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HomeBUSINESS & FINANCEAttorney Fees For A Fraudulent Transfer Are Not Tax Deductible

Attorney Fees For A Fraudulent Transfer Are Not Tax Deductible

One of the most intriguing and discussed creditor-debtor—and thus asset protection—cases in recent years was the subject of my article, Lawyer, Law Firm, And Bank Exposed To Civil RICO And Other Liability For Assisting A Debtor Post-Claim In Kruse (November 24, 2021).

As the article’s title suggests, this case involves a debtor who, following a car accident, engaged in a series of transfers with the intent of thwarting the judgment enforcement rights of the victim, who suffered severe injuries. Today, we examine a subsequent ruling in that case that further demonstrates that post-claim planning can not only fail but also place the debtor in a significantly worse position than if nothing had been done.

Due to a car accident, Christina Kruse obtained a judgment in excess of $2.5 million against Steven Weller. Later, Kruse sued Weller and others for fraudulent transfers to invalidate Weller’s post-claim transfers of his assets to a family member and a newly formed LLC. In 2018, the Iowa state court issued an order invalidating these fraudulent transfers. These are the contextual details.

Kruse’s counsel, Justin Swaim, filed a fee affidavit, and the Iowa state court awarded Kruse $100,000 in attorney fees. This is pertinent to today’s discussion.

In the interim, Weller voluntarily filed for Chapter 7 bankruptcy in the U.S. Bankruptcy Court for the Southern District of Iowa. This petition, if successful, would have nullified Kruse’s $100,000 attorney fees award. To prevent this, Kruse, Swaim, and Swaim’s law firm (to whom the attorney fees were ultimately owed) filed an adversary action with the bankruptcy court to proclaim the attorney fees non-dischargeable.

Weller objected to the adversary proceeding, and Kruse moved for summary judgment, resulting in the decision in In re Weller (Kruse v. Weller), Case No. 22-30011-ALS (Bk.S.D. Iowa, March 6, 2023), which will be discussed next.

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Kruse argued that the attorneys’ fees were not dischargeable under the U.S. Bankruptcy Code because they were awarded pursuant to her fraudulent transfer action. Weller argued in his defense that he relied on the counsel of his attorney when he made the transfers and then reversed the transfers once he realized that the counsel was incorrect. All of this raises questions under two bankruptcy statutes, 11 U.S.C. 523(a)(2)(A) and 523(a)(6), and each will be examined individually.

The text of Section 523(a)(2)(A) is as follows:

“(a) A discharge does not release a debtor from liability for any debt.

“(2) for money, property, or services, or for an extension, renewal, or refinancing of credit, to the extent obtained by:

“False pretenses, a false representation, or actual fraud”

Court decisions have interpreted “actual fraud” to include fraudulent transfers under the intent test, which is UVTA 4(a), and has essentially only one element: the debtor made the transfer with the intent to thwart the creditor’s collection rights.

The Iowa state court found that Weller intended to defraud Kruse in Kruse’s fraudulent transfer action, and the bankruptcy court would also find that finding to be dispositive in this non-dischargeability action. If the underlying action that resulted in a finding of “actual fraud” awarded attorney fees, then the attorney fees are also not dischargeable. In accordance with Section 523(a)(2)(A), Weller’s request to discharge the attorney fees award would be denied.

The other relevant statute is 523(a)(6), which states:

“(a) A discharge does not release a debtor from any debt.

“(6) for willful and malicious injury caused by the debtor to another entity or the property of another entity…”

This provision does not require a finding of fraud, only that the debtor intended to cause harm to a person or their property (the “willful” part) and actually did so (the “malicious injury” part). This has been interpreted to mean that “willful and malicious injury by the debtor” has occurred when a debtor intends to harm the collection rights of a creditor.

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In awarding the attorney’s fees in the first instance, the Iowa state court had also determined that Weller had acted with the intent to harm Kruse’s collection rights and had, in fact, harmed those collection rights; thus, the Iowa state court’s prior findings would also be dispositive here.

In the end, the bankruptcy court ruled that Kruse’s $100,000 attorney’s fee award could not be discharged, despite Weller’s objections.

ANALYSIS

The most important lesson of this case is something I’ve preached for a long time: Fraudulent transfers can not only fail to protect assets, but they can also easily place the debtor in a much worse position than if they had never acted. This is the precise outcome of this case: Weller’s attempts to transfer his assets were thwarted by the Iowa state court, which also awarded Kruse $100,000 in non-dischargeable attorney’s fees. This effectively means that Weller will never be able to discharge these fees.

Nevertheless, some asset protection planners continue to tell their clients a blatantly false statement: “So what if you make a fraudulent transfer, since it will be undone and you will be no worse off than if you had not tried?” As demonstrated by this instance, nothing could be further from the truth. If you hear someone say that, you should flee because they are either intentionally deceiving you or, more likely, they have no idea what they are talking about.

Weller’s defense that he did not have the requisite intent for the attorney fee award to be non-dischargeable because he relied on the advice of his counsel and then attempted to reverse his transfers when he realized he had received poor advice is another lesson from this case. The bankruptcy court simply disregarded this defense and did not even mention it in its opinion for one straightforward reason:

it is not a defense to non-dischargeability under Section 523(a). If Weller chooses to pursue it, he may have a valid malpractice claim against his counsel for giving him bad advice in the first place, but that is a separate matter. Before the bankruptcy court, it was simply irrelevant. If a debtor had the intent, they forfeited their discharge, regardless of how they arrived at that intent.

In general, attorney opinion letters are of dubious value in cases involving fraudulent transfers, as they do not negate intent. However, these opinion letters can attempt to mitigate any claims for punitive damages that a creditor may attempt to add to a fraudulent transfer judgment. This, too, is a topic for another time.

Losing the right to discharge a debt is a terrible thing for a debtor because it means the debtor will never be able to get rid of the debt by any means other than paying it in full or settling with the creditor, who typically has little incentive to compromise. Over the years, I’ve had to represent individuals in judgment enforcement proceedings who had unforgiven debts; their accounts of being relentlessly harassed by creditors were devastating.

On the other hand, what they did to make their debt non-dischargeable in the first place was typically something that would diminish sympathy for them; they made their own bed and must now lie in it. In accordance with the oft-stated purpose of the bankruptcy process, which is to give debtors a “fresh start” in their financial affairs, bankruptcy judges frequently go to great lengths to grant a debtor a discharge. Thus, when a bankruptcy judge denies a discharge, it is typically because the debtor has committed a truly heinous act.

The courts have determined that fraudulent transfers are among them. Take heed.

 

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