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Carefully Constructed Trusts Can Protect Assets

Filed under Asset Protection Strategies. Fact checked on May 24, 2012.

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Asset protection trusts, which can be established in several states as well as in foreign countries, can shield a grantor-beneficiary's assets from the reach of creditors.

By placing assets into a trust for a beneficiary, you can shield them from the reach of the beneficiary's creditors. So, if you place assets into a trust for your children, you children's creditors can't seize those assets. However, what if the beneficiary is yourself? When a grantor places assets in a trust for his own benefit (a self-settled trust,) the law is less clear as to whether the assets can be shielded from the grantor's/beneficiary's creditors.

In the last decade, nearly a billion dollars has flowed out of the United States and into offshore trusts situated in Nevis, St. Kitts, the Bahamas, the Cook Islands and other offshore jurisdictions. Why? The primary reason is that, unlike most states, these jurisdictions do not prohibit the use of a self-settled spendthrift trust.

In an effort to capture some of this investment capital, Alaska, in mid-1997, modified its trust statutes to legalize a spendthrift clause in a self-settled trust. Not to be out done and, in particular, to preserve its status as the premier site for business and investment, Delaware immediately followed Alaska's lead with a similar change. Since then, Nevada has joined them.

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When Alaska, Delaware and Nevada modified their trust statutes to legalize a spendthrift clause in a self-settled trust, they created a significant departure in American law. Up until that time, the only effective way to create a self-settled spendthrift trust was to form it offshore, outside of U.S. jurisdiction.

These states also eliminated the rule against perpetuities. This antiquated rule limits the duration of a trust to the life of some person living at the time the trust is created, plus 21 years. As a result, the Alaska, Delaware and Nevada asset protection trusts can continue indefinitely.

Missouri has a more limited exception to the rule that makes a self-settled spendthrift trust invalid. In that state, the exception does not apply where the trustor is the sole beneficiary of either the income or the principal, or the beneficiary of a fixed portion of the income or the principal. This exception has existed since the 1980s. However, because of the limited nature of the exception, Missouri has not been considered a significant option for opening an asset protection trust.

Alaska, Delaware, and Nevada Offer Asset Protection Trusts

If the grantor is the a beneficiary, a trust can potentially function as an asset protection device, provided that the trust:

  • is irrevocable
  • has an independent trustee
  • does not provide for mandatory distributions of income or principal (i.e., such distributions are subject to the discretion of the trustee)
  • has a spendthrift clause

These conditions are the standard requirements that must be met for any self-settled spendthrift trust. In addition, however, the statutes require that:

  • the trustee must be an individual who is a resident of the state in which the trust is located, or a bank and trust company licensed in that state
  • some or all of the trust assets must be located in the state (a bank account will suffice, so that the other assets can be invested by the trustee elsewhere)
  • the trust documents and administration must be in the state
  • certain creditors can reach the assets

With respect to this last requirement, significant differences exist between the different state statutes. In short, the Alaska statute offers significantly better protection against the claims of creditors.

Domestic Asset Protection Trusts Can Face Challenges in Bankruptcy

While federal bankruptcy courts have jurisdiction that stretches across the states, it is an oversimplification to state that a domestic asset protection trust could not survive in a bankruptcy proceeding. Federal bankruptcy law requires that the court honor any exemption established under state law.

Thus, in a bankruptcy proceeding, the same issue is presented--which state's laws will be applied? If the bankruptcy court finds that Alaska, Delaware, Nevada or Rhode Island law applies to the trust, because of investing in real property or forming business contacts in the state, for example, then the trust will be upheld as valid and exempt from the bankruptcy proceeding.

At this time, the outcome cannot be safely predicted. Arguments can be made that support either position. Because of the distinct advantages of these new asset protection trusts, and the significant protections offered particularly by Alaska's statute, one thing probably can be safely predicted--when a significant sum is at stake, a creditor is likely to challenge the validity of the trust on the grounds discussed above.

Full Faith and Credit Clause Questions Remain Unsettled

When considering an United States based asset protection trust, you'll need to be aware of the implications of the Full Faith and Credit Clause in the U.S. Constitution. It requires each state to recognize a judgment entered in another state. Thus, as the argument goes, the state in which the trust exists would have to recognize another state's judgment, and thus allow a creditor access to the trust's assets despite the spendthrift clause.

