California private retirement plans (a/k/a “PRPs”) are the hottest asset protection vehicle selling in the Golden State and the latest flavor-of-the-day planning tool. Because PRP assets are exempt from creditors under CCP § 704.115(a)(1), those assets carry a statutory protection from creditors that is all too rare in the most creditor-friendly state in the Union.
But can somebody create a PRP for themselves primarily for the purpose of asset protection? A recent court opinion, O’Brien v AMBS Diagnostics, LLC, 38 Cal.App.5th 553, 251 Cal.Rptr.3d 41 (Aug. 8, 2019), tells us that the answer to this question is “No”.
In 2010, Timothy O’Brien and three other folks formed AMBS Diagnostics, LLC, but for whatever reason O’Brien and the others ran into disputes which ended with O’Brien setting up a competing business. Diagnostics sued O’Brien for stealing its customers and breaching his fiduciary duties, and the court ultimately ruled against O’Brien and awarded Diagnostics close to $500,000 in compensatory damages and another $125,000 in punitive damages.
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So far, it sounds just like an ordinary intra-physician partnership squabble of the sort that daily provides sound employment for a not insubstantial part of the attorney profession. But it is not that dispute that is interesting to us, but rather what happened when Diagnostics then attempted to enforce (collect) its judgment against O’Brien.
Diagnostics levied against several of O’Brien’s assets, including four individual retirement accounts (IRAs) then valued at $465,350 and change. For his part, O’Brien stated that he had funded those accounts as a contribution towards his retirement, and claimed that they were exempt from levy under CCP § 704.115(a)(3), which provides that IRAs are partially exempt in California to the extent of the debtor’s future retirement needs.
Here, let me digress and say that in California, the amount that somebody needs for retirement is an ephemeral and elusive amount that seems to be determined primarily by the judge going back into chambers, donning a blindfold, and throwing darts at a board. The court opinions in this area are utterly inconsistent and make little sense, other than to let one conclude that the standard of retirement that seems to be envisioned by the judges is not that of a person living in a Beverly Hills estate, but rather that of somebody making their permanent abode in a cardboard box outside of LAX. Now, back to our case.
In this case, the trial court held that O’Brien’s IRA accounts were completely exempt, although CCP § 704.115(a)(3) clearly states that IRAs are only partially exempt to the extent of the debtor’s retirement needs per ¶ (e) of that section. Diagnostics appealed the decision, and the California Court of Appeals reversed the trial court and said that the IRAs were indeed only partially protected. The date of the California Court of Appeals opinion was April 21, 2016.
On My 9, 2016, just 18 days later, O’Brien formed a new company called The Personal Branding Group, LLC, and then within a month, on June 3, 2016, the LLC formed a 401(k) plan for the benefit of its employee, i.e., O’Brien. The managing member of the LLC was O’Brien, and the Trustee of the 401(k) plan was . . . you guessed it . . . O’Brien.
The LLC itself lasted less than a year. As quickly as O’Brien created the 401(k) plan, he rolled his IRAs into this plan, and then wound up the LLC the following spring. That left O’Brien with just the 401(k) plan. At least O’Brien was honest in why he went through these frantic machinations, which he admitted was to protect the moneys in his IRAs from creditors.
A few months after O’Brien had rolled his IRAs into the new 401(k) plan, Diagnostics attempted to levy on the 401(k) for those funds. O’Brien filed a claim for exemption, claiming that those funds were now fully and completely exempt under CCP 704.115(a)(1), and also asserted that his “repositioning” (his word) of the funds was not a fraudulent transfer.
In challenging the claim of exemption, Diagnostics argued that the 401(k) was not designed for O’Brien’s retirement purposes nor did he use it as such. Diagnostics also pointed out that O’Brien had violated the restrictions for rolling over IRAs into a 401(k), and argued that O’Brien could not convert partially-exempt IRA funds into fully-exempt funds simply by rolling them over into such a plan.
The trial court agreed with O’Brien that the funds were fully exempt, and instead of conducting a thorough analysis of fraudulent transfer law merely held that the transfer of the funds from the IRA to the 401(k) was simply a “consequence” of the rollover process. The Court also dismissed Diagnostics claim that O’Brien had violated the restricts on rollovers with the comment that O’Brien could retroactively amend the 401(k) plan so that the rollover was kosher. Finally, the trial court found that the funds were for the purpose of funding O’Brien’s future retirement needs.
Diagnostics once again appealed.
The California Court of Appeals first noted that although private retirement plans are given a statutory exemption from creditor collection under CCP § 704.115(a)(1), to qualify the plan must be principally or primarily designed and used for the debtor’s retirement purposes, and not some other reason:
“This baseline requirement of a bona fide retirement purpose seeks to accommodate the constitutional mandate to safeguard a source of income for retirees at the expense of creditors  while at the same time guarding against the over-shielding of assets should the exemption apply to anything a debtor unilaterally chooses to claim or label as intended for retirement purpose.”
