The Use and Abuse of Domestic Asset Protection Trusts
May 18, 2005
J. Alan "Alan" Jensen- Portland
Introduction
In an era of unprecedented litigiousness, domestic asset protection trusts (“APT’s”)
have become increasingly popular. Until recently, no U.S. jurisdiction extended
spendthrift protection to trusts in which the grantor had retained an interest,
at least to the extent of such retained interest.
An asset protection trust is an irrevocable, self-settled spendthrift trust that
protects a portion of an individual’s assets from creditors. The hallmark of an
APT is that, unlike other forms of spendthrift trusts and other asset protection
techniques, it permits the donor to retain a beneficial interest in the trust,
while removing it from the reach of future creditors.
APT’s have historically been formed in offshore jurisdictions, such as Bermuda,
the Isle of Man, the Cook Islands, and various Caribbean nations. Recently,
APT’s have been authorized in seven US jurisdictions: Delaware, Alaska, Nevada,
Rhode Island, Utah, Oklahoma, and Missouri. The remainder of this article will
focus on domestic APT’s, rather than offshore APT’s.
I. Asset Protection Trusts Generally
Although domestic APT statutes vary in their details, they share some common
traits:
- Transfer to irrevocable trust
- Resident trustee
- Specific incorporation of state law
- Inclusion of spendthrift clause
- Grantor’s retained interests
- Tail periods for extinguishing claims
Transfer to Irrevocable Trust
The transfer of assets must be to an irrevocable spendthrift trust. It may be a
direct transfer from the grantor to the trustee or may result from the grantor’s
exercise of an inter vivos power of appointment under an existing trust.
Resident Trustee or Qualified Trustee
The trustee is typically an independent individual, bank, or trust company
resident in the state. Some states (e.g., Delaware) permit an out-of-state
co-trustee. The grantor may not serve as the trustee, but may serve as an
investment advisor and may reserve a veto power over distributions.
The trustee must maintain custody of some or all of the trust corpus, must
maintain trust records, prepare fiduciary income tax returns, or materially
participate in the administration of the trust.
Trust Protector
Many APT’s typically have a trust protector, a fiduciary who may veto
distributions and investments or remove and replace the trustee. The trust
protector adds an additional tier of checks and balances in the management of
the APT.
Incorporation of State Law
The trust instrument must expressly incorporate that state’s law to govern the
trust’s validity, construction, and administration. In Delaware, for example,
any claim involving a Delaware APT can only be brought in that state’s court.
Spendthrift Clause
The trust instrument must include a spendthrift provision prohibiting the
attachment or assignment of any beneficiary’s interest in the trust.
Grantor’s Retained Interests
The typical APT permits the grantor to retain the following defined interests:
- Discretionary distributions of income and/or principal
- Veto power over distributions
- Special testamentary power of appointment
However, the Delaware Act permits the following additional retained interests:
- Mandatory right to trust income
- Income or principal from a CRUT or CRAT
- Unitrust distribution (up to 5%)
- Receipt of principal at the trustee’s sole discretion or pursuant to an
ascertainable standard
- Right to remove the trustee or investment advisor
- Right to serve as an investment advisor
- Use of real property under a QPRT
- Not limited to individuals—corporations and partnerships may create an APT.
Tail Periods
There are certain “tail periods” that begin to run upon the grantor’s transfer
of assets to the APT. At the expiration of the tail period, the enforcement of
nearly all future creditors’ claims is barred. Claimants who bring suit within
the relevant tail period must prove the existence of a “fraudulent transfer.”
Most APT statutes provide that future creditors (those whose claims arise after
the trust was created) must bring their claim within 4 years from the date of
transfer to the trust. Existing creditors (those whose claims arose before the
trust was created) must bring their claim within the later of 4 years from the
date of transfer to the trust or 1 year after the creditor discovered (or should
have discovered) the existence of the trust.
Fraudulent Transfer
A creditor who brings a claim within the relevant tail period must prove that
the transfer to the APT was a “fraudulent transfer.” Fraudulent transfer or
fraudulent conveyance provisions exist under both the federal Bankruptcy Code
and state law. Most states have adopted a version of the Uniform Fraudulent
Transfers Act.
An existing creditor may establish a fraudulent transfer if the grantor made the
transfer without receiving reasonably equivalent value in exchange for the
transfer; and the grantor was insolvent at the time (or the grantor became
insolvent as a result of the transfer).
A future creditor may establish a fraudulent transfer if the grantor made the
transfer:
(1) With the actual intent to defraud any creditor; or
(2) Without receiving reasonably equivalent value in exchange for the transfer;
and the grantor:
(a) was engaged in a transaction for which his remaining assets were
unreasonably small in relation to the transaction; or
(b) intended to incur (or believed he would incur) debts beyond his ability to
pay as they became due.
