A Qualified Personal Residence Trust (commonly referred to as a QPRT) has long been a method by which an individual can gift their home to someone else (typically children) at a reduced tax cost, while retaining the ability to live in the home for a set number of years. QPRTs can be an effective way to minimize tax costs in transferring property. But they might not be effective as asset-protection devices any longer, now that the Ninth Circuit Bankruptcy Appellate Panel has upheld a groundbreaking January 2014 order obtained in favor of TAV on behalf of the Chapter 7 bankruptcy trustee.
In 2010, an individual named Robert A. Ferrante filed for Chapter 7 bankruptcy in Orange County. At the time of the filing, Mr. Ferrante was living in a multi-million dollar mansion on the bay of Newport Harbor. Title to the lavish residence, however, was not held by Mr. Ferrante; instead, the legal owner of the residence was a QPRT settled by Mr. Ferrante in 1994 by which he sought to transfer the residence to his children at the end of a 20-year term (i.e. in 2014) but by which he maintained the ability to reside in the property for the length of that term.
That QPRT – referred to as the “Harbor Island Trust” by virtue of the property’s prime location on Harbor Island Drive in Newport Beach – was, or at least purported to be, irrevocable. A revocable trust is one in which the settlor (the creator) of the trust retains the ability to revoke the trust and thus obtain any property held by the trust. An irrevocable trust, on the other hand, is one which the settlor cannot revoke after its creation.
This distinction between revocable and irrevocable trusts is significant, particularly for bankruptcy purposes. In bankruptcy, a revocable trust belongs to the estate; in other words, the bankruptcy trustee may liquidate the trust, and any assets held by the trust, for the benefit of a debtor’s creditors. An irrevocable trust, on the other hand, is protected in bankruptcy and may not be used to satisfy outstanding debts. QPRTs are typically labeled as irrevocable trusts, and therefore many debtors expect them to be protected in a bankruptcy. But, as the Bankruptcy Court found in the case of Mr. Ferrante and is explained below, mere labels of irrevocability do not necessarily control the Bankruptcy Court’s treatment of the trust.
Despite its label as an irrevocable trust, the trustee of Mr. Ferrante’s bankruptcy estate identified it as a trust which was, in substance if not form, actually revocable. Accordingly, he retained special litigation counsel – the firm of Thomas Vogele & Associates, APC – to file an adversary complaint by which the Trustee sought to recover the Harbor Island Property for the benefit of Mr. Ferrante’s estate and creditors.
Years of litigation ensued. In December of 2013, the Trustee filed a motion by which he sought to declare the QPRT to be revocable such that the asset it owned – the Harbor Island mansion – belonged to the bankruptcy estate. In an unprecedented move, the Bankruptcy Court for the Central District of California, the Honorable Theodor C. Albert presiding, issued an order on January 29, 2014 agreeing with TVA and deeming the QPRT revocable.
The Court’s determination was based on two separate and independent grounds. The first ground was relatively straightforward. One paragraph of the specific QPRT instrument contained language permitting Mr. Ferrante to “acquire all or part of the Residence from the trust immediately prior to the expiration of the trust.” This contradicted IRS regulations, passed on December 23, 1997, which ordered that any QPRT “must prohibit the trust from selling or transferring the residence, directly or indirectly, to the grantor . . . during the retained term interest of the trust.” (See 26 C.F.R. § 25.2702 5(c)(9).) By permitting Mr. Ferrante to buy back the Harbor Island mansion prior to the expiration of the trust, the QPRT did not comply with IRS regulations, and thus was no QPRT at all, rendering it unprotected in Mr. Ferrante’s bankruptcy.
Faced with this finding, the astute QPRT creator would perhaps reason that he or she could safeguard against this outcome by strictly complying with the IRS regulations and prohibiting such “buy-back” language. But the Bankruptcy Court went one step further. Not only did the Court find that Mr. Ferrante’s QPRT was revocable for bankruptcy purposes, but it also it held that all QPRTs may be revocable for such purposes, noting that “QPRTs are gift and inheritance tax delay devices. They are not…creditor protection devices.”
The Bankruptcy Court arrived at this conclusion via a peculiar quirk of QPRT law. The IRS regulations governing QPRTs state that a trust must lose its QPRT status if the trust residence, e.g. the Harbor Island mansion, “ceases to be used” or held for use as the settlor’s personal residence. (26 C.F.R. § 25.2702-5(c)(7)(i).) The Trustee reasoned that because Mr. Ferrante could voluntarily choose to move to a new residence, he controlled whether or not he used the Harbor Island mansion as his personal residence. He therefore controlled the QPRT status of the trust. The Bankruptcy Court agreed: “the trust instrument utilized here gives the debtor [Mr. Ferrante] ‘back door’ access to the corpus [the mansion] at any time in his discretion. All that [Mr. Ferrante] needs to do is move out with intention to abandon the subject property as his ‘personal residence’ and the QPRT status is lost.”
Mr. Ferrante appealed the Bankruptcy Court’s decision to the Bankruptcy Appellate Panel for the Ninth Circuit (“BAP”). The BAP ultimately ruled that the Bankruptcy Court’s first basis for finding the QPRT revocable – the existence of the prohibited buy-back provision – sufficed, and as such affirmed the Bankruptcy Court’s decision on that ground. It declined to reach the broader context of whether all QPRTs may be revocable in the bankruptcy context.
Ultimately, the Bankruptcy Court’s decision could have wide-ranging impact on the treatment of QPRTs in bankruptcy. But one distinction about Mr. Ferrante’s trust should be noted. Mr. Ferrante’s trust contained language that stated the trust terminated upon loss of QPRT status and on such termination all assets (the mansion) were to be distributed to the settlor (Mr. Ferrante). This gave the Trustee a clear path to recover the asset: because the trust’s very existence relied upon its status as a QPRT, and because Mr. Ferrante controlled whether the trust qualified as a QPRT, Mr. Ferrante controlled the existence of the trust (and the distribution of its assets). This allowed the Bankruptcy Court to hold that the trust was clearly revocable by Mr. Ferrante in one manner or another.
The question on the mind of any debtor, creditor, or QPRT creator moving forward, of course, is how the Bankruptcy Court’s treatment of Mr. Ferrante’s QPRT will affect other QPRTs in the bankruptcy context moving forward. In that respect, Mr. Ferrante’s case offers a clear map of what not to do when drafting a QPRT. A QPRT creator will refrain from inserting any provision which permits the settlor to buy back or otherwise obtain the trust residence. Just as importantly, a shrewd QPRT creator will not permit the trust to terminate if and when it loses its QPRT status. Instead, the QPRT drafter should provide that, upon loss of QPRT status, the trust becomes a Grantor Retained Annuity Trust (“GRAT”), another form of irrevocable trust that transfers financial gifts while minimizing tax liability.
Given the Central District Bankruptcy Court’s decision, it remains to be seen whether or not these precautionary measures will prove effective in protecting QPRTs from discerning creditors and bankruptcy trustees. The outcome of future disputes will likely hinge on the efficacy of the trust instrument and the degree to which the future court finds the Ferrante ruling persuasive. At this point, however, one thing is clear – QPRTs are not necessarily the asset protection devices many thought they were, and anyone involved with such a trust must plan and proceed accordingly.