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Domestic Asset Protection Trusts: Do They Work?

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Estates, Gifts and Trusts Journal; BNA Tax Management

Howard Rosen, Esq. and Patricia Donlevy-Rosen, Esq.

September, 1998

INTRODUCTION

Many seminars and articles of late have introduced and discussed the concept of domestic asset protection trusts. This is primarily a result of “protective” trust legislation enacted in 1997 by Alaska(1) and Delaware(2) (Missouri(3) has also enacted such legislation, but has not promoted it as have Alaska and Delaware).

The Alaska Act, effective April 2, 1997, was designed to allow an individual to create an Alaska trust from which he or she is eligible to receive discretionary distributions without exposing the trust to claims of creditors of the settlor (with certain exceptions). The new legislation also attempts to enable an individual to make completed gifts to the trust for estate tax purposes. These completed gifts to the trust would be removed from the individual’s estate; however, the legislation permits the individual to remain as an eligible/discretionary beneficiary of the trust’s assets. It also repeals the rule against perpetuities with resect to Alaska trusts.(4)

The Delaware Qualified Dispositions in Trust Act,(5) effective July 9, 1997, states in its Synopsis that it was enacted “to facilitate the establishment in Delaware of irrevocable trusts that will allow trust settlors to transfer assets from their estates, in order to reduce the federal estate taxes that would otherwise be due upon their death.”

In passing these acts Alaska and Delaware were seeking to help their local banks and trust companies capture some of the trust business which has been otherwise going to offshore trust companies, as Americans seek to protect themselves from litigation and/or obtain certain federal estate tax benefits. This article will not focus on the tax rules, but rather on just what the title indicates – do domestic asset protection trusts work?

BACKGROUND

Let’s review the background of asset protection under U.S. trust law in general before we proceed.

Trusts have been used since the Crusades to protect assets.(6) Over the past several hundred years, a public policy inspired erosion of that tradition has occurred. For example: Under the general rule, if a settlor retains extensive powers or controls over a trust, that could be held to show that the trust was invalid from its inception, because the trustee is supposed to be in control, not the settlor. If the trust were found to be invalid, a creditor could reach the trust assets because the assets would be deemed never to have been transferred to the trust (that is, they still belong to the settlor).

Another aspect of general U.S. trust law is that a person cannot establish a spendthrift trust(7) for his or her own benefit and obtain any asset protection benefits from the spendthrift aspect of the trust.(8)

Finally, under general U.S. trust law, the settlor’s creditor can reach trust assets to the extent of the maximum property interest potentially available to the settlor/beneficiary under the trust.(9) Thus, if the settlor were one of several discretionary income and principal beneficiaries, the settlor’s creditor would be able to reach the entire trust, since that would equate to the maximum property interest potentially available to the settlor.(10)

These weaknesses, or erosions, in U.S. trust law result in the tax rule that if a settlor transfers assets to a trust under which he or she is a beneficiary, and his or her creditors can still reach the assets because of applicable law or otherwise, then the transfer is incomplete for federal estate and gift tax purposes,(11) and the entire value of the trust will be included in the settlor’s gross estate.(12) To the contrary, if the transfer were complete, (13) appreciation in trust assets occurring after the transfer would be excluded from taxation in the settlor’s estate(14), resulting in an “estate freeze”.

Having observed this trust law weakness, and seeking to obtain the estate freeze benefit, the legislatures of Alaska and Delaware enacted legislation in 1997, and the legislature of Missouri in 1989, which purportedly permits a settlor of a trust to be a discretionary beneficiary of a protective trust and have the transfer of assets into the trust treated as a completed transfer for federal estate and gift tax purposes.(15) Whether this goal can be obtained in the U.S. remains to be seen.

U.S. CONSTITUTIONAL ISSUES

Whenever domestic asset protection trusts are discussed, United States Constitutional issues arise. Specifically, the full faith and credit clause,(16) the supremacy clause,(17) and the contract clause(18) of the U.S. Constitution.

Under the full faith and credit clause, each state is required to recognize the judgments of the courts of the other states. Under the supremacy clause, the federal government and its laws are supreme to the extent they conflict with state laws. Under the contract clause, no state may pass a law which infringes on the ability of persons to contract with each other.

