounting firm would be entitled to limited liability as a result of the firm's incorporation, it would be consistent with the apparent statutory purpose to shield managers within the firm who do not have direct involvement with the engagement. On the other hand, persons actually involved in the engagement, either as reviewers or managers, should not count on a limited liability status, even if their involvement does not encompass the deficiencies in the conduct of the engagement that gave rise to the claim.
The Letter of the Law
To secure the apparent advantages of incorporation, accounting firms should observe certain formalities. First, they must follow appropriate corporate procedures such as the issuance of shares, the election of directors and officers, the filing of corporate tax returns, directors and shareholders meetings, and maintenance and retention of appropriate corporate records. Secondly, they should also keep detailed records as to who worked on each engagement. Normally, this will be recorded in the firm's workpapers and time records. Such records will thus form the basis for determining who may be held personally liable on the engagement.
The Administrative Burden
While incorporation can be beneficial, it may be of little help to small firms, all of whose members tend to be consulted on virtually every engagement. Conversely, large firms whose practices extend to other states that do not provide similar protection might also find incorporation to be of insufficient benefit to offset the added administrative burden.
There is the further possibility of having each member of the firm incorporate as an alternative in addition to incorporation of the firm. This possibility does not seem to provide any greater shield against personal liability and imposes a greater administrative burden than incorporation of the firm. Moreover, the absence of significant capital within each such professional corporation could jeopardize its separate legal existence, as discussed later.
Thus, there is a serious question whether the courts would recognize the separate existence of personal PCs. Many of the partners of Finley Kumble, the large law firm that declared bankruptcy in 1987, had utilized this concept which was largely ignored in the firm's bankruptcy proceeding.
REDUCING THE NUMBER OF FIRM OWNERS
The Affirmative Case
A second possibility for reducing the exposure of the firm's partners to vicarious liability is to limit "partnership" status to those persons who hold key managerial positions. This tactic could also be used in a PC. Under this approach all members of the firm not accorded shareholder or partner status would be given a bonus based upon the firm's profits in lieu of an equity participation. Thus, under traditional common law rules, they could not be vicariously liable for the actions of other employees of the firm (including those retaining partnership or shareholder status), but rather only for their own wrongful acts. In this respect, this measure gives greater protection than incorporation, which might not afford limited liability to anyone who works on an ill- fated engagement, regardless of his or her culpability.
This rather simple change in a firm's structure, of course, poses a number of problems. First, it may violate the fee-splitting prohibitions currently imposed under the laws of many states. For example, in New York there is a regulation requiring that at least 35% of the firm's "income" (which may be interpreted as "revenue") be divided among the firm's partners. It is questionable whether such arbitrary regulations can be enforced in an era of rising costs and employee/partner ratios.
Second, this strategy may deprive a number of younger professionals of their ultimate goal of proprietary status. More importantly, it may impair their ability to develop new business for the firm. Third, it may deprive them of their rightful interest in a portion of the firm's equity. To some extent, this latter problem can be overcome by merely establishing a departure or retirement bonus arrangement geared to years of service and final salary.
Perhaps the greatest shortcoming of this shielding technique is that it may be of little help to those persons who most need protection; namely, the senior members of the firm who have accumulated significant assets. As long as such persons remain active, they will have to retain their "partner" status. Nevertheless, even the senior members derive some benefit from this arrangement, which effectively reduces the pool of assets available to satisfy an uninsured judgment and thereby reduces a plaintiff's incentive to pursue its claims against the assets of the individual firm members.
To make this strategy work, persons losing their proprietary status would be required to surrender their equity participation and would not be able to participate in the firm's management. If they do not surrender these powers, they could be deemed "partners-in-fact" and thereby become subject to vicarious liability. Firm members choosing to surrender their proprietary interests could convert their equity into subordinated debt interests that could be payable over a designated period or upon death or retirement. Although this damage control strategy has some disadvantages in terms of accounting operations, it could enable a majority of the firm's "partner" level employees to avoid vicarious liability.
