INTENT TO DEFRAUD FUTURE CREDITORS

Fraudulent conveyance law may allow a creditor to recover assets transferred by a debtor to third parties. A common misconception is that a debtor can transfer assets to third parties (including trusts) without being subject to fraudulent conveyance rules if the transfer is made to protect the assets against FUTURE creditors of the debtor (as contrasted with EXISTING creditors at the time of transfer).

A recent appellate court decision demonstrates that this is incorrect. In the case, the U.S. sought to recover assets transferred to a trust by a taxpayer using provisions of the Washington state uniform fraudulent conveyance act. The appellate court upheld the trial court in finding a fraudulent conveyance, based on the taxpayers' repeated admissions that they transferred property to the trust in order to avoid potential future creditors. This intent to defraud FUTURE creditors was enough to find the requisite "actual intent to hinder, delay or defraud a[ ] creditor" required under the statute. Note that Florida has a substantially similar statute to Washington in this regard.

This is not to say that there is no difference in the application of fraudulent conveyance law regardless of whether the affected creditor is a present creditor or was a future creditor at the time of transfer. For example, a creditor in existence at the time of transfer at times will not need to show actual or constructive intend to hinder, delay or defraud if the transfer was made when the debtor was insolvent or the transfer renders the debtor insolvent. A mere future creditor cannot rely solely on insolvency under many fraudulent conveyance acts but instead must still show actual or constructive intent to hinder, delay or defraud.

U.S. v. Townley, Slip Copy, 2006 WL 1345248 (9th Cir. No. 04-35767)

GRANTOR TRUST, AS TO INCOME ONLY

Under Internal Revenue Code Section 678, a person is treated as the owner of any portion of a trust with respect to which that person has the power, solely exercisable by himself or herself, to vest the corpus or the income in himself or herself. When a person is treated as the owner of a portion of a trust under section 678, special rules apply to not tax the trust directly. Instead, the person treated as the owner takes into account the trust's items of income, deduction, and credit attributable to that portion of the trust.

As Thomas B. Goldsby, Jr. learned, the "portion" of the trust that the deemed owner is taxable on can be limited at times to the income of the trust, and not the corpus.

Mr. Goldsby was an income beneficiary and trustee of a trust. Instead of receiving the income of the trust, he allowed it to remain in the trust - although it was treated on the books and records as segregated and due to Mr. Goldsby. The trust contributed a conservation easement in real property it owned to charity which qualified for the charitable income tax deduction. Mr. Goldsby reported himself as owning the portion of the trust making the contribution, and sought to take the income tax deduction individually. The IRS challenged his use of the deduction, asserting that Mr. Goldsby was taxable only on the "income" portion of the trust and that the contribution was made from principal or corpus, so that deduction was not allocable to him under the grantor trust rules.

Mr. Goldsby did make some interesting arguments, but they were all rejected by the Tax Court. First, he asserted that since he left undistributed net income in the trust, this was effectively mingled with and converted to corpus, and thus he still should have been entitled to the deduction. This was rejected because under the trust agreement Mr. Goldsby had no interest in corpus and because the net income was separately accounted for on the trust books and records as undistributed income and not principal.

Second, Mr. Goldsby argued that the conservation easements came from the undistributed net income, regardless of whether that income was converted to principal. However, Mr. Goldsby provided no evidence how the contribution was made from such net income instead of the principal assets of the trust,and thus this argument was also rejected.

Thus, in situations where an income tax item relates to corpus/principal and not income, and the grantor trust rules are involved, care must be taken to determine whether the grantor trust rules apply to income only, or also to principal in determining which taxpayer bears the benefits or burdens of the tax item.

Thomas B. Goldsby, Jr., TC Memo 2006-274

LIMITS ON DAMAGES FOR VIOLATION OF NONCOMPETE AGREEMENTS [FLORIDA]

Florida law allows employers to protect themselves by entering into noncompete agreements with employees. Such agreements generally provide that if the employee ceases to work for the employer, the employee may not work for a competitor or take on former clients of the employer for period of time and/or in a fixed geographic area.

Violations are generally enforceable by injunction - a court can prohibit a violating former employee from working for a competitor or otherwise violating the agreement. The agreement may also allow for monetary damages to the employer.

There are limits to monetary damages that can be imposed. In a recent case, an insurance agency entered into a noncompete agreement with one of its agents. The agreement provided that the insurance agency would receive as liquidated damages in the event of a breach of the agreement by the agent (a) $10,000, plus (b) the entire commissions earned by the agency on the accounts sold and/or serviced by agent during the 24 months before the agent ceased to work for the agency. The agent stopped work for the agency and went to work for a competitor, violating the agreement.

The agency obtained a damages award for$161,572.88 under the liquidated damages provision. The agent challenged the damage award, claiming that the liquidated damages provision was unenforceable as a penalty.

The appellate court noted that parties to a contract may stipulate in advance to an amount to be paid as liquidated damages in the event of a breach, provided that the damages resulting from the breach are not readily ascertainable, and provided that the sum stipulated as damages is not so grossly disproportionate to any damages that might reasonably be expected to follow from a breach that the parties could only have intended to induce full performance, rather than to liquidate their damages. If, however, a penalty provision is disguised as a liquidated damages provision, it is unenforceable. The theory is simply that we do not allow one party to hold a penalty provision over the head of the other party "in terrorem" to deter that party from breaching a promise.

In the case at issue, the court had a problem with three aspects of the liquidated damages provision. First, the agency was entitled to 100% of the commissions payable to the agency on the agents accounts for the prior 2 years - however, if the agent had stayed with the firm some portion of those fees would have been payable to the agent so ALL of the commissions payable to the agency is not a fair measure of damages to the agency. Second, the damages were based on ALL of the agent’s former accounts, not just the ones that followed the agent to her new place of work. Again, this was deemed to be an unfair measure of damages suffered by the agency from the breach of contract. Lastly, in addition to these penalties, another $10,000 penalty was thrown in for good measure.

Based on these observations, the appellate court held that the monetary damages were in the nature of a penalty and were not enforceable as liquidated damages. Using the case as a guide, employers can allow for monetary damages for these types of breaches, but they must be a fair measure of actual damages likely to be suffered from the breach.

JANE MARIE BURZEE, Appellant, v. PARK AVENUE INSURANCE AGENCY, INC., Appellee. 5th District. Case No. 5D05-3608. Opinion filed December 29, 2006.