In arguing that the full faith and credit clause does not affect the ability of Alaskan trusts to protect assets, one alleged authority has stated that the trustee is not the same person as the settlor, and that therefore a judgment obtained against the settlor would not be enforceable against the trustee in Alaska (who is a different person than the settlor). While this is entirely true, its avoids the issue of how trust assets are actually reached by claimants. If a judgment were obtained against a settlor in Florida who had created an Alaska trust and the claimant was unable to collect that judgment, he or she would bring a post-judgment fraudulent transfer action and join the trustee in Alaska as a transferee (as any transferee would be joined over whom jurisdiction could be obtained). Once that joinder is accomplished, the Florida court would have jurisdiction over that trustee, and an order issued by the Florida court determining that the transfer into the trust was a fraudulent transfer, will, as a result of the full faith and credit clause, be enforceable in Alaska.

Let’s compare domestic and offshore asset protection trusts in light of the full faith and credit clause: a creditor holding a judgment in his favor from a U.S. court cannot hope to have the courts of the (properly selected) offshore jurisdiction enforce the U.S. judgment.(19) The creditor must commence a new action in the offshore jurisdiction, and utilize a lawyer admitted to practice before that court (not his U.S. lawyer). In most asset protection trust favorable jurisdictions, the foreign lawyer cannot accept such a case on a contingency fee basis — this means that the claimant must make a significant personal financial commitment before his case even gets off the ground. Assume that commitment is made. What’s next? A consideration of the legal basis for the creditor’s attack on the trust: if the trust situs jurisdiction has been carefully selected, its laws will preclude many conventional legal bases of attack, usually leaving as the only avenue of attack the argument that a fraudulent transfer was involved in establishing the trust. Here the creditor is faced with a nearly insurmountable burden of proof and a severely contracted statute of limitations (or no statute of limitations at all).(20) These hurdles in the legal obstacle course of attacking the offshore trust are not the end, however. If threatened in its original situs jurisdiction, the properly drafted offshore trust can move to another trust favorable jurisdiction — requiring the creditor to start his litigation all over again in the new jurisdiction. How does this offshore legal obstacle course compare with the protection afforded by domestic asset protection trusts? Let’s see: as discussed above, a creditor making a fraudulent transfer attack on the trust will be able to obtain jurisdiction over the domestic trustee, and, if successful, reach the trust assets in satisfaction of the claim. Protection? Remember, the foreign court will not enforce the U.S. judgment: compare foreign court “will not enforce” with the Alaska/Delaware courtrequired to enforce…you decide — do you want to roll the dice, or eliminate risk?

To date, there have not been any serious arguments that the supremacy clause of the United States Constitution would not take precedence over the Alaska or Delaware trust protection laws. The clause would apply, for example, where a federal bankruptcy court issued an order directing the trustee of an Alaskan trust to distribute assets to a creditor, even if contrary to Alaska law, the Alaskan trustee would nevertheless the required to obey that federal court order.(21)

The supremacy clause issue is non-existent with respect to an offshore jurisdiction.

The contract clause of the Constitution is somewhat more esoteric. The argument is essentially that no state can enact legislation infringing upon the ability of persons to contract with each other, and that the Alaska/Delaware legislation does just that, by protecting a party’s assets. Again, this issue would not obtain with respect to an offshore jurisdiction.

PRACTICAL CONSIDERATIONS

Let’s take a look at the practicalities, and compare establishing a trust (for example) in Alaska, with establishing a trust in the Cook Islands.

First, Alaska & Delaware are part of the United States, and as such they are subject to the full faith & credit clause of the United States Constitution. Thus, if jurisdiction is obtained over the trustee or assets in either state, the other state’s judgment will be enforced – period. Section 13D of the Cook Islands International Trusts Act 1984 specifically provides that foreign judgments are NOT ENFORCEABLE. This was illustrated in the above discussion.

Second, the Alaska and Delaware Trust Acts, due to either the political pressure of their local financial institutions, or a mistaken belief that nexus in the form of asset presence is necessary to constitute the trust as an Alaskan or Delaware trust, requires that some assets be physically located in Alaska(22) or Delaware(23), as the case may be. Both reasons lack merit for the individual settling the trust. If the reason is the former, then the legislature merely insured additional revenues to their local entities without an attendant benefit to the trust settlor, who may be forced to forgo investment opportunities offered by non-Alaska/Delaware institutions.