SEGREGATION OF PROFESSIONAL ACTIVITIES
The laws of most states only preclude the incorporation into a "business corporation" of entities rendering "professional services." Such services are generally defined as those for which the provider is required to obtain a license from the state. Accounting firms, however, customarily perform a number of services for which no license is required, such as litigation support services, management advisory services, and tax preparation services. In fact, most states only require a license for those who either prepare or render reports on financial statements. Accordingly, a great many services commonly provided by accounting firms, including the preparation of tax returns, may legally be performed by a "business" corporation whose shareholders can enjoy complete limited liability.
It is also theoretically possible for an accounting firm to transfer its assets, including leasehold improvements and physical assets, to a business corporation from which it could then lease those assets. In this way, the assets could be insulated from liability claims asserted against the accounting firm. These possibilities are intriguing as they may offer the firm's assets as well as those of its members protection from potentially devastating claims.
It is also theoretically possible to divide an accounting firm into other units (such as by offices, regions, or departments) with or without trying to seek limited liability through the use of the business corporate form. In this way, the firm could be divided into separate "water tight" units so that the financial destruction of one unit would not jeopardize the firm's existence.
To a large extent, however, these strategies for minimizing liability threats may be blocked by several legal doctrines. The first is the doctrine of "fraudulent conveyances" under which transfers of assets to a related business corporation can be voided under certain circumstances. The second is the doctrine of "piercing the corporate veil" under which related companies effectively operating as a single unit may be deemed a single corporation. The third is the doctrine of "respondeat superior" that holds liable any entity that effectively controls the actions of the entity which commits a wrongful act. As each of these legal doctrines is primarily designed to prevent injured parties from being frustrated in the efforts to recover damages, they tend to be broadly drawn and liberally interpreted, casting a cloud of doubt over efforts to compartmentalize an accounting practice.
The doctrine of fraudulent conveyances is designed to invalidate, under certain circumstances, the transfer of assets by a person or entity so that the transferor's creditors can seize them notwithstanding their prior transfer. For example, in New York, the doctrine prohibits six varieties of fraudulent transfers: 1. By an insolvent party or one that would be rendered insolvent as a result of the transfer if made for less than fair consideration; 2. By persons who are defendants in a litigation; 3. By persons engaging in a business that would be rendered undercapitalized as a result of the transfer; 4. By persons who are about to incur debts; 5. Made with an actual intent to defraud; and 6. By partnerships under certain conditions.
It must be appreciated that the fraudulent conveyance statute not only precludes transfers of assets, but also assumptions of liabilities by the subject person or entity. This could be important with respect to any plan to transfer the firm's assets to a holding company and lease them back. In such a case, even though the transfer of the assets may not run afoul of the statute, the lease obligations so assumed may be deemed fraudulent conveyances.
From the breadth of these prohibitions, it is also clear that a transfer made by a firm while faced with a pending or threatened litigation or a transfer that effectively strips the firm of its operating assets could violate the fraudulent conveyance statute. Accordingly, the discussion herein assumes that any restructuring will be effected at a time when the firm has no pending or threatened litigation against it and that the proposed restructuring is not intended to defraud any known creditor or to denude the firm of its assets. Rather, this discussion is intended solely to offer as much protection as possible to the firm's partners and shareholders against the possibility of unforeseen liabilities.
Under the fraudulent conveyance statute, transfers by a partnership are subject to attack if they are made to a partner of the firm and the conveyance will render the partnership insolvent even though the partner agrees to pay the partnership's debt. In addition, they will be voidable if made to a third party without fair consideration to the partnership even though there may have been fair consideration flowing to one or more of the partners. Because all the restructuring proposals enumerated above contemplate a transfer by a partnership to its partners, to a "sister" or subsidiary entity or to a PC, they could run afoul of this prohibition.
About Insolvency and Unreasonably Small Capital
Underlying these proscribed partnership transfers are the definitions of "insolvency" and "fair consideration." Insolvency is deemed to exist when the present fair salable value of the transferor's assets is less than the amount that will be required to pay the firm's probable debts as they become fixed and mature. With respect to partnerships, the aggregate net assets of the firm's partners (as well as the partnership) are considered to be partnership assets. Thus, the mere incorporation of a professional partnership could be construed to be a conveyance of a substantial portion of the total net assets of the firm.
