For the past several years asset protection has been one of the fastest growing areas of law. It is also one of the most controversial – the goal of asset protection is to shield assets from the reach of creditors. Asset protection planning is premised on the creditor’s ability to collect. After all, if the creditor has no right or power to collect on a judgment, there is no need for protective planning. Simply put, asset protection is about structuring the ownership of one’s assets to safeguard them from potential future risks. Asset protection structures can be domestic, international or a combination of both. Domestic asset protection commonly uses business and estate planning tools such as limited liability companies, family limited partnerships, trusts and the like. Properly implemented asset protection planning does not hide assets or serve as a means to evade U. S. income taxes.
The goal of all asset protection planning is to insulate assets from claims of creditors without concealment or tax evasion. It is usually impossible to completely and absolutely protect assets, and the focus is on making assets more difficult and more expensive to reach. All asset protection planning is based on the following two premises: (1) creditors can generally reach any asset owned by a debtor; and (2) creditors cannot reach those assets that the debtor does not own. When working within the context of the first premise, the goal is to make it more difficult and more expensive for a creditor to reach the debtor’s assets. This may include encumbering assets, converting assets from non-exempt to exempt, substituting assets or transferring ownership to legal entities. Working within the second premise, the goal is to fit within its parameters, but without any detriment to the client-debtor. Generally, this means that as the end-result of the planning the debtor should not own any assets, but should retain their beneficial enjoyment and some degree of control.
B. Use of Domestic Trusts in Asset Protection
Continuing with the second premise, debtors strive to achieve two incompatible goals – (i) they want to possess the beneficial enjoyment or control of their assets, whether through direct ownership or otherwise, and (ii) they also want to distance themselves from the ownership and control over the assets, to make such assets inaccessible to creditors. In this obvious dichotomy, trusts come to the rescue by splitting the beneficial enjoyment of trust assets from their legal ownership.
The beneficiaries of a trust are the beneficial owners of the assets holding equitable interests, but they do not hold legal title to the assets. The legal title is vested in the trustee of the trust. The trustee of a trust thus stands in the position of a fiduciary to the beneficiaries. The trustee holds title to the trust assets for the benefit of the
beneficiaries and has to administer the trust for the benefit of the beneficiaries and no one else.
A creditor’s ability to satisfy a judgment against a beneficiary’s interest in a trust is limited to the beneficiary’s interest in such trust. Consequently, the common goal of asset protection trusts is to limit the interests of beneficiaries in such a way so as to preclude creditors from collecting against trust assets. Although trusts are widely used in asset protection not all types of trusts are effective asset protection devices. However, a properly drafted and structured trust may be an almost impregnable form of asset protection.
The most commonly drafted trust is the revocable inter-vivos trust (the so-called “living trust”). Living trusts can protect non-settlor beneficiaries from claims of creditors to the same extent as irrevocable trusts. However, if the debtor is a settlor (“creator”) of the trust, the living trust will not provide the settlor-debtor with any measurable degree of asset protection, because and to the extent of the settlor’s power to revoke. Consequently, any trust created to protect the assets of a settlor must be irrevocable.
If the settlor of a trust is also a beneficiary of a trust, then the assets that the settlor has retained a benefit in will not be protected by the trust’s spendthrift clause.This is known as a prohibition against “self-settled” trusts. The settlor does not need to be either the sole settlor or the only beneficiary of the trust. As long as the settlor is a beneficiary of the trust to any extent, to that extent the trust will be deemed self-settled.
Example: Husband and wife establish a trust for their own benefit, and contribute their community property. The trust will be self-settled as to each spouse.
Example: John settles a trust for the benefit of his children, but retains for himself the right to income for life. To the extent of John’s retained lifetime income interest, the trust is self-settled. The remainder interest for the benefit of children is not self-settled, as the children-beneficiaries were not settlors.
If a trust is self-settled that means only that the interest of the settlor-beneficiary is not protected from creditors. It does not mean that the trust is invalid, that other beneficiaries are unprotected or that the trust does not offer other benefits. In the above example, the trust is self-settled only as to John, and not as to his children.
The prohibition against self-settled trusts in California is well-settled. In DiMaria v. Bank of California Natl. Assoc., the settlor-beneficiary of a trust retained the right to the income for life and to invade principal if income was insufficient for her support, with remainder interest given to her children. The trustee was required to make distributions pursuant to an ascertainable standard. The settlor could not revoke the trust. The court held that only “the income and the additional corpus required for her support and obtainable by her from the trustee” is subject to creditor claims. The rest of the corpus, including the remainder interest were not for the benefit of the settlor-beneficiary, and thus not self-settled (and therefore not reachable by the settlor’s creditors).
A properly drafted trust, incorporating the pointers from the discussion above, may be an insurmountable obstacle to creditors; provided that the trust is for the benefit of a third party beneficiary. Most asset protection clients are looking to protect their own assets. Consequently, the majority of domestic asset protection trusts are self-settled. Because California strips the spendthrift protection of a self-settled trust, practitioners must look to other jurisdictions. Several U. S. jurisdictions now allow self-settled trusts to afford their settlors the protection of the spendthrift clause. Alaska was the first jurisdiction to enact such laws in 1997 and was shortly followed by Delaware, Nevada and a few others.
