Lawgic

The Use and Abuse of Domestic Asset Protection Trusts

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:

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

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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