The use of the concept of "present fair salable value" implies that the transferor's assets are only equivalent to what a third-party would pay for them at present. Accordingly, in the context of an accounting practice, it can be argued that work-in-process probably has negligible value. Moreover, in view of the number of suits for fees that are engendered through collection procedures initiated by accounting firms, even the firm's "good" receivable should probably be discounted. Most professional firms have little in the way of fixed assets and tend to pay out annually virtually all of their earnings not necessary to satisfy immediate cash needs. Hence, for purposes of the fraudulent conveyance statute, most accounting firms are probably operating near or possibly beyond the legal threshold of insolvency. This would be especially true after eliminating the assets of the firm's partners. Thus, the very act of incorporation as well as transfers to other related corporations arguably violates the statutory prohibitions against "fraudulent conveyances." This possibility, however, can generally be avoided with proper planning.
The statutory definition of "fair consideration" speaks in terms of the "fair equivalent" of that which is received in exchange and the "good faith" of the transferor in making the exchange. Although this definition clearly poses problems in terms of a distribution by professional corporations to their principals (as such transfers would be deemed to be without consideration), it would probably not cause the invalidation of transfers made in conjunction with the incorporation of a part of an accounting firm as long as the shares of the newly created corporation were issued to the transferring firm or to its partners.
Assuming that the asset transfers made in conjunction with a plan of firm restructuring did not violate the special partnership rules discussed above, it is still possible that such transfers might render the firm undercapitalized. Under the fraudulent conveyance statutes, any transfer that unreasonably reduces capital of a business is deemed to be fraudulent to both present and future creditors. Should this provision be liberally interpreted, it could effectively nullify any restructuring of an accounting firm adopted as a damage control technique.
Unfortunately, there have been few cases that have dealt with what is meant by "unreasonably small capital." To be sure, that sufficiency of capital depends in large part on the specific needs of the business. The courts, however, recognize that companies involved in hazardous or speculative businesses require more capital than those in less volatile businesses.
In the final analysis, whether a firm's restructuring will be deemed fraudulent because it was left with insufficient assets will be determined by the court. Although, the presence of an actual intent to defraud is not necessary, such intent will obviously be taken into consideration by a court along with more traditional factors. In this regard, the absence of known claims may influence the court to conclude that the firm was not rendered undercapitalized by the restructuring. Similarly, an ample amount of liability insurance coverage can help persuade the court that the firm's capital was not rendered unreasonably small.
Although potential legal challenges to a firm restructuring do pose a risk that it will be for nought should a substantial liability be incurred, the potential benefits certainly seem to make it worth the risk. At the very least, a restructuring presents a major obstacle to the claimant who may be forced to compromise a claim on a basis that will not threaten the firm's further existence.
PIERCING THE CORPORATE VEIL
Aside from dangers imposed by fraudulent conveyance statutes, there is also the possibility that, where justice demands, the courts might disregard the separate existence of a corporation formed to conduct a portion of a firm's business and pierce the corporate veil. In examining the separate existence of a subsidiary or sister corporation, the courts will look to see if one entity tends to dominate the actions of the other so that the latter might be fairly characterized as a "mere instrumentality" or "department" of the former. Naturally, the likelihood of such a finding will be increased if the "subservient" entity has been given inadequate operating assets or if its creditors have been led to believe that they are dealing with the dominant entity. The courts will also inquire into the following factors: * Whether the two entities have common beneficial owners, directors and/or officers; * Whether the entities have observed appropriate corporate formalities, such as the maintenance of separate corporate and financial records, the issuance of stock certificates and the election of officers and directors; * Whether the officers of the subservient entity actually take orders from the entity's board of directors or from the officers of the dominant entity; * Whether the dominant entity exercises fiscal control over the subservient entity by maintaining the assets necessary for the conduct of the subservient entity's business or by actually paying its salaries and expenses; * Whether transactions between the two entities are conducted on an arms-length or favored basis; and * Whether the public statements of the entities are consistent with the entity's claim of a separate existence.