Therefore, a serious question exists as to the effectiveness of the changes that Delaware, Nevada and Alaska made to their trust laws. The question can really be reduced to one word: jurisdiction. If the trustor resides in a different state, a creditor could sue the trustor/beneficiary outside of the state where the trust is sited, in the state in which the trustor resides. The state in which the suit is filed would likely rule that, under its laws, the assets are reachable by the creditor, consistent with the general rule in most states that a spendthrift clause in a self-settled trust is invalid.

The same result might occur where the creditor was able to file suit in its home state, rather than in the state with the trust. Normally, a lawsuit can be filed in the state in which a contract is formed or a tort (e.g., negligent act) is committed.

Unfortunately, to date, there have been few reported cases on this issue involving an asset protection trust in any of these states. A few cases, involving tax issues, have produced mixed results and, thus, do not offer firm guidance. The above argument can be extrapolated from these few cases. However, this argument oversimplifies the issues.

Each of these cases turned on its own unique facts and involved other issues. Moreover, if a challenge ended up in federal court, which is likely with this type of conflict-of-laws issue, the federal court would have to decide which state's laws to apply--the law of state with the trust, or the law of the trustor's or creditor's home state.

The asset protection trust statutes require that the trustee reside in the state, that some or all of the trust's assets be located there, and that the trust administration and paperwork be located there. Arguably, these requirements were enacted to attract capital into these states. However, a secondary goal was to establish grounds for a court to find that the law of state of the trust, rather than the trustor's or creditor's home state, should be applied to the trusts.

Both states' statutes also expressly provide that they have jurisdiction over the trusts. Further, the trust document itself also will have a choice of law clause that establishes the state of the trust as the controlling law. While none of these facts can assure a favorable outcome, they do buttress the argument that the law of Alaska or Delaware should control the outcome.

Some states assert jurisdiction over any trust where the beneficiary is a resident of the state. Thus, for example, Connecticut imposes an income tax on a resident's share of income from an out-of-state trust. This provision recently was upheld as valid by the courts. In doing so, the courts have concluded that Connecticut has jurisdiction, because Connecticut law dictates that jurisdiction is not determined by where the trust is set up, but instead by where the beneficiary resides. This conclusion, according to the courts, is justified because the interest in the trust is deemed to be personal property owned by the resident beneficiary.

Strategies to Reduce Conflict of Law Issues

One of the most complicated issues involved in setting up a United States-based asset protection trust is the question of jurisdiction when state laws conflict. However, there are a number of strategies that can help minimize the risk of conflict of laws issues.

Real Property Assets Help Establish State Jurisdiction

Probably one of the most secure ways to establish jurisdiction over the trust in the state of the trust is to have the trust invest in real property (land and buildings) situated in that state.

It is clearly established that jurisdiction over real property is accorded to the state in which the real property is situated. Thus, the trust could invest in a rental apartment building or a condominium located in Delaware or Alaska, depending on the site of the trust.

While using this strategy would limit investment choices and reduce liquidity, it would also make it very difficult for creditors from outside these states to challenge the validity of the trust.

Warning

Because a state can assert jurisdiction over real property located within the state, it would be a mistake for an trust to invest in real property located outside of the state where it was created. Doing so would likely ensure that the state in which the real property is located will have jurisdiction, and that the trust, at least to the extent of this asset, is invalid.

Business Contacts Help Establish State Jurisdiction

As noted above, one strategy to increase the validity of this type of trust involves investing in real property in the state in which the trust was formed. Another involves having business contacts there as well.

In theory, the greater the contacts with the state of creation (whether Alaska, Delaware, Nevada or Rhode Island,) the greater the likelihood that a court will uphold the validity of the trust. Therefore, because Delaware, in particular, represents a very favorable place to form a business entity, the business owner could first form the business entity there, and then have the business fund an asset protection trust in the same state. The entity could fund the trust as part of the compensation package for the owner of the business.

While certainly not a guarantee that the state will have jurisdiction over the trust, this strategy does at least offer support for this conclusion. For example, in a recent case the right of Connecticut to tax a Delaware trust was upheld on the grounds that Connecticut had jurisdiction over the trust. Connecticut was found to have jurisdiction, in large part, because the beneficiary of the trust was a resident of Connecticut.