If the reason is the latter, the Alaskan/Delaware legislature should have looked at corporate law to see that this is not necessary. For example, one can establish a corporation in Delaware with nothing more than a registered office in that state, and there would be no question that the corporation is subject to Delaware law. Of course, if that corporation does business in another state it will have to comply with that state’s registration requirements, but its internal construction will be governed by Delaware law.

In the Cook Islands, there is no requirement that assets be located there, but merely that a Cook Islands trustee company be used and that the trust be registered as to its name and date. The assets may be located anywhere in the world. In the event of a problem, the assets should be located where their preservation is most secure – in an institution with no U.S. ties.

Now let’s look at how creditors attack a trust. The creditor will either argue that the trust is invalid because the settlor retained too many powers and controls, or the creditor will argue that transfers of assets into the trust were fraudulent transfers.

Neither Alaska nor Delaware has addressed the retained powers/controls issue, thus leaving that avenue of attack wide open. Similarly, neither state has adequately addressed the issue of fraudulent transfers.

In the Cook Islands, the retained powers/controls issue has been legislated away by Section 13C of the International Trusts Act 1984, with the result that a settlor can be a beneficiary of a trust (any type of beneficiary – Alaska and Delaware only permit the settlor to be a discretionary beneficiary)(24), retain the power to revoke the trust (without the consent of another party)(25), the power to amend the trust, and numerous other powers, without the retention of such beneficial interest or powers constituting an element in determining whether the trust is valid or invalid. In addition, the Cook Islands has enacted extensive fraudulent transfer legislation. Under Cook Islands law, if a settlor is solvent after making a transfer of assets into his or her trust, he or she is deemed not to have the requisite intent to establish a fraudulent transfer (essentially resulting in a “zero” statute of limitations), and no “subsequent” creditor has standing to bring a fraudulent transfer claim (as is the case under U.S. law). Compare this with a four-year statute of limitations in Alaska, and a potentially open-ended statute of limitations in those states which have adopted the Uniform Fraudulent Transfer Act (such as Florida).

Next, let’s consider the standard of proof required to establish a fraudulent transfer: the typical U.S. standard is the civil standard, proof by a “preponderance of the evidence”(26) or “clear and convincing”; in the Cook Islands, in order to establish a fraudulent transfer, the plaintiff must submit proof “beyond a reasonable doubt”.(27) As the reader knows, this is the standard of proof we use in United States to establish criminal responsibility. As if that standard of proof were not enough of a deterrent, Cook Islands legislation has eliminated from consideration by the court many of the factors which, under U.S. law, would tend to indicate fraudulent transfer intent on the settlor’s part.(28)

Finally, let’s discuss the practical issue of costs. Promoters of the Alaska and Delaware trusts tout that these trusts are less expensive to establish than an offshore trust. Of course, this depends upon the attorney engaged to prepare the trust document, but beyond that, the authors have never seen an instance where the trustee fees (a continuing cost) in Alaska and Delaware (typically charged on a percentage of asset value, with a minimum fee) were not at least twice as much as those charged by the Cook Islands trust companies (typically flat fees).

CONCLUSION

The forgoing discussion leaves one with but one conclusion: let someone else experiment with domestic asset protection trusts. There is no need to reinvent the wheel.

1. Alaska: The Alaska Trust Act, effective April 2, 1997, Alaska Laws, SLA 1997, Ch. 6 (H.B. 101)(which amended or added AS. §§13.12.205(2), 13.27.050(a), 13.36.035, 13.36.310, 13.36.390, 34.40.010, 34.40.110(a), 34.40.110); see also AS § 09-30-100 et. seq. (Uniform Foreign Money Judgments Recognition Act, 13 ULA 261, §3); §09-60-010; Ak. RCP 82 (costs, including attorneys fees, awarded to winner of civil lawsuits in Alaska courts).

2. Delaware: 12 DCA §§3570 – 3576 (1997) (the “Qualified Dispositions in Trust Act”), as amended in part by Sections 36 and 37 of the Banking and Financial Services Amendments Act of 1998, enacted March 30, 1998, effective for trusts becoming irrevocable after July 9, 1997; see also, 6 DCA §§1304, 1305, 1309.