There is no magic formula utilized by the courts in determining whether to pierce the corporate veil. Instead, they generally act on the totality of the facts and are usually unwilling to disturb a corporate structure that has been formally observed. Nevertheless, a restructured accounting firm will present a close case even if the divisions are made along relatively logical lines such as state boundaries, between physically separated offices, or departments within the same office. To better assure the separate legal existence of its components, a firm undertaking a major restructuring may have to alter a number of business practices.
CHANGE BUSINESS PRACTICE
Accounting firms generally operate under a single name and seek to market themselves by their ability to provide a wide variety of services over a broad geographical area. Should a firm seek to restructure, this practice would either have to cease or at least be modified so as to expressly state that the various entities are only affiliated, rather than integral parts of a single enterprise.
Second, accounting firms customarily provide across-the-board services. If an accounting firm is divided, there will necessarily be a great deal of cross referrals or subcontracting among the newly created entities. Such arrangements tend to invite conflicts of interest. For example, assume a client of the audit department needs tax advice and is sent to the newly formed tax service corporation. The client may question whether this referral was really in his or her best interest, or whether the audit corporation will receive a referral fee which might be in contravention of state law. To be sure, the audit corporation will be reluctant to give up its right to profit from the tax services rendered to a referred client. On the other hand, if the referral can be justified on the basis of reduced charges, this might support the argument that the two corporations were really separate.
Third, accounting firms enjoy a number of economies of scale in the form of consolidated administrative, hiring and training, and support functions. To create the appearance of separate existence, many of these shared functions may have to be separated, imposing duplication.
Aside from these functional concerns, there are the administrative problems of having to keep separate books and records, of maintaining separate contractual arrangements (such as leases and malpractice insurance) of recording each interentity transaction, of filing separate corporate reports and tax returns and of observing other corporate formalities. Such burdens will undoubtedly be cumbersome unless the firm already maintains its records with extreme care.
The Balance of Risks
Notwithstanding these factors, it is clearly possible to divide an accounting practice into legally recognizable separate entities. The real issue to be decided in each case is whether creating the separate entities for potential protection is cost efficient. Moreover, the greater the reason for seeking such protection, i.e., because a segregated portion of the practice is particularly risky, the greater the likelihood that a court might deem that the separation was made to defraud the firm's clients.
Despite these problems, there clearly will be situations in which such operational divisions will not be unduly costly. Moreover, having certain functions performed by a national service office for all separate operating units will minimize those costs without jeopardizing the protection being sought by restructuring.
There is still the possibility that one entity, because of its close relationship with the entity that committed a wrongful act, will also be named as a defendant, if not held responsible. An accounting firm would be particularly vulnerable to such claims in view of customary quality control and training practices. Moreover, to the extent that one entity within the group retained another to perform services for its clients, both might be held legally responsible for damages caused by the conduct of the engagement.
BUSINESS JUDGMENT IS REFINED
Although there are a number of theoretical possibilities for restructuring CPA firms to minimize the impact of an uninsured liability claim, most such possibilities entail operating burdens and legal risks so that in some cases they may not be worth pursuing except in narrowly defined circumstances. The best possibility for damage control at the firm level is incorporation for firms of 15 or more professionals with operations limited to states whose laws provide limited liability for professionals. In addition, all firms, whether or not incorporated, could benefit from limiting proprietary status to those who actively participate in the firm's management. Although the other restructuring techniques described herein might be beneficial in some limited circumstances, using them to separate each aspect of a firm's practice could prove to be counter-productive. Such techniques should probably be limited to segregating only the firm's riskiest practice areas.
PROTECTION OF INDIVIDUAL ASSETS
Individual firm members can take measures to protect their own assets. These measures range from transferring assets to relatives or to sheltered funds.
Transferring assets to a spouse or child will generally remove the assets from attachment by a creditor. Such a transfer, however, will be for nought if it is found to be a fraud on the transferor's creditors. Accordingly, such transfers should not leave the CPA insolvent or be made while litigation is pending or even threatened. Perhaps equally important, such transfers should only be made if the CPA's relationship with the recipient is stable. Notwithstanding these potential dangers, transferring assets to members of the CPA's family, or better yet, accumulating assets in the name of a spouse, (by simply living off the CPA's earnings and saving) will generally safeguard a portion of the family assets from the CPA's creditors.
