Marital Property Liability and Exemptions: Keeping Creditors at Bay
The client is sitting in front of you with a worried look. Her husband’s business is in trouble and creditors are lining up at the courthouse to obtain judgments against him. One of the creditors is suing him for fraud. She brought a small inheritance to the marriage which she has managed over the years. She used some of it to start a small but profitable business after the children started school. She wants you to advise her as to what, if any, property is at risk in a post-judgment enforcement proceeding against her husband. How do you go about analyzing the marital property liability issues to reach a proper conclusion?
It may be profitable to read an article entitled Marital Property Liabilities: Dispelling the Myth of Community Debt, by Tom Featherson and Allison Dickson, Texas Bar Journal, January 2010, pp. 17-20. The article describes a “multi-step process” to follow in determining marital property liability issues.
The four questions it suggests to ask are:
- Is the debt the obligation of the husband, wife, or both?
- Was the debt incurred before or during marriage?
- Is the debt tortious or contractual in nature?
- Are there any other “substantive, nonmarital rules of law” that can cause one spouse to be liable for the debt of the other spouse?
Once such questions are answered the analysis can begin.
All of a debtor spouse’s property interests answer for the debtor spouse’s debts, including separate property; special community property (property subject to the debtor spouse’s sole management, control, and disposition); joint community property. The non-debtor spouse’s special community property answers for tortious debt incurred during marriage but not for contractual debt. The non-debtor spouse’s separate property only answers for the debtor spouse’s debt incurred in clearly defined circumstances such as debt incurred for necessaries like emergency medical care or basic food, clothing, and shelter or for federal tax liability. In such circumstances the general rule is all of the non-debtor spouse’s property is available to satisfy such debt.
Applying the above framework to your client’s situation, we know she is the non-debtor spouse trying to avoid debt incurred by her husband during marriage. All of the debt is likely to be contractual although she needs to keep an eye on the fraud claim. It is likely all of the debt is business-related and not subject to any other rules of law unless there are income tax liabilities owing. Thus, for the most part the joint community property is at stake but her special community property (her business and the profits from the same) and separate property (her inheritance remaining) are likely to remain free of such claims.
Although the article’s analysis ends there, your analysis is not complete without asking one final question: Is the property at risk, in fact, exempt by law? The more significant exemptions include: homestead; personal wages, annuities, life insurance policies, retirement plans/income, federal benefits such as social security and disability, the laundry list of personal property exemptions in Chapter 42 of the Texas Property Code. Once received in hand, some of these exemptions can be lost. Further, some exemptions are limited and do not protect against every type of debt.
In the collections industry Texas is considered the second most debtor friendly state in the Union, just behind Florida. It was a calculated move on the part of O.J. Simpson when he moved to Florida following his acquittal. He was able to live an opulent lifestyle and avoid paying virtually all of the multi-million dollar judgment that followed because he had a slew of exemptions at his disposal. However, his ability to do this was also the result of sound asset protection planning that had been put into place long before his legal troubles arose. And that is a good place to begin our discussion of exemptions. If one is to advise a client on how to take advantage of exemptions, such advice must be given and followed before the date any event occurs which may expose a client to liability; otherwise, any transfer of assets from non-exempt status to exempt status is subject to scrutiny and the possibility of being set aside under the Texas Uniform Fraudulent Transfer Act. See: Chapter 24 of the Texas Business and Commerce Code.
Most people timely utilize exemptions without realizing it. For example, the average middle-class person: owns a home (exempt under homestead laws); receives a regular salary (exempt from garnishment under Tex. Prop. Code Ann.§ 42.001 (b)); owns one or two cars (part of the “laundry list” of exemptions one can aggregate at § 42.002 – $50,000 aggregate for a single person and $100,000 aggregate for a married couple); is likely to have the majority of savings, if any, in some type of retirement plan (unlimited exemption under § 42.0021); has furniture, food, and lawn equipment worth less than $10,000.00 (part of the amount a person can aggregate under the “laundry list” of exemptions); owns jewelry which is less than $4,000.00 in value (a “laundry list” exemption which can be aggregated up to $12,500.00 for a single person and $25,000.00 for a married couple; id. at § 42.002 (a) (6)); maintains a bank account that averages less than a $500.00 balance (this can be garnished but is not cost effective).
Some of the foregoing exemptions are utilized under the laundry list of personal property exemptions found in Texas Property Code § 42.002. That statute allows an individual to aggregate up to $50,000.00 of the listed items. This means a person can pick and choose from the items listed and can claim them as exempt, but only for the values that add up to $50,000.00 or less. The exemption is $100,000.00 for married couples. Once added to the other exemptions, nearly everything the average middle-class person owns is exempt.
Some of the less utilized “laundry list” exemptions one can aggregate are: tools and vehicles of trade; horse, cattle, and other animals of various numbers; firearms and sporting equipment; vehicles owned for the use of other adults living at home. Note that all such “laundry list” exemptions are valued after deducting the purchase money owing and any other encumbrances such as taxes. For example, a car that is worth $30,000 but is secured by a note owing $25,000.00 has a value of $5,000. Other exemptions available with no limit in amount include: college savings; personal injury settlements; health aids; worker’s compensation payments; social security benefits; cemetery lots; insurance benefits, including annuities and annuity payments; child support and alimony payments.
No discussion of marital property liability and exemptions is complete without mentioning how to properly categorize and separate business assets and earnings from wages. A summary of case law is as follows: revenues earned from passive income generation such as rent from a rental property and the increase in value of a passive income property can remain classified as separate property if the property from which the income is generated is already separate property. However, even when a business is started using separate property, revenue generated by the business from the labor of the non-debtor spouse is considered community property as is the increase in the value of the business from such labor. In the scenario described in Part I of this two-part article, the non-debtor spouse runs her business, pays herself a salary, and controls all of its revenue and assets; thus, it is special community property.
The wages she receives may remain special community property or may become ordinary community property depending on how much money is controlled and whether it is commingled with her debtor husband’s assets such as in a joint checking account. If damages are awarded upon a fraud claim, the value of the business and its revenues are at risk to answer for the judgment. While one is correct to point out there must be some increase in the business’s value from the investment of separate-property money, courts tend to view businesses as growing because of the labor and toil of people and are quick to ascribe the increase in the value of businesses as being due to such labor.
As previously mentioned, regular wages are exempt. However, in order to earn wages a person must work for someone else. Thus, if the non-debtor spouse’s business is a sole proprietorship, the “wages” she pays herself are not considered wages and are available to satisfy her husband’s creditors depending on the type of judgment and whether she controls the “wages” as special community property. Even if the “wages” are controlled as special community property, such “wages” can be seized to answer for a judgment against her husband based upon fraud. The better practice is for her to incorporate the business and to pay herself a fair salary. In that event she is working for someone else – even though it is a corporation she owns and her wages are exempt.
She should also maintain separate control of the wages so they remain special community property. While lawyers often hear the refrain that the principal benefit of entities is to shield officers, directors, and shareholders from individual liability, this scenario illustrates one of the other benefits of incorporating businesses: to protect assets.