[Internal citations and quotations marks omitted.]
To determine whether a plan was primarily or principally to be used for retirement purposes, a court is to look at the totality of the surrounding facts and circumstances, including five important but non-exclusive facts:
(1) The debtor’s own subjective intent in creating the plan;
(2) The timing of the plan in relation to other ongoing events (read: litigation against the debtor);
(3) The debtor’s ability to control and access the plan funds;
(4) Whether the plan complied in its design and use with applicable IRS rules, and
(5) Whether the debtor actually used the funds for retirement instead of for some other purpose.
Here, the Court of Appeals thought that the trial court erred in looking at whether the moneys in O’Brien’s 401(k) plan were to be used for his retirement, instead of looking at whether the 401(k) plan itself was to be used for his retirement. Importantly:
“An inquiry into the initial purpose of the funds is legally distinct from an inquiry into the purpose of a plan or account where the funds were subsequently placed; otherwise, funds that were initially placed in a plan or account for retirement purposes would be forever exempt; however, the law, as noted above, is to the contrary.”
[Italics in original.]
Looking at how the 401(k) plan itself (as opposed to its moneys) were to be used, the Court of Appeals found as follows:
First, O’Brien admitted that he created the 401(k) plan to protect the plan’s assets from his creditors, which was not principally or primarily for a retirement purpose.
Second, the timing of the O’Brien’s decision to implement the 401(k) plan and roll his IRAs into it was clearly not driven by any retirement decisions of O’Brien but instead hastily done so as to defeat his creditors.
Third, the 401(k) was not put in place as a result of any independent decision of an employer to benefit its employees, but instead O’Brien himself made the decisions to form the LLC and have the LLC create the plan for his benefit, i.e., this was all O’Brien’s doings.
Fourth, the 401(k) plan violated the IRS rules for funding such plans, and it did not matter one whit that O’Brien could later have caused the plan to be retroactively amended, because what was relevant was O’Brien’s intention at the time the 401(k) plan was created and not what happened afterwards.
For his part, O’Brien argued that because the trial court found that he had not fraudulently transferred his IRA funds into the 401(k) plan — because the IRA funds were themselves exempt in some part — that meant that the transaction was kosher.
The Court of Appeals rejected this argument as “mixing apples and oranges”. Whether or not the transfer from the IRAs to the 401(k) was technically a fraudulent transfer, the fundamental question went O’Brien’s intent in setting up the 401(k) plan as an asset protection vehicle instead of a bona fide retirement plan, and that the transfer was not technically a fraudulent transfer did not negate O’Brien’s intent.
Similarly, the Court of Appeals rejected O’Brien’s argument that he ultimately wanted to have the funds in the 401(k) plan available for his retirement, noting that while that might have given O’Brien a secondary purpose for creating the 401(k) plan, that was still not the primary purpose of the plan.
Having determined that 401(k) plan was not an exempt asset because it was not primarily and principally used as a retirement plan, the Court next addressed what effect that ruling had in terms of the disposition of this case.
The creditor, Diagnostics, argued that because the funds were in the 401(k) plan, and the 401(k) plan was not exempt, then all the funds were available for levy by Diagnostics to satisfy the judgment. In effect, Diagnostics argued that although the funds may have been partially exempt when the were in O’Brien’s IRAs, those funds lost their protection when O’Brien rolled them over to the 401(k) plan.
The Court of Appeals disagreed, noting that California has a tracing statute in CCP § 703.080 which allows exempt funds to continue to be protected to the extent they can be traced back to an exempt status. Here, the funds were partially protected in the IRAs, and it was easy to trace the funds from the IRAs to the 401(k) too, so whatever partial protection the funds had in the IRAs they would get in the 401(k) plan too.
How much protection? The Court of Appeals could not discern this from the record, so it remanded the case back to the trial court to make a determination how much of those funds O’Brien and his wife needed to live on in retirement.
Some promoters of California private retirement plans will tell their clients something like: “Because a PRP is statutorily exempt from creditors, you can do it specifically for asset protection reasons and it will still be exempt.” This opinion says that is 100% wrong.
A PRP must be created for predominantly retirement reasons. The Plan document should spell out in detail the retirement purposes and objectives, and document them both at the outset and each year thereafter. Merely giving lip-service to retirement planning will not cut it. As to whether retirement is the primary and principal reason for the plan, the trial court is instructed to look at the totality of facts and circumstances, and not merely take the debtor’s self-serving word for it, or glowing recitals in the trust document that it was for retirement purposes.
Looking at each of the factors mentioned by the Court of Appeals, we see the Red Flags that the trial courts are to look for.
First, what was the debtor’s true subjective intent in creating the plan?