In those cases wherein the CPA is not comfortable in simply transferring assets to another family member, other more sophisticated measures may be taken. Most of these measures take advantage of state statutes exempting certain personal property from attachment. In general, the exempt property represents what the state legislatures regard as the necessities of life, which not even judgment creditors are allowed to seize.
In New York, those exemptions are contained in Civil Practice Law and Rules (CPLR) Sec. 5205, which contains a host of personal items including: clothing, furniture, the family bible, household appliances, tools, family pictures, school books, etc. New York law does not stop at household appurtenances. This provision also exempts certain trusts from attachment for the collection of money judgments. Accordingly, transfers of assets to trusts offer a possibility for sheltering personal assets. Other ways of sheltering include depositing personal assets in a protected pension plan and transferring real estate into certain joint tenancy arrangements.
Trusts as Sheltering Devices
The laws of most states permit formation of a variety of trust instruments, whereby the trust creator contributes assets for the benefit of others to be managed by a trustee. While it is also possible for the creator to be either the trustee or a beneficiary of the trust he or she has created, such dual capacities will usually destroy the trust's ability to shelter its assets from creditors of the creator. Set forth below is a brief description of types of trust arrangements and their ability to withstand attachment by creditors of the trust's creator.
Spendthrift Trusts. Express trusts to apply or pay the trust assets and/or income to a designated person are deemed by statute to be "spendthrift," i.e., the beneficiary is free to do what he or she wishes with the monies once received, but may not transfer his or her right to such payments, unless the trust instrument confers on the beneficiary the power to do so. The courts tend to support the non-assignable nature of a beneficiary's interest, reasoning that they are supported by the public policy of "protecting an individual against the results of his own improvidence or misfortune."
Property held in trust for a debtor-beneficiary by such spendthrift trusts is usually exempt from judgment creditors. Also exempt in New York is 90% of the trust income of the debtor-beneficiary. However, that 90% of trust income can also be reached by judgment-creditors to the extent it exceeds the amount necessary for education and support of the beneficiary.
Trust for the Benefit of the Creator. If the beneficiary of a trust is also the creator, there is no spendthrift protection. In the words of the New York statute, "A disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator."
The creditor can only reach a trust's assets to the extent the creator-debtor has an interest. For example, if the person creates an irrevocable trust in which he or she retains a beneficial interest, his or her judgment-creditors may attach the retained interest, but no more.
One exception to this rule is the life insurance trust. An irrevocable life insurance trust created by the insured for his wife and children was held in 1936 not to be void as to the creditors of the insured, even if the insured reserves the right to change the beneficiary, assign the policies, and/or borrow from them. However, there is no guarantee that a modern case will have the same result. Perhaps a safer course of action to protect the assets of such a trust would be for the insured to assign all his rights under the policy to his spouse and make her the beneficiary. Then, there would be no question as to whether he has retained any beneficial interest or control over the policy.
Revocable Trusts. Revocable trusts are completely unprotected from creditors. When a creator reserves an unqualified power of revocation, he or she is deemed the absolute owner of the trust property as far as the rights of creditors are concerned. This is true even if a creator of a trust does not retain a beneficial interest in the trust, but simply reserves the power to revoke it.
The rule is the same for "bank account trusts," (commonly called Totten Trusts or "tentative trusts,") which are created when an individual deposits money in a bank account, registered in the individual's own name as trustee for another. Because Totten Trusts can be revoked, modified, or terminated, by the depositor during his or her lifetime, judgment-creditors of the depositor may reach the trust corpus during the depositor's life.
Irrevocable Trusts in Which the Creator Has No Beneficial Interest. The best way for a CPA to shelter assets from creditors is to create an irrevocable trust in which the CPA retains no beneficial interest. In this type of trust, the trust assets can only be reached if the transfers of assets to the trust were made with actual intent, (as distinguished from intent presumed by operation of law), to hinder, delay, or defraud either present or future creditors. However, because the CPA would have no authority to reach the trust assets or change any of the trust provision, the CPA must make sure that he or she has a trusting and stable relationship with the named beneficiaries.