3. Missouri: V.A.M.S. §§ 428.005-428.059, 456.020, 456.080 (1989).

4. Supra, note 1.

5. Supra, note 2.

6. Comment, Avisheh Avini, “The Origins of the Modern English Trust Revisited, 70 Tul. L. Rev. 1139 (Mar. 1996).

7. A “spendthrift trust” is a “(t)rust in which the interest of a beneficiary cannot be assigned by him or reached by his creditors.” Austin W. Scott & William Fratcher, The Law of Trusts, §151 (4th ed. 1987).

8. See Restatement (2d) Trusts §156 (1957); Austin W. Scott & William F. Fratcher, The Law of Trusts § 156 (Rev. 4th ed. 1989). Some states statutorily prohibit spendthrift protection to self-settled trusts: Ariz. Rev. Stat. Ann. §14-7705 (Supp. 1993); Cal. Prob. Code § 150304 (West 1991); Ga. Code Ann. § 53-12-28(c) (Supp. 1994); Ind. Code Ann. § 30-4-3-2 (West 1994); Kan. Stat. Ann, §33-101 (1986); La. Rev. Stat. Ann.§2004(2) (West Supp. 1994); Mo. Ann. Stat. § 456.080.3(2) (Supp. 1994); Mont. Code Ann. § 72-33-305 (1993); N.Y. Civ. Prac. L. & R. § 5205(c)(Consol. Supp. 1993); Okla. Stat. Ann. tit. 60, §175.25G (West 1994); R.I. Gen. Laws § 18-9.1-1 (1988); Tex. Prop. Code Ann. §112.035(d)(1984); Va. Code Ann. §55-19(C) (Michie Supp. 1994); W. Va. Code §36-1-18 (1985); Wis. Stat. Ann. §701.06(1)(West 1981 & Supp. 1993).

9. Restatement (2d) Trusts §156(2); Rosen, 810 T.M., Asset Protection Planning, A-15; In re Robbins, 826 F.2d 293 (4th Cir. 1987).

10. Restatement (2d) of Trusts §156. See also, Ariz. Rev. Stat. Ann. § 14-7705(B) (Supp. 1993); Cal. Prob. Code §15304 (West 1991);Va. Code Ann. §55-19(C)(Michie Supp. 1994).

11. Rev. Rul. 77-378, 1977-2 CB 347. The settlor transferred one-half of his income-producing assets to an irrevocable trust with a corporate trustee, who was directed to accumulate income and add it to principal during the settlor’s lifetime. At the settlor’s death, the trust assets were to be distributed to the settlor’s family. Because the trustee had absolute and uncontrolled discretion to pay income or principal to the settlor during his lifetime, the IRS ruled that the transfer was an incomplete transfer for gift tax proposes, relying on Paolozzi v. Commissioner, 22 T.C. 182 (1954) and Herzog v. Commissioner, 116 F.2d 591 (2d Cir. 1941). NOTE, Form 709 (United States Gift Tax Return), to be filed reflecting an incomplete gift. Treas. Reg. §§25.2511, 25.2514.

12. Estate of Paxton v. Commissioner, 86 T.C. 785 (1986), where a trust was includable in the settlor’s gross estate because, as a result of an express or implied understanding between the settlor and the trustee that the trustee would distribute income or principal at the settlor’s request, the settlor’s creditors could compel distributions. Vander Weele v. Commissioner, 27 T.C. 340 (1956), acq. Rev. Rul. 62-13, 1962-1 C.B. 181., where a transfer to an irrevocable Michigan trust was held to be incomplete for gift and estate tax purposes where the trustees were authorized to pay the settlor as much of the principal and income as they deemed appropriate for his comfort, and thus the future and current creditors of the settlor could reach the trust assets.

