Written by Paul Deloughery, J.D., August 2019.
The Quick Answer is “yes.” Asset Protection Trusts are legal in the 18 U.S. states (and various foreign jurisdictions) that permit them. But I still don’t recommend using them. Here’s a quick summary of APTs:
|1.||Are Asset Protection Trusts supported by any federal statute?||No.|
|2.||Are they supported by state statutes?||As of July 1, 2019, there are 18 states that allow Asset Protection Trusts.|
|3.||Are they supported by state case law?||Not really. There is one questionable case that supports offshore APTs. [LINK] There are ZERO cases upholding Domestic APTs. The recent case of Toni 1 Trust v. Wacker made it clear that a
DAPT will not protect assets against your creditors in non-DAPT states.
|4.||Do they protect assets in a bankruptcy?||No.|
|5.||Other considerations?||They generally are against public policy. Asset Protection Trusts are created pursuant to statutes that specifically refer to the purpose being “asset protection.” This makes it easier for a creditor to argue that you engaged in a fraudulent transfer, and for a court to order you to return the assets.|
An Asset Protection Trust is a trust that you set up for yourself with the intention of protecting your assets from your creditors. (In legal jargon, it’s called a self-settled spendthrift trust.) So how does this supposedly work? Let’s start from the basics and then work our way from there.
1. What’s a trust?
A trust is a legal arrangement whereby you transfer something to another person to hold for the benefit of a beneficiary. A short example will help illustrate this.
Imagine you get a job in Europe. You’re not married, but you have an 18-year-old son who you want to be able to live in your house. The problem is that your son is irresponsible, and you don’t trust that he’ll take care of your house, let alone pay for utilities and property taxes. So, you transfer the house plus some money to your good friend, Butch, with the agreement that he’ll use the money to take care of the house for your son’s benefit. In this case, you were the Settlor (or Grantor or Creator) of the trust. Your son was the beneficiary. And your good friend, Butch, was the Trustee.
There could be many variations to this story. If, for example, you had all three roles (Settlor, Trustee and Beneficiary), and if you made sure you could make changes in the future, it would be like a “Living Trust” or a “Revocable Trust.” A main benefit of having a Revocable Trust is that you can name a successor trustee to take over in case you ever become incapacitated or passed away. However, a Revocable Trust does not protect you from your own creditors or bankruptcy.
2. What Is an Asset Protection Trust?
Simply put, it’s a trust created by a person for that person’s own benefit, and that by its terms is protected from the person’s creditors. Lawyers refer to this as a Self-Settled Spendthrift Trust. There are different versions that have varying degrees of effectiveness. Historically, it has been against public policy to be able to do this, so courts would not enforce them. However, as of July 1, 2019 there are 18 states that specifically permit the creation of Domestic Asset Protection Trusts. If the trust is created in a foreign country whose laws permit it, it is commonly called a Foreign Asset Protection Trust. Common countries in which U.S. citizens create APTs are the Cook Islands and Nevis.
Using the previous example, let’s say you decided not to take the job in Europe but wanted to protect the house from any future creditors, you could set up an Asset Protection Trust. You could do this by creating a document (a “trust”) that names you as the Settlor (or Grantor) AND the beneficiary, but names Butch as the trustee. That trust document could recite the law in one of the states that allows for the creation of Asset Protection Trusts, and you could say that it’s protected from any future creditors of yours.
3. But, is setting up an Asset Protection Trust “legal”?
Let’s divide this into two sub-questions. First, will the assets be safely protected if a creditor or the government tries to get a court order directing the trustee to turn over the assets to your creditors? And, second, do you face any legal liability for setting up an Asset Protection Trust? The next two sections will discuss these questions.
Will Your Assets Be Protected?
To answer this question, we need to next ask, “Protected where and in what context?”
1. In Domestic Asset Protection States.
As of July 1, 2019, the following 18 states have statutes that specifically allow Asset Protection Trusts: Alaska, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming. As of writing this article (in August 2019), there are NO COURT CASES confirming that a Domestic Asset Protection Trust (created in one of the DAPT states listed) actually works.
A DAPT “should” work, at least if you get sued in a state court in one of the 18 states in which you created your DAPT. And also assuming you funded the trust properly, and didn’t engage in a fraudulent transfer or other activity that could cause the court to disregard the trust. (Explained below.)
2. In a Non-DAPT State.
If you were to create a DAPT in one of the states that permit it, but you live in a non-DAPT state, you would be required to hire a trustee in the DAPT state. This would be a requirement of the DAPT state’s statute. The only court cases dealing with DAPTs have defeated the trusts. See In re Mortensen , (Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011), and Waldron v. Huber (In re Huber), 2013 WL 2154218 (Bk.W.D.Wa., Slip Copy, May 17, 2013. The most recent case of Toni 1 Trust v. Wacker illustrates that there isn’t even a viable theory as to how a DAPT would protect assets against the creditors of the settlor in a non-DAPT state.