The first test is a subjective “badges of fraud” test. Relevant lines of inquiry
include whether the grantor has been sued or threatened with suit, whether the
grantor effectively retained control over the assets, whether the grantor
transferred substantially all assets to the APT, and whether the transfer to the
APT occurred shortly before or after the grantor incurred a substantial debt.
The essence of this test is whether the grantor could reasonably have
anticipated the future creditor’s claim upon funding the APT.
The second test is a more objective test which calls for an examination of the
sufficiency of the grantor’s assets in light of the circumstances at the time of
the transfer.
If a creditor successfully challenges a transfer to an APT as a fraudulent
transfer, the creditor can recover its debt, plus any costs and attorneys’ fees
allowed by the court. The existence of a fraudulent transfer as to one creditor
will not inevitably invalidate the trust for all creditors. Each creditor must
demonstrate as to its own particular circumstances that a transfer was
fraudulent.
Exempt Creditors
For public policy reasons, two classes of creditors enjoy special status (except
in Nevada and Utah) and are exempt from the provisions of APT statutes: (1)
spouses and children and (2) existing tort claimants. These creditors may reach
trust assets without regard to any tail period and without having to prove the
existence of a fraudulent transfer.
Trust assets will not be protected against child support claims or claims for
alimony or marital property asserted by one who was married to the grantor at or
before the time of the transfer to the trust. Since one does not acquire the
status of “spouse” under this exemption if the grantor’s transfer pre-dates the
marriage, an APT is a discreet alternative to a pre-nuptial agreement.
APT statutes do not insulate trust property from tort claimants (death, personal
injury, or property damage) on or before the date of the transfer to the trust
where the injury is caused (in whole or in part) by an act or omission of the
grantor or by someone for whom the grantor is vicariously liable
Efficacy of Domestic APT’s
Although domestic APT’s are becoming an increasingly common asset protection
device, their effectiveness has not been thoroughly tested in US courts. APT's
may be vulnerable to being set aside in bankruptcy court or in accordance with
an out-of-state judgment. In the real world, however, plaintiffs must weigh the
heavy costs of litigation against the likelihood of successful recovery.
Bankruptcy Court
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the
“Bankruptcy Act”) was signed into law on April 20, 2005 by President Bush and is
slated to go into effect on October 17, 2005. The fraudulent transfer
provisions, however, are effective immediately.
Prior to this legislation, bankruptcy laws were silent as to the treatment of
self-settled trusts. Under the prior laws, APT's were vulnerable to challenge by
a bankruptcy court under Supremacy Clause of the US Constitution (which states
that federal law supersedes state law). However, the new Bankruptcy Act sets
limits and standards on its reach over APT's through the “Talent Amendment”
which leaves APT's largely intact.
The Talent Amendment provides that a bankruptcy court may set aside certain
transfers to “self-settled trusts or similar devices” made within ten years of
filing a bankruptcy petition. A claimant seeking to challenge an APT bears the
burden of proving that the debtor made the transfer with the intent to hide,
delay, or defraud creditors. In essence, the Bankruptcy Act effectively extends
the applicable tail-period of state law to ten years if the grantor declares
bankruptcy.
The Talent Amendment was approved by the Senate in lieu of the Schumer
Amendment, which sought to remove the intent requirement described above. The
Schumer Amendment would have set aside all transfers to an APT within ten years
of filing for bankruptcy, regardless of fraudulent intent. Thus, the Talent
Amendment may be viewed as tacit congressional acceptance on the validity of
self-settled trusts, absent fraud.
Full Faith & Credit
The Full Faith and Credit Clause of the U.S. Constitution requires courts of
each state to recognize judgments rendered by courts of another state. As long
as the rendering court has proper jurisdiction and the judgment was not
fraudulent, the other state court must recognize it and give it the full effect
that such judgment would have had if rendered by the such state’s own court.
Jurisdiction
A judgment creditor must proceed in a state court that has jurisdiction over
some aspect of the trust (this does not necessarily mean the state in which the
APT was settled). The creditor will either have personal jurisdiction over the
trustee, grantor, or beneficiaries; or in rem jurisdiction over trust assets.
There are several ways to obtain personal jurisdiction over a trustee, grantor,
or beneficiary:
- Domicile. Individuals are always subject to jurisdiction of courts within
their domiciles.
- Long-Arm. Long-arm jurisdiction arises if the trustee or grantor has
sufficient contacts with the forum state.
- Corporations. Corporations are subject to jurisdiction of courts in their
state of incorporation and any state in which they conduct business.
There are also several ways to obtain in rem jurisdiction over the trust assets.
State courts have jurisdiction over all property within the state’s borders,
including real property, bank and brokerage accounts, and shares of stock of
corporations incorporated in that state. If a trust holds stock in many
different corporations, its property may be subject to the jurisdiction of
several states’ courts.