13. Reg. §25.2511-2(b), provides that a completed gift is made when the transferor parts with dominion and control over the property that is the subject of a disposition. Rev. Rul. 76-103, 1976-1 CB 29, where the settlor created an irrevocable trust for his own benefit and that of his family, and the trustee had absolute discretion to distribute income to the settlor and to change the trust situs. Ancillary facts showed that the trust was primarily created for the benefit of the settlor. The IRS ruled that, if a trust is formed in “a state where the [settlor’s] creditors cannot reach the trust assets, then the gift is complete for Federal gift tax purposes…” Note, when a completed gift is made, there may be gift tax consequences. Code § 2702; Rev. Rul. 76-491, 1976-2 CB 301, ruled that a gift to a trust that allows the trustee to make distributions to the settlor is a taxable gift of the entire gift.

[Absent an overriding Crummey power, a gift to a trust which permits the trustee to make discretionary distributions to the settlor or another beneficiary does not qualify for the gift tax annual exclusion, because the donee has no present interest. Code §2503(c); Reg. §25-2503-3(a); Rev. Rul. 73-405, 1973-2 C.B. 321 (However, transfers will qualify for gift tax annual exclusion where certain transferees are permitted by the trust to withdraw property transferred to it up to the amount of the annual exclusions not used elsewhere).]

14. Ltr. Rul. 9332006 (not a precedent). The settlor transferred assets to an offshore trust of which he was one of the discretionary beneficiaries. The IRS ruled, relying on Rev. Rul. 76-103, that the transfer was a completed gift and would not be included in the settlor’s gross estate for Federal estate tax proposes because, under the law governing the trust, the settlor’s creditors could not reach the trust assets.

15. That is, the settlor’s creditors purportedly cannot reach trust assets.

16. U.S. Const., Art. IV, §1.

17. U.S. Const., Art. VI, §2.

18. U.S. Const. Art. I, §10.

19. The full faith and credit clause applies between the states. Between countries there is sometimes comity: an agreement to recognize a judgment of another country’s courts. Negating any possibility of comity some offshore jurisdictions have enacted specific legislation either giving offshore trusts immunity from foreign (including U.S.) judgments, or rendering judgments unenforceable if based upon laws inconsistent with the trust law of the jurisdiction, or if the judgment relates to matters governed by its laws (such as fraudulent transfers, property rights arising from marriage, heirship or bankruptcy). Jurisdictions with such legislation include Anguilla, the Cook Islands, Nevis, St. Kitts, and St. Vincent and the Grenadines. Offshore jurisdictions lacking such legislation, such as the British Virgin Islands, Gibraltar, Guernsey, Jersey, Isle of Mann, Liechtenstein, are generally not used by prudent advisors for asset protection purposes.

20. Statutes of limitations shorter than those available under U.S. law, and a “beyond a reasonable doubt” burden on the creditor to prove “actual intent” to commit a fraudulent transfer, are statutorily provided in the Cook Islands, Mauritius, Nevis, St. Kitts (“beyond a doubt”), and St. Vincent (Cook Islands: International Trusts Act 1984 (as amended 1985, 1989, 1991, 1995-96), §§13B and 13K; Mauritius: Offshore Trusts Act, 1992, §10); Nevis: Nevis International Exempt Trust Ordinance, 1994, §§24 and 49; St. Kitts: St. Christopher and Nevis Trusts Act, 1996-23, §21; St. Vincent: International Trusts Act, 1996, §§45 and 46); compare with the lesser burden provided by Bermuda law where the creditor needs to prove only “on a balance of probability” (Bermuda: Conveyancing Amendment Act, 1984, §36C).

21. Note, in Missouri, a local bankruptcy court declared that the statute providing for asset protection trusts did not change the “existing” rule prohibiting self-settled creditor protection trusts. In re Enfield, 133 B.R. 515 (Bankr. E.D. Mo. 1991). Thus, at least in a Missouri bankruptcy, the domestic asset protection trust would appear to offer no protection against the settlor’s creditors.

22. AS §13.36.035(c)(1)(1997);

23. 12 D.C.A. tit.12 §3570(8)(1997).

24. AS §34.40.110; DCA §3571

25. Alaska requires “the consent of a person who has a substantial beneficial interest in the trust” which “would be adversely affected by the exercise of the power…” AS §34.40.110. Delaware does not provide any means for the settlor to revoke the trust.

26. Gabaig v. Gabaig, 717 P.2d 835 (Alaska 1986).

27. §13B(1) International Trusts Act 1984, as amended.

28. §13B(5) International Trusts Act 1984, as amended.

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