Thus, by extension, it can be argued that Connecticut would assert jurisdiction over a Delaware asset protection trust where the beneficiary resided in Connecticut. This is a more likely outcome where the beneficiary is also the trustor, which is the usual scenario in an asset protection trust. If Connecticut law were to apply to the trust, the trust would be invalid, in accordance with the general rule (outside of the state of creation) that a self-settled asset protection trust with a spendthrift clause is invalid.

In contrast, if a Delaware entity created the Delaware trust, there is less likelihood that another state would be deemed to have jurisdiction, because the trustor exists in Delaware. It is possible, however, that a court would "collapse" the transactions and hold that the owner of the business entity effectively created the trust, or rule that the residence of the beneficiary alone would be determinative of the issue of jurisdiction. The only sure conclusion is that the use of the business entity to create the trust increases the possibility that Delaware law would be applied to the trust and that, accordingly, the trust will be declared valid.

Should a judgment be rendered in state in which the trust is sited upholding the validity of the trust, an argument also can be made that the trustor's home state will then be compelled by the same Full Faith and Credit Clause of the U.S. Constitution to honor this judgment.

Challenges Where Trustor and Trust Are Residents of Same State

Note that if the trustor is a resident of the state of the trust, an issue can still exist as to validity of the asset protection trust when the creditor is a resident of a different state, or the creditor's claim is based on an event that occurred in another state. An Alaska trust might, for example, be challenged by a former spouse, pursuant to a court judgment of alimony or child support from another state. Or the trust might be challenged by a creditor based on an auto accident that occurred in another state.

However, if you are a resident of the state of the trust, it is probably less likely that the trust will be successfully challenged. Your residency will make it more likely that a federal court will find that Alaska or Delaware law should apply to the case. Nevertheless, because of the absence of direct rulings on the issue, this result is far from guaranteed.

Comparing Creditor's Rights between Asset Protection Trust Statutes

A common misunderstanding is that the Alaska and Delaware asset protection statutes are identical. This is incorrect, especially where the statutes provide exceptions that allow creditors to reach the trust's assets. 

The Alaska statute contains only two very narrow exceptions under which creditors can reach the trust's assets. A creditor can breach the trust if:

  • the trustor transferred assets to the trust intentionally as a means of defrauding the creditor, and the creditor brings suit within one year of the time he or she learned, or should have learned, of the transfer, but within four years in any event, or
  • at the time of a transfer, the trustor was in default by more than 30 days under a court order of child support, and the creditor is attempting to enforce an order of child support

With respect to the first exception, the grounds that can be used by the creditor are actually narrower than it first appears. The Alaska statute requires that the creditor prove actual fraud--that is, intent, factually. This means the creditor is prohibited from using the "badges of fraud" that the courts have established, upon which intent can be inferred. Instead, the creditor must prove what the trustor was actually thinking at the time of the transfer. This is a very difficult burden.

The second exception is so narrow that it is quite easy to avoid. This narrowness also means that the trustor can immunize his or her assets against the alimony, child support (in most cases) and property claims of a past, present or future spouse. 

The effects of this provision are two-pronged: The protections offered by the statute are extremely significant, as these types of claims can exhaust wealth; since the protections are so extreme and seem to go against the trend, especially in terms of enforcement of child support orders, it means the provisions also will generate controversy, and thus challenges by creditors will be likely.

The Delaware statute creates much wider exceptions than the Alaska statute. Specifically, in Delaware, a creditor can reach the trust assets if:

  • actual fraud (intent) can be proved; here, unlike in Alaska, creditors can use the badges of fraud to establish intent; the same time limitations that apply in Alaska also apply in Delaware
  • the claim is made by a current, or former, spouse, and is for alimony or a property distribution
  • the claim is for child support
  • the claim stems from personal injuries or property damage, and the claim arose before the transfer

The Alaska statute offers significantly greater protection than the Delaware statute. In Alaska, absent actual fraud, current and former spouses cannot reach the trust's assets for claims of alimony, claims based on property distributions or virtually all claims for child support. Also, claims based on personal injury or property damage occurring before the transfer will not be successful in Alaska. In Delaware, all of these claims are specifically allowed by statute.