One variety of irrevocable trust is a Spousal Remainder Trust in which the creator transfers property to a trustee, who pays all net income to or for a child for a set term, and at the end of the term, pays the remaining trust property to the creator's spouse. The CPA should not name him- or herself as trustee, because that may be interpreted as a retention of control over the trust. Because the CPA would have no beneficial interest in the trust, and would not reserve the right of revocation, the trust assets cannot be reached by the CPA's creditors. The only way the trust assets may be attached is if the creation of the trust is proven to be fraudulent conveyance.
Similarly, a CPA can create an irrevocable non-reversionary trust totally for the benefit of his or her children, with an independent trustee holding and managing the trust assets. Like the Spousal Remainder Trust, the trust corpus cannot be reached by creditors and can only be attached if it is proven to be a fraudulent conveyance.
Pension Plans as Shelter Devices
A second technique to protect individual assets is to deposit them into a protected pension plan. Although there are usually strict limitations as to which assets a person can protect in this manner, this technique does not require the CPA to entrust the deposited assets to another individual. Unfortunately, not all pension arrangements are protected against claims by the beneficiary's creditors.
The general rule in New York and in most states is that plans created by somebody other than the debtor will be protected from attachment. In addition, Keogh plans are usually safe from creditors even though a Keogh plan is founded by the individual himself. Individual retirement plans (or IRAs), however, are not usually protected, although their status may vary from state to state. Sec. 401(k) retirement plans, like Keogh plans, are also generally exempted from attachment by the beneficiary's creditors, as are qualified retirement plans created by a business entity for the benefit of its employees.
A recent Supreme Court decision, however, has unsettled the law in this area by holding that employee benefit plans encompassed by ERISA are controlled by federal (and not state) law and are only protected from creditors to the extent provided is ERISA. This decision, in Mackey v. Linear Collections Agency and Service, Inc., 486 U.S. 825 (1988), in effect removes certain protections against creditors that are provided for pension plans under state law as ERISA only protects pension plans from being attached. ERISA "welfare" plans, however, are not subject to the protection against attachment. This decision requires that every plan be analyzed in terms of whether it is governed by ERISA and whether it is a welfare or pension plan to determine whether the plan's assets are protected from attachment.
Notwithstanding the general protection afforded by certain pension plans, CPAs should be careful when transferring assets just after being sued. This is because such transfers may nevertheless be invalidated as fraudulent. Under New York law, (as well as that of most states), all transfers made after a debtor becomes a defendant in a lawsuit are conclusively presumed to be fraudulent conveyances, and New York CPLR Sec. 5205 prevents transfers to a trust days before the "interposition of the claim on which the judgment was entered" (i.e., when the summons was served on the defendant). Thus, a prospective judgment-debtor must make pension plan contributions well in advance of any claim that is being asserted.
Real Estate Transactions
Because a CPA's home is likely to be among his or her principal assets, CPAs should give additional consideration to protecting their homes from creditors. In addition to the various transfers discussed earlier, it is also possible in many states to place real estate holdings in a joint tenancy with rights of survivorship, sometimes called a "tenancy by the entirety." While a simple joint tenancy will not preclude a creditor from attacking a CPA's interest in jointly-held property and compelling a sale and a division of the proceeds, a joint tenancy with rights of survivorship is generally effective against creditors' claims. This is because the extent of the CPA's ownership in the property cannot be determined until the death of the CPA or the other joint-tenant. For this reason, the courts in many states, including New York, will not compel a sale of jointly held property by one of the co-tenants. As a result, creditors will usually not bother to attach their debtor's interests in such properties. Before embarking on a transfer of title, it is essential to ascertain how the pertinent state law treats survivorship rights. Moreover, any such transfer must not be effected under circumstances that might render it a fraudulent conveyance.
While most claimants against CPA firms are generally satisfied with the proceeds from the firm's professional liability policy, CPAs must consider ways to protect themselves against the possibility that their insurance coverage may not suffice, in which event their personal assets, as well as those of their firm, may be in jeopardy. There are a number of methods that can be used to achieve such protection; however, they may also pose new problems. Further consultation with an attorney experienced in this area is recommended.
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