1. Domestic Asset Protection Trusts
While California, like most jurisdictions, strips the spendthrift protection of a trust when it is self-settled, certain jurisdictions no longer conform to this rule. These jurisdictions include certain U.S. states, like Delaware, Alaska and Nevada. Forming an irrevocable trust in one of these jurisdictions may be another way to preserve the protection of the spendthrift clause of a self-settled trust. All of these domestic self-settled asset protection trusts shall be referred to as “DAPTs.”
Using Delaware as sample DAPT jurisdiction, a Delaware DAPT must comply with the following requirements: (i) the trust must be irrevocable and spendthrift; (ii) at least one Delaware resident trustee must be appointed; (iii) some administration of the trust must be conducted in Delaware; and (iv) the settlor cannot act as a trustee. The DAPT jurisdictions appear to be a simple solution for a settlor of a self-settled trust seeking asset protection if the settlor is a resident of a DAPT jurisdiction and has assets in the jurisdiction. California residents with California assets may not be able to reap the asset protection benefits of these trusts.
2. Qualified Personal Residence Trusts
The Qualified Personal Residence Trust (“QPRT”) is a statutory trust created by the U.S. Congress back in 1989 and provides a means for significantly reducing the estate tax consequences of the family home and one vacation home. The QPRT also provides an excellent asset protection vehicle since it is an exception to the self-settled rule: you no longer own the property once the trust is established.
An individual creates a QPRT by transferring his residence and/or vacation home to an irrevocable trust (usually for the benefit of family members) but retaining the right to use the residence rent-free for a specified period of time. The tax savings occur only if the grantor of the trust survives the period of his or her retained interest.
Upon the transfer of the residence to the trust, the settlor is regarded as making a present gift of only the "remainder" interest in the trust. The attractiveness of the QPRT results from the favorable gift tax valuation rules that apply to remainder interests. This value as determined by the IRS's actuarial tables is the fair market value of the residence (less its mortgage) less the actuarial value of the term of years' interest retained by the settlor. If a trust other than a QPRT were used, the total value of the residence would be subject to tax, but with the QPRT, since there is a term estate attached to it, only the remainder interest is valued. This means a far lower value for estate tax purposes. Although the settlor must survive the period of his or her retained interest in order for the tax savings to be achieved, there is no gamble involved. If he or she fails to survive the retained interest period, the full value of the residence will be taxed, but that is the same valuation if the residence had never been transferred to the QPRT. There is no penalty. Also, the settlor may continue to occupy the residence once he has survived the retained interest period, but he must pay rent in order to avoid inclusion of the residence in his estate. There are a number of advantages of the Qualified Personal Residence Trust:
a. Many people implement Qualified Personal Residence Trusts to greatly reduce gift or estate taxes that would otherwise be imposed upon the full value of their residence. The QPRT provides a painless way to make significant gifts to children and grandchildren. Even though the gift is made currently, the owner retains the right to continue to use the residence well into the future. There are very few planning strategies remaining that provide this combination of benefits.
b. The settlor's creditors cannot take the property because it is no longer owned by the settlor. The remainder beneficiaries’ creditors cannot take the property because it is not theirs until the end of the trust term. The property is therefore fully insulated from adverse takings.
c. All appreciation from the property flows to the beneficiaries, not to the settlor's estate.
C. Use of International Trusts in Asset Protection
The term “International Trust” usually means a trust that states that it shall be interpreted under the laws of a foreign jurisdiction. This means that the laws of the foreign jurisdiction will apply to the trust and the enforceability of the trust’s spendthrift clause. This difference has a number of key advantages:
1. All foreign jurisdictions that compete in the asset protection market allow self-settled trusts to be an effective shield against creditors. This is similar to the domestic DAPT jurisdictions that have now gone the same route. However, foreign trusts are not subject to the Full Faith and Credit clause or the Supremacy Clause. This means that with a foreign trust there is never any doubt that the favorable law of the foreign jurisdiction will be applied to the trust, and there is also no doubt that the foreign jurisdiction does not have to enforce any judgment coming out of the United States (state or federal).
2. The foreign asset protection jurisdictions provide that the creditor has the burden of proving a fraudulent conveyance. More importantly, the creditor’s burden of proof is the higher standard of “beyond a reasonable doubt” (as opposed to a “preponderance of the evidence”).
3. In foreign jurisdictions the statute of limitations on bringing a fraudulent conveyance action is not only short, but it also begins running on the date of the transfer, not the date the transfer is “discovered.”
4. Finally, while not a legal deterrent, the costs associated with challenging an international trust may prove to be an insurmountable obstacle to most creditors.
The assets of an international trust need to be located offshore only when the creditor commences its collection actions against the debtor-settlor. Until such time when the settlor becomes a judgment debtor, the trustee can hold trust assets in the U.S. For fraudulent transfer purposes, the relevant testing date is the settlement of the trust. Where the trust holds its assets, or what those assets are, is irrelevant in the fraudulent transfer analysis. However, because the assets may need to be moved offshore quickly, there is a strong preference for using international trusts to hold liquid assets.