While the chances that the Delaware statute will be challenged are somewhat lower, this really is not an argument in favor of establishing the trust in Delaware. If the trust is formed in Alaska and a challenge is successful (e.g., for child support), the trustor will likely be no worse off than if the trust were set up in Delaware. However, in Alaska, there is at least a possibility that the creditor's claim will be defeated.

Generally, consideration should be made to forming the trust in Alaska rather than Delaware if child support, alimony and marital property distributions are important issues, or there is the possibility of a claim based on an earlier act of negligence.

If the business entity is formed in Delaware, the entity could establish the trust there. This may make it more likely that Delaware law will be applied to the trust and that, accordingly, the trust will be upheld as valid. This would be even more likely if the business entity had actual contacts there (e.g., an office, bank account, etc.) or if the trust owned real property in the state.

Additional Factors Affecting Domestic Asset Protection Trusts

When deciding whether to set up a domestic asset protection trust, there are a number of miscellaneous issues to consider.

Fees. There will be legal fees for drafting the trust and fees charged by the trustee for administration of the trust. These costs, in many cases, will pale in comparison to the savings that can be generated if the trust protects you from a major judgment creditor--provided, of course, that the trust is upheld as valid.

Irrevocable nature of the trust. Because the trust will have to be irrevocable, the decision to establish the trust should be well thought out. Once established, you cannot change your mind as to particular provisions (for example, you can't remove your wayward son from the list of contingent beneficiaries) or as to whether the trust should have been created in the first place.

Discretionary distributions. Further, because the trust should not be structured to make mandatory distributions of income or principal, you will have to depend on the trustee's judgment in deciding whether to make a requested distribution.

However, you will have provided the trustee with guidance in making discretionary distributions in the trust document. Further, many clients use a letter addressed to the trustee requesting, but not requiring, that distributions be made when requested under certain circumstances. While not bound by such a letter, trustees know they will not be in business long if they gain a reputation as being unresponsive to client's requests. Thus, in practice, requests generally are honored.

Estate tax and income tax considerations. Assets within a properly constituted asset protection trust should escape federal estate taxes. Thus, the trust also functions as an estate planning device.

Transfers to the trust should be deemed completed gifts. Such transfers would reduce the unified estate tax exemption. However, the trustor could transfer amounts up to the annual gift exclusion (adjusted annually for inflation), per beneficiary of the trust (other than to himself or herself), without reducing the exemption (see our discussion on this annual gift tax exclusion).

The trust ordinarily would be a separate tax-paying entity, absent special language that establishes a different result. This may not be desirable, as it creates additional administrative burdens and costs, and usually results in higher taxes. However, special language can be used to make the trust a grantor trust. In that case, the trust's income would all be taxed to the trustor, at his or her individual rates, and reported on the trustor's individual income tax return, Form 1040. This option is likely to lower the tax burden and administrative costs of the trust.

Other clauses. A domestic asset protection trust should have a trust protector clause, anti-duress clause and change of situs clause. These clauses are most commonly found in offshore trusts and are discussed in that context.

Risk. Finally, the law concerning the validity of domestic asset protection trusts is not yet settled. You need to be aware that the trust may be challenged, and there is a possibility that the trust will be declared invalid. For this reason, some consideration should also be given to establishing an offshore asset protection trust rather than a domestic one.

To date, there have been no reported cases on the validity of a domestic asset protection trust against a challenge mounted outside one of these states. For this reason, some planners still recommend offshore asset protection trusts rather than domestic trusts.

However, offshore trusts are more expensive to establish. Further, many individuals are hesitant about investing offshore, because of concerns (mostly unfounded) about the jurisdiction's stability, currency valuation issues, etc. Finally, offshore trusts also can be challenged, but only in very specific ways.

You should consult with an estate planning attorney before deciding whether to establish a self-settled asset protection trust, and, if such a trust is to be formed, whether to use a domestic or an offshore jurisdiction for the trust's establishment.

If the decision is made to establish a domestic asset protection trust, consideration should be given to using the strategies of investing in real property or forming business contacts there to bolster the argument that the law where the trust is located should be applied to the trust.

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