Asset Protection

June 24, 2010 by Mitchell A. Port

The following article is reprinted from a newsletter written by my friend, Jacob Stein, an asset protection attorney at Klueger & Stein, LLP:

Spouses' Liabilities to Third Parties: California Creates a Problem and Provides a Solution

Assume that a spouse in California becomes liable to a third party, either as a result of a tort claim, a business debt or any other source. To what extent may the other spouse (the "non-debtor spouse") be held liable for the debts of the "debtor spouse"? Unfortunately, California statutory law is mostly good news for creditors and bad news for married debtors. But the Family Code provides spouses who engage in some early planning with an escape hatch, permitting the non-debtor spouse to avoid the debts of the debtor spouse.

The problem has two sources. The first is that most of the assets of married spouses in California are community property. A spouse's earnings are community property, and assets acquired during the marriage with the earnings of one or both spouses are also community property. Even if an asset started out as a spouse's separate property, either having been received by one spouse as a gift or an inheritance or having been owned by one spouse prior to marriage, it is likely that the asset will, over time, be commingled with community property and thus became community property.

It is the second source that really creates the problem. Section 910 of the Family Code provides that, with limited exception, "the community estate is liable for a debt incurred by either spouse before or during marriage, regardless of which spouse has the management and control of the property and regardless of whether one or both spouses are parties to the debt or to a judgment for the debt." As a result of §910 -- and contrary to widespread belief – there is no such thing in California as a "community debt" or a "separate debt." The issue is not the nature of the debt but the nature of the asset. If the asset is part of the "community estate," the asset will be subject to seizure by a creditor of either spouse. The confusion probably results from the experience of family law practitioners. In the context of a divorce proceeding, the court is required to determine which of the debts that arose during the marriage were "separate or community and confirm or assign them to the parties..." Family Code §2551. But outside of the context of a divorce (and, to a lesser extent, in probate) there are no "community" or "separate" debts. Community property will stand to answer for the debts of the debtor spouse even if the debt was incurred for the debtor spouse's exclusive personal benefit. See In re Soderling, 998 F.2d 730 (9th Cir. 1993).

The rule for spouse's separate property is very different. Except for "necessaries of life," the separate property of a non-debtor spouse is not liable for the debts of the debtor spouse, whether the debt arose prior to or during the marriage. Family Code §913-914.

The harshness of the rule embodied in §910 is slightly mitigated by Family Code §911, which provides that the marital earnings of the non-debtor spouse will not be held to answer for the premarital debts of the debtor spouse. In effect, this means that a creditor cannot garnish the wages of a nondebtor spouse for the premarital debts of the debtor spouse. Once the nondebtor spouse has received the wages, the wages are liable for the premarital debts of the debtor spouse unless the nondebtor spouse deposits the wages in an account to which the debtor spouse has no access.

It is interesting to note how radical a departure Family Code §910 is from the forty "common law" states that do not have a community property regime. In these states, the general rule is that assets -- including earnings -- titled in the name of a non-debtor spouse are not liable for the other spouse's debts. See, e.g. Ill. Compiled Statutes ch. 750 §65/5 ("...neither the wages, earnings or property of either [spouse] nor the rent or income of such property, [shall] be liable for the separate debts of the other.")

Moreover, many common law states have retained "tenancy by the entirety," a form of ownership for real property. If property is titled as such, and only one spouse is a debtor, that spouse's creditors cannot seize or encumber the property as long as the marriage persists. See, e.g. Mich. Code §600.6023a ("Property...held jointly by a husband and wife as a tenancy by the entirety is exempt from execution under a judgment against only 1 spouse.") The essence of tenancy by the entirety is that it cannot be severed without the consent of both spouses, and the nondebtor spouse will never consent to a severance of the tenancy.

The Family Code, having created the problem in §910, provides a solution in §850, which permits spouses to "transmute" their assets from community to separate. By means of simple "transmutation agreement," spouses may effectively remove themselves from the entire California community property regime, as fully as of they had never set foot in California. The result is, of course, that only the separate assets of a debtor spouse can be seized by that spouse's creditors to satisfy that spouse's debts. Presumably, even after a transmutation agreement, the separate assets of one spouse could be reached by a creditor who provided "necessaries of life" to the other spouse.

There are only two requirements for a valid transmutation agreement, one that is easy to comply with and the other which is fraught with difficulties. In order for the transmutation of real property to be effective against third parties, the transmutation must be recorded. Family Code §852(b). Presumably, a deed transferring title from both spouses to one spouse, as that spouse's "sole and separate property," should be sufficient to satisfy this requirement, but the better practice is to record a "Memorandum of Transmutation Agreement," making explicit just what has occurred.

The second requirement poses the challenge for practitioners. Family Code §851 provides that "A transmutation is subject to the laws governing fraudulent conveyances." Fraudulent conveyances in California are governed by the Uniform Fraudulent Transfer Act, Civil Code §3439 et. seq. What is and what is not a fraudulent conveyance is way beyond the scope of this article. However, it is safe to assume that a transmutation agreement that transmuted all of a married couple's assets into the separate property of the low-risk spouse, leaving the high-risk spouse with nothing, would be a fraudulent transfer, since no one gives away assets and receives nothing in return unless the avoidance of creditors is the motivation. However, it is equally safe to assume that if each spouse were to cede a community property interest in half of the assets to the other, with the result that each spouse were to emerge from the transmutation agreement with a separate property interest in half of the marital assets, such a division could not be considered a fraudulent conveyance. This places a premium on fairly valuing and carefully dividing the assets. It is recommended that each spouse emerge from the transmutation agreement with a sufficient amount of liquid assets. If one spouse receives nothing but cash, and the other spouse receives a separate property in interest in unproductive raw land, the spouse with the raw land cannot pay his or her debts as they come due, resulting in that spouse's insolvency, a hallmark of a fraudulent conveyance.

One might assume that, at best, a transmutation agreement solves only half of the problem, leaving a high-risk spouse's separate assets vulnerable to creditors. But not all assets are equally desirable to creditors. Assume that a married couple owns only two assets, a parcel of commercial real estate fairly valued at $1,000,000, and a business fairly valued at $1,000,000. As we have seen, if both assets are community property, both may be seized by the creditors of each spouse. A creditor may effectively seize the real estate simply by recording a judgment. The creditor may – but need not – foreclose upon the property. Eventually the debtor will have to deal with the creditor, because the real estate cannot be sold or refinanced without the creditor's judgment being removed. But the business is another matter entirely. It might be sold to a willing buyer at arm's length for $1,000,000, but it might be worth far less in the hands of a creditor, especially if the debtor is willing and able to compete with the business following the seizure. In order to satisfy a judgment, a creditor will have to install a receiver in the business, an expensive and not always effective remedy. Creditors generally are not interested in operating businesses. They want assets that are either cash or are readily reduced to cash. These are the assets that should be transmuted into the separate property of the low-risk spouse.

Finally, transmutation agreements share one thing in common with almost every other asset protection device: The "earlier" you do it, the more likely it will hold up.