3. In Bankruptcy.
DAPTs do not protect assets in a bankruptcy. U.S. Bankruptcy Code Section 548(e) provides:
(1) In addition to any transfer that the [bankruptcy] trustee may otherwise avoid, the [bankruptcy] trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if—
(A) such transfer was made to a self-settled trust or similar device;
(B) such transfer was by the debtor;
(C) the debtor is a beneficiary of such trust or similar device; and
(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted.
(2) For the purposes of this subsection, a transfer includes a transfer made in anticipation of any money judgment, settlement, civil penalty, equitable order, or criminal fine incurred by, or which the debtor believed would be incurred by—
(A) any violation of the securities laws (as defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47))), any State securities laws, or any regulation or order issued under Federal securities laws or State securities laws; or
(B) fraud, deceit, or manipulation in a fiduciary capacity or in connection with the purchase or sale of any security registered under section 12 or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78l and 78o(d)) or under section 6 of the Securities Act of 1933 (15 U.S.C. 77f).
That’s a lot of words. But basically, it means that if you transfer your assets to a Domestic Asset Protection Trust for the purpose of protecting your assets from current or future creditors within ten years of filing for bankruptcy, then the bankruptcy trustee can order the assets be turned over to the court and used to pay the debtor’s creditors.
At this point, you might be thinking, “Well, I never intend to file for bankruptcy. So, this doesn’t matter. I’ll move to a DAPT state and create a DAPT and I’ll be safe!” Yes, well ignorance is bliss until the truth slaps you in the face. And the truth is that your creditors can simply file an Involuntary Petition pursuant to 11 U.S. Code § 303.
And your final comeback would be: “Ok. I’ll create a DAPT and simply wait out the ten years!” Yes, it’s true that would work. But I personally wouldn’t feel very protected if I bought a new car, and the owner’s manual explained that the airbags would only begin working after 10 years. Or if I moved into a new house and the local fire department warned me that they would only come put out a fire if it occurred ten years or more in the future. We as consumers and citizens would never put up with those terms. However, that’s exactly what proponents of DAPTs say. Just get this DAPT, and it will completely protect you after ten years.
- Appearances. Creditor attorneys love finding trusts specifically created for asset protection for a number of reasons. First, it signals that the debtor has assets to protect. Second, both DAPTs and foreign APTs are asset protection trusts created under statutes that specifically refer to the purpose being “asset protection.” This makes it easier to argue that the debtor engaged in a fraudulent transfer since the purpose of the trust is clearly for asset protection.
- Confidentiality. Assets in DAPTs as well as assets in offshore trusts must be disclosed on a standard bankruptcy questionnaire; and failure to disclose can result in bankruptcy fraud and criminal penalties.
- Cost and Complexity. DAPTs must meet all the requirements of the DAPT statute. This includes having a qualified trustee in the DAPT state. Professional trustee fees and attorney fees add to the ongoing costs of a DAPT.Offshore trusts are even more expensive. First, they are notoriously expensive to create ($20,000 – $40,000+), and they require annual payments to a foreign trust company in the range of $5,000 to $10,000 per year. If you are a U.S. person and you have established a foreign Asset Protection Trust, your reporting responsibilities include:
- “Checking the box” on IRS Form 1040, Schedule B, Part III;
- IRS Form 3520
- IRS Form 8938;
- FinCEN Form 114 (the “FBAR”).
In addition, the foreign trustee must file IRS Form 3520-A and 1041, and if the Trustee does not file this form, then you must.
If you are a beneficiary of a foreign trust, and you receive a distribution from the foreign trust, then your reporting responsibilities include:
- “Checking the box” on IRS Form 1040, Schedule B, Part III;
- IRS Form 3520; and
- IRS Form 8938.
In addition, if you receive more than 50% of trust income or assets, you must also file FinCEN Form 114 (the “FBAR”), which requires you to disclose the exact location, account numbers, and the maximum dollar amount in each account each year. Failure to properly report offshore trusts and accounts can result in criminal penalties and severe civil penalties which can exceed the amount in the offshore accounts.
Alternative to APTs.
Luckily, there is an alternative to Asset Protection Trusts. Magellan Law is the proud provider of the Asset Vault Trust. This is a trust in which you are not a beneficiary and not the trustee, but you retain a special power of appointment to be able to transfer the assets to someone other than yourself (or your creditors) at a later date. In addition, a Trust Protector is a third party (usually your lawyer) who acts as an independent decision-maker and can make various changes to the trust and transfer the assets to you or someone else if that makes sense in the future.
The benefits of an Asset Vault Trust include:
- It is supported by statutes and court case law around the country. The trust is not a new school of thought nor is it based on foreign laws. We have carefully researched generations of legal precedent right here in the U.S. to find what has always worked and we design our trusts to be in compliance.
- It is a domestic irrevocable non-self-settled trust (non-DAPT) carefully designed to provide the best asset protection. Generations of legal precedent have made clear that the only type of trust that has withstood the test of time as a proven method of asset protection is a non-self-settled trust, aka a third party trust. This means that the settlor of the trust creates the trust for beneficiaries other than him or herself. For all the marketing that has gone into promoting self-settled trusts (DAPTs and Offshore Trusts), they have no wins when challenged in court. The only trusts that have withstood court challenges and Bankruptcies are non-self-settled trusts.
