McCourt Divorce Sheds Light on Asset Protection

Show of hands, who has not heard of the McCourt divorce case?  If you live in Los Angeles there is barely any other news coverage.  While public divorces of the rich have always made great fodder for gossip journalists, this divorce sheds some light on a frequently used, but infrequently discussed, asset protection technique. 

In community property states like California, assets that are deemed community property can be reached by creditors of either spouse.  Whenever we have a client that is married and has a creditor problem, we will always consider making some community property assets the separate property of the other spouse.  This is commonly accomplished through a form of a post-nuptial agreement known as the transmutation agreement (more on those below).

Transmutation agreements work really well, especially when spouses sign them well in advance of a possible creditor claim.  We always caution our clients that transmutation agreements are fully enforceable for all legal purposes.  Meaning, they are effective not only as to the creditors of the spouses’, they are effective as to the spouses themselves in the event of a divorce.  That is why it is good practice to divide up the assets equally.  This way on divorce there is no disadvantage to either spouse.

Greed, of course, trumps legal agreements and common sense (sarcasm intended).  I wonder if Jamie McCourt would have challenged the post-nuptial agreement if the divorce took place three years ago, when real estate prices were sky-high?

Here is some substantive information on how transmutation agreements work and how they should be structured to best protect assets.  (Citations omitted.)

Many postnuptial agreements have as their purpose the change, or transmutation, of the character of the parties’ property from separate to community, or vice versa.  Spouses are free to alter the character of property in this manner, provided that all statutory requirements are met.  A transmutation agreement may be used to change the character of property to be acquired in the future, as well as property that the spouses own at the time of the agreement.

The principal limitation on transmutation agreements between spouses is that (i) they must be fair and based on full disclosure of the pertinent facts, and (ii) they must not be a fraudulent transfer of assets.

The following are the major considerations pertaining to transmutation agreements: (i) except for certain interspousal gifts, transmutations of real or personal property are not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected; (ii) transmutations may be made with or without consideration; (iii) transmutations of real property are not effective with respect to third parties without notice of the transmutation, unless the transmutation is recorded; (iv) transmutations are subject to the laws governing fraudulent transfers; and (v) a statement in a will of the character of property is not admissible as evidence of a transmutation of the property in any proceeding commenced before the death of the person who made the will.

Transmutation agreements have certain tax implications.  For income tax purposes, if spouses file a joint return, then characterization of property as community or separate is irrelevant, as all income is aggregated.  However, if spouses file a separate return, then each spouse must report his or her one-half share of community income, and his or her separate income.  Because transmutation agreements change the nature of the property (including earnings and other income), they have the greatest income tax impact on separate tax returns.

Transfers of property between spouses are generally nonrecognition events for income tax purposes, as they are always considered to be gifts with basis carryover.  There are a couple of exceptions: (i) transfer to a spouse who is a nonresident alien at the time of the transfer; (ii) transfer in trust, to the extent that the sum of the liabilities assumed, plus the liabilities to which the property is subject, exceeds the total adjusted basis of the property; or (iii) transfer in trust, of an installment obligation.

The more important tax aspect of a transmutation agreement is the effect that it has on basis step-up (or step-down) at death. 

On a spouse’s death, one-half of the community property belongs to the surviving spouse, and the other half belongs to the decedent.   If the property has appreciated in value during the time that it was held, the entire property will receive a stepped-up basis equal to its fair market value on the date of the deceased spouse’s death, if the decedent’s half of the property was included in his or her estate.   The surviving spouse will receive a stepped-up basis in his or her half of the property, and will therefore have a smaller gain on disposition of that property.

By comparison, if the spouses had held the property separately in joint tenancy with a right of survivorship, the surviving spouse would automatically receive his or her half of the property by operation of law through the original joint tenancy title, and not through inheritance or any other type of succession after death.  Consequently, his or her basis would not be stepped up if the property has appreciated, but instead would remain at the original cost basis.

Thus, while transmutation agreements are generally desirable from an asset protection standpoint, they may have adverse tax consequences, because of the loss of one-half of basis step up.  By carefully coordinating the transmutation agreement with the spouses’ will or trust, many of the adverse tax consequences can be minimized or eliminated.  For example, if the spouses’ residence is the separate property of the surviving spouse, then while the residence will not receive a step-up in basis, up to $250,000 of gain will be sheltered on the sale of the residence.

It is important to remember that the loss of the basis-step up on one-half of property is important only if it is anticipated that the surviving spouse will be selling his or her separate property.  Thus, if the surviving spouse retains her separate assets and sells the property inherited from the decedent (which received a basis step up), no adverse tax consequences will result.

The practitioner should also keep in mind that spouses may enter into a transmutation agreement at any time, during marriage.  Accordingly, while the spouses are working or practicing their profession (and they are exposed to risks) they can enter into a transmutation agreement and transfer certain assets to the low-risk spouse.  When the spouses retire and risks dissipate, the spouses can enter into another transmutation agreement and convert their separate property back to community, regaining the full step up.

While postnuptial agreements are generally subject to the same notice and recording rules as premarital agreements, the rules for transmutation agreements are slightly different.

A transmutation of real property is not effective with respect to third parties who are without notice of the transmutation unless the transmutation instrument is recorded.   While recording is not a prerequisite to the validity of the transmutation as between the spouses, it is a prerequisite in making the transmutation effective with respect to third parties who are otherwise without notice.  This requirement is consistent with the fact that transmutations are subject to the laws governing fraudulent transfers.

When clients are first apprised of the uses of transmutation agreements their first impulse is to transfer all the assets to the low-risk spouse.  While this impulse is logical, transmutation agreements are subject to fraudulent transfer laws.  This means that when assets are divided between spouses pursuant to a transmutation agreement, the division should be on a somewhat equal basis.  Approximately 50% of net fair market value of the assets should go to each spouse.   While this practice minimizes the fraudulent transfer likelihood, now only 50% of the assets are protected, and not 100%.  However, the usability of the transmutation agreement can be buttressed by allocating “desirable” assets to the low-risk spouse and the “undesirable” assets to the high-risk spouse.  In this context, desirable and undesirable is evaluated from a creditor’s point of view.

Example:  Mrs. Curie is a physics professor at Cal Tech, and Mr. Curie is a plastic surgeon.  Mr. Curie gets sued by patients on a bi-weekly basis (he is the high-risk spouse) and Mrs. Curie has never been sued and will probably never get sued (she is the low-risk spouse).  The assets of the two spouses are:  the medical practice valued at $1 million and a house valued at $1 million.  How should the transmutation agreement divide these assets?

The transmutation agreement should make the medical practice the separate asset of the husband and the house the separate asset of the wife.  From a creditor’s standpoint, the house is a desirable asset (easy to collect against), and the medical practice is an undesirable asset (no value to the creditor other than receivables).  Consequently, while the allocation is on a 50-50 basis (each spouse gets an equivalent amount of assets), the asset that is easy to collect against has been moved to the low-risk spouse (where the asset is unreachable by the creditor of the high-risk spouse).

Accordingly, when Mr. Curie is sued again by one of his patients, the patient can collect only against the medical practice, and not against the house.