Enforcement of Judgment
If a creditor has successfully obtained a judgment from another state’s court,
it must find a way to have it enforced against the assets of the APT. If the
other state court’s jurisdiction is based on the situs of trust assets, that
court could compel the surrender of assets by court order (attachment,
garnishment, etc.), forcing the party in possession to convey the assets to the
creditor.
If the court’s jurisdiction is over the trustee or the grantor, but not over the
assets, the court might issue an order against the trustee or the grantor.
Otherwise, the creditor must seek enforcement of the judgment in the state where
the trust assets are located. This judgment should be enforced under the Full
Faith & Credit Clause and should authorize the turnover of trust assets located
in that state.
Integration with Other Planning
An APT is not a stand-alone device. Rather, asset protection is part of an
overall wealth preservation and management process that includes investment
advice, insurance planning, income tax planning, estate planning, and wealth
protection.
Candidates for APT's include professionals; individuals exposed to lawsuits
arising from negligence, intentional torts, and contractual claims; officers,
directors, and fiduciaries; and real estate owners with exposure to
environmental claims.
II. Tax Consequences Relating to APT’s
Federal Income Tax Treatment
If the grantor of an APT retains the right to receive discretionary income and
principal distributions, the trust will be a grantor trust. Grantor trusts are
disregarded entities and all trust income, whether or not received by the
grantor, is taxed to the grantor. However, if distributions to the grantor must
be approved by an adverse party, it could be a non-grantor trust, insulating the
grantor from tax liability. PLR 200247013.
Gift Tax
A transfer to an irrevocable trust is not automatically a completed gift. If the
donor retains certain limited powers of appointment, completed gift status can
be avoided. PLR 200148028. A transfer to an APT is a completed gift if the
grantor surrenders control over assets. However, the inability of grantor’s
creditors to reach assets negates retained control. PLR 9837007.
Escaping Income Tax and Gift Tax.
Two private letter rulings permit the grantor to escape both income tax and gift
tax. In these rulings, the grantor was not deemed the owner of the trust due to
the existence of adverse parties who exercised discretion in making
distributions, protecting him from income taxation. The same rulings further
held that the grantor did not make completed gifts to an irrevocable trust, due
to the retention of a limited testamentary power of appointment. PLR’s 200148028
and 200247013
Estate Tax
Inclusion of the trust assets in the gross estate depends on the degree of
control the grantor retains in the trust. A discretionary receipt of income or
principal is not a retained interest in the trust, absent an understanding with
the trustee, whereas other retained interests would compel inclusion in gross
estate. §2036(a). The inability of creditors to reach trust assets negates the
implied ability to revoke or terminate the trust. §2038(a).
III. Attorney Protocol for Establishing APT’s
Due to ethical constraints, as well as the potential for civil or even criminal
liability under certain circumstances, attorneys must be prudent in accepting
and counseling clients. Precautionary measures should consist of client
investigation, due diligence, and a solvency analysis. It is imperative that the
attorney be fully aware of the client’s financial and legal situation, which
should be independently verified through due diligence procedures to uncover any
existing, foreseeable, or threatened claims. Due diligence involves an objective
investigation of the client’s finances, business, legal, and other relevant
information.
The attorney should also perform an analysis of the client’s financial solvency.
This analysis begins by listing all of the client’s assets, subtracting all
debts, liabilities, and claims, and subtracting assets that are already
protected from creditors’ claims under federal or state law (e.g., homestead,
qualified retirement plans, insurance, and annuities). The result is the
client’s net worth available for asset protection planning.
There is no magic number or safe harbor percentage in the amount of assets that
are transferred to the trust. However, the more that the amount transferred
reduces the client’s remaining solvency, the greater the likelihood of scrutiny.
Many commentators and practitioners recommend transferring less than one-third
(1/3) of the grantor’s net worth (as calculated above). The factors to consider
include the dollar-amount of assets transferred, the nature of the client’s
business and professional activities, the potential source of any claims, and
any additional asset protection planning tools available to the client. The goal
should be to leave sufficient wealth for existing and foreseeable creditors.
Providing adequate reserves for such claimants diminishes the odds of a
successful fraudulent transfer assertion.
Without the benefit of hindsight, it is impossible to determine what will be
deemed an appropriate level of due diligence. Such determination will depend
upon the specific facts and circumstances involved. However, the potential
consequences of a failure to conduct sufficient due diligence in planning an
asset protection trust warrants an abundance of caution.
For more information, contact J. Alan Jensen or Janene Sohng via e-mail at
alan.jensen@hklaw.com and
janene.sohng@hklaw.com, respectively, or toll free at 1-888-688-8500.
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1. Nevada and Alaska have slightly different tail periods.
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