This is very similar to a voidable transaction (was: fraudulent transfer) analysis, where the court looks to the surrounding circumstances to discern the debtor’s true intent in creating a PRP. If there is evidence that the primary purpose of the plan was to be an asset protection vehicle, then the PRP probably is not going to survive scrutiny.
Second, was the debtor in financial distress or facing possible (or actual) litigation when the PRP was created?
Again, this is very similar to a voidable transaction analysis: The debtor may say that he did the PRP for financial reasons, but if a creditor is circling at the time the PRP is created, then good luck getting it to stand up. Which is to say that a PRP is like all nearly all other effective asset protection vehicles in that it needs to be formed when the debtor has no creditor issues at all, real or potential.
Third, was the debtor the driving force behind the creation of the PRP and controlled the PRPs assets as if they were his own?
A private retirement plan is the statutory counterpart to a public retirement plan. The latter are created by governmental entities to provide for the retirement of their government employees, and the former are created by private businesses to provide for the retirement of their private-sector employees. In both cases, there is typically an employer who is much bigger than a single plan participant that creates and funds the retirement plan.
Contrast this situation with that of O’Brien, who simply set up a single-member LLC not involving anybody else in any way but himself, and then had that LLC create the 401(k) plan just for himself. Collapsing the paper formality of the new LLC, this was just O’Brien creating the 401(k) plan for himself. The Court of Appeals found that this was a red flag.
Further, the new LLC did not fund the plan, i.e., it did not generate profits that were used to benefit its employee. Rather, O’Brien himself fund the 401(k) plan entirely by rolling his own money into it. The self-funding of the 401(k) plan was also a red flag to the Court of Appeals.
There is also, very importantly, an issue of the debtor’s control and access of the funds that is identified by the Court of Appeals, being that it is a red flag (but not singularly dispositive) if the debtor is the person in control of his own plan and can control access to the PRP funds, keeping in mind that typical such plans in the governmental and business worlds have third-party trustees and administrators who control the plans and have minds independent from that of the participant.
Fourth, did the plan comply with IRS rules for such plans?
At first glance, one might note that nothing in CCP § 704.115(a)(1) requires private retirement plans to be tax-qualified, and it is perfectly feasible and proper to have a private retirement plan that is not tax-qualified at all. But if one considers more deeply the Court of Appeals’ opinion, what that opinion is really telling us is that if the plan purports to be tax-qualified, i.e., the debtor participated in the plan for ostensible tax reasons, then if the plan fails to be tax-qualified that is good evidence that the debtor’s primary purpose for the private retirement plan was not retirement. That the private retirement plan purported to be tax-qualified but failed is not conclusive on the issue of the purpose of the plan (none of these factors are singularly dispositive) but it is another red flag.
Fifth, did the debtor actually use the funds for retirement instead of for some other purpose?
The Court of Appeals did not elaborate on this factor in the context of this case, so this opinion provides no meaningful guidance on this point. It may be that the Court of Appeals concluded that O’Brien actually did intend to use the funds for his retirement. If so, that was a mark in his favor. In other cases, however, this factor has been telling, such as where a debtor uses the funds for his own personal purposes, makes loans to himself, etc. — all those things being red flags to be avoided.
It cannot be emphasized enough that these five factors are not exhaustive, meaning that in a given case a court might point to other things to make that fundamental determination as to whether the retirement plan was primarily and principally meant for the debtor’s retirement purposes. A particular retirement plan could lose on all five factors and still survive that fundamental determination, or win on all five factors and still be determined to be for some purpose other than to fund the debtor’s retirement. Very much like the Badges of Fraud in voidable transaction law, these are simply roadside points-of-interest markers for the courts to look at in the context of the overall facts and circumstances of each case.
Which is to say that the test of whether a PRP has a primary retirement purpose is really a “bad tuna” test — are the facts and circumstances of the particular case such that the court gets a whiff of a scent that the tuna is bad even though it looks fresh. Somebody might create a private retirement plan with meticulously-drafted documents that are three-feet thick, but if a court gets a whiff of bad tuna because of surrounding facts, the private retirement plan is probably not going to qualify as exempt under CCP § 704.115(a)(1).
That sort of test drives planners nuts, because they want certainty that if they draft A, B, and C correctly, then the plan will survive. But no amount of drafting, structuring, or other brilliant transactions can get around the fundamental issue of the debtor’s intent in creating the PRP, and that is what is being tested.
The one thing that is clear from this case is that if the PRP was created for creditor protection reasons, then it is per se Dead On Arrival.
O’Brien v AMBS Diagnostics, LLC, 38 Cal.App.5th 553, 251 Cal.Rptr.3d 41 (Aug. 8, 2019). https://privateretirementplans.com/2019-obrien-concerning-california-private-retirement-plans.html