- It provides maximum flexibility. You need to understand something about the words “revocable” and “irrevocable.” The word “revocable” means that the thing (a phrase or document) can be revoked (cancelled) or changed. On the flip side, something that’s “irrevocable” cannot be revoked or changed. People often ask me whether a particular trust is “revocable” or “irrevocable,” and my answer is usually that it depends on what you’re talking about. A standard Living
Revocable Trust is (typically) revocable and amendable as long as the settlor (the person who initially created the trust) is alive and has mental capacity to make legal decisions. However, a trust called “Bob and Jane Smith’s Revocable Living Trust” could actually be partly irrevocable if either Bob or Jane is incapacitated or deceased. (I personally dislike including the word “Revocable” or “Irrevocable” in the title to a trust document, because it can often conflict with reality.) The Asset Vault Trust is partly revocable and partly irrevocable. The terms of the trust that cannot be amended by the settlor are (a) that the settlor cannot be a trustee or beneficiary (because that’s what’s required to provide asset protection), (b) that the settlor’s spouse cannot be trustee or beneficiary, and (c) that no creditor of the settlor or his/her spouse can be a trustee or beneficiary. The other terms of the trust can be changed/amended. In addition, there is a Trust Protector whose role is to oversee trust activities and make changes as needed (from replacing a bad trustee to virtually re-drafting the trust). Finally, the Asset Vault Trust includes a special power of appointment whereby you (the settlor) can transfer the trust assets to someone other than yourself (for instance, your spouse). You can think of the Asset Vault Trust like a tank that protects you from gun fire, but includes a hatch so you can always crawl out of it. It gives you maximum protection and maximum flexibility.
The first rule of asset protection is to avoid engaging in risky behavior. If you own a company with trucks driving around, make sure the drivers take regular drug and alcohol tests, and have ongoing safety training.
The second rule is to make sure you have adequate insurance. Though I often say that insurance is not a cure-all, [LINK] it is great when it provides coverage. Not only does it provide at least some coverage for specific risks and occurrences, but it will provide a legal defense attorney. Lawyers are expensive, and having an insurance company that’s obligated to pay for lawyer can take a huge burden off you. Also, umbrella insurance is relatively cheap and covers many things not otherwise covered by your other policies.
The third rule is to use your various business entities if you have them. This includes:
- Maintain corporate formalities. If you have a corporation, comply with your own Bylaws (which often state that you are required to hold and document annual meetings of the shareholders and directors).
- Sign documents in your official capacity. If you’re signing documents as trustee, sign “Joe Blow, Trustee of the XYZ Trust.” For a case discussing the importance of this, see the In Re Brooks case.
- Put assets in the proper entity, preferably as directed by your asset protection attorney. You can have the fanciest Limited Liability Limited Partnership, but if your $5 million stock portfolio is in your personal name, guess how much protection the limited partnership provides. (Hint: NONE.)
Finally, the fourth rule, after you have those first three aspects covered, is to create a well-conceived asset protection plan. Asset protection, done properly, is not a cookie cutter proposition. There is no single solution that fits every client. It involves integrated business, tax, estate and asset protection planning.
- Asset Protection vs. Taxes. What may seem like an amazing idea from the standpoint of asset protection planning (such as transfer your low-basis but highly appreciated real estate to a Family Limited Partnership) may be bad from a tax standpoint. In this case, your interest in the FLP may be subject to a valuation discount of, let’s say, 35%. As a result, at your death your heirs would only receive a 65% step up in basis rather than the 100% step up in basis they would otherwise receive.
- Asset Protection vs. Estate Planning. Also, it’s normally a good idea for your revocable trust to be the General Partner of your Family Limited Partnership. In that way, if you die or become incapacitated, the successor trustee of your trust can automatically take over, making for a smooth transition. However, what if your revocable trust says that your second wife (or second husband) becomes the trustee upon your death? That could create significant friction between your natural children and your spouse. Also, maybe your spouse has no idea how to manage a partnership.
- Estate Planning vs. the Real World. In August 2019, I tried to open a business account for an LLC that had a revocable trust as the member and manager. From an estate planning standpoint, this is ideal because there would be a smooth transition if anything happened to the member/manager. However, this literally froze the computer at Chase Bank, which didn’t know how to process this fact pattern. When I contacted alternate banks, they said that this arrangement posed problems in light of the U.S. Treasury Department’s customer due-diligence rule.
Don’t try this at home. Asset protection planning is complicated and is constantly changing. The chances are that any book or internet article on the subject is outdated.
Disclaimer: This article does not create an attorney-client relationship. The information on this website is of a general nature and is not intended as legal advice. Every person’s situation is different, and you need to consult with an attorney regarding your particular facts. Paul Deloughery is admitted to practice law in Arizona. He assists clients in other states, however, with the help of local counsel in the particular state.