AV-Rated Attorney Paul Deloughery is licensed in Arizona and helps clients throughout the U.S.

Does a Domestic Asset Protection Trust Work?

by | Apr 21, 2020 | Answers, Asset Protection, Business Owner? | 0 comments

Asset Vault Trusts (aka Special Power of Appointment Trusts) provide greater asset protection, flexibility and anonymity.

All states allow you to put your life savings and other assets in a trust so creditors can’t get them. But only some states allow you to remain a beneficiary of that same trust.[1] In other words, you get access to your money, but your creditors don’t. You always have money for whatever you need. And you get to tell creditors to pound sand. The technical name for this is a “self-settled spendthrift trust.” The common name is Domestic Asset Protection Trust, or DAPT.

Currently, there are 19 states that permit the creation of a Domestic Asset Protection Trust. If they are so popular, they must work, right? Keep reading and find out.

What is a Trust?

A Trust is an arrangement that allows someone else, called the trustee, to hold assets on your behalf. Since the assets are held for your benefit, you are the “beneficiary.” The person who creates the trust is called the “settlor” or “grantor”.

What is an “Asset Protection Trust”?

An asset protection trust is a trust that shields some assets from potential future liabilities. This provides the settlor (the person who created the trust) with a sense of security and peace of mind. There are two main types of asset protection trusts. The first is called a Foreign Asset Protection Trust (FAPT). The other is a Domestic Asset Protection Trust (DAPT). There is also an alternative, an Asset Vault Trust (aka Special Power of Appointment Trust), which we’ll get into later.

By the way, this article does not discuss two main ways that asset protection trusts are defeated. Those two ways are fraudulent transfers and veil piercing.[2] You can have the most protective trust in the world. But if you engage in either of those two things, your trust will be worthless.

The best trust will protect you from:

  • lawsuits
  • bankruptcy
  • IRS audits
  • divorce
  • government actions

It will also help keep your information private. It will be flexible. And it will be cost-effective. So let’s run down your options and see what is the best.

Foreign Asset Protection Trusts (FAPTs).

Historically, the general rule has been this. If you can get assets from a trust, then so can your creditors.[3] This began to change during the first half of the 20th century. That’s when some offshore jurisdictions started allowing Foreign Asset Protection Trusts.

Hammock hanging from palm tree on beach

Hiding your wealth on a tropical island sounds like a great idea. But is it?

During the first half of the 20th century, certain smaller countries began enacting legislation allowing for the creation of self-settled trusts. Such offshore locations were located relatively close to the wealthy people wanting to protect their assets. For example, wealthy British folks used Jersey in the Channel Islands. United States citizens used the Bahamas. Towards the end of the 20th century, the development of the Internet and cheaper airfare made the location of the trust company less important. As a result, other countries such as the Cook Islands and St. Kitts & Nevis joined in offering FAPT solutions.

However, FAPTs have their limits. For starters, there is a growing body of U.S. law defeating these trusts.[4] Also, an FAPT is not effective at protecting onshore assets (such as real estate and U.S. bank accounts). Also, courts have prevented assets from shifting to an FAPT when under an attack by creditors. See In re Brooks, 217 B.R. 98 (D. Conn. Bkrpt. 1998).

Man holding money and saying "Shhh"

Foreign Asset Protection Trusts do not help with financial privacy.

If anonymity is a goal, having an FAPT is not a good solution. Assets in an FAPT must be disclosed on a standard bankruptcy questionnaire. Failure to disclose the trust’s existence can result in a finding of bankruptcy fraud and criminal penalties.

FAPTs also have a reputation of being associated with criminal activity and unethical conduct. For that reason, there is a tendency for judges, juries and government agencies to view settlors who create FAPTs as a criminal who is attempting to hide assets or evade the law. Examples of people hiding ill-gotten gains in another country are repeatedly in the news. Most recently, the Sackler family was in the news for doing just this. They operated Purdue Pharma and made billions of dollars on OxyContin sales.

Finally, FAPTs are expensive and complicated to maintain. They require annual payments to a foreign trust company in the range of $5,000 to $10,000 per year. FAPTs also require the completion of IRS Forms 3520, 3520-A, and 1041. Offshore accounts and investments must be reported on IRS Form TD F 90-2.1, which requires you to disclose the exact location, account numbers, and maximum dollar amount in each account each year. Foreign accounts must also be reported on your personal income tax return, Form 1040. Form 8938 must also be filed for all offshore accounts. Failure to properly report FAPTs and foreign accounts can result in criminal penalties and severe civil penalties.

Domestic Asset Protection Trust (DAPT)

The first state to enact legislation allowing for self-settled spendthrift trusts was Alaska in 1997. Nineteen states now offer some degree of asset protection for a DAPT. These are:

  1. Alaska
  2. Connecticut
  3. Delaware
  4. Hawaii
  5. Indiana
  6. Michigan
  7. Mississippi
  8. Missouri
  9. Nevada
  10. New Hampshire
  11. Ohio
  12. Oklahoma
  13. Rhode Island
  14. South Dakota
  15. Tennessee
  16. Utah
  17. Virginia
  18. West Virginia
  19. Wyoming
Road sign saying this way, that way and the other way

It’s hard to know what to do when Asset Protection Trusts are so heavily promoted.

The effectiveness of a Domestic Asset Protection Trust can depend on whether the settlor is in bankruptcy and whether the settlor is in one of the 19 states with a Domestic Asset Protection Trust statute. It is likely that a Domestic Asset Protection Trust will be effective in a lawsuit brought in the state where the DAPT was created. One case confirming the effectiveness of a DAPT was Klabacka v. Nelson, 133 Nev. 164 , 394 P.3d 940 (2017) (in a divorce and division of assets action, the parties’ separate property trusts were validly created self-settled spendthrift trusts and were thus protected from spousal support and child support claims).

However, if the settlor is sued in a state that does NOT have a Domestic Asset Protection Trust statute, the court will apply the home state’s laws and not the laws of the DAPT. See Toni 1 Trust v. Wacker, 413 P.3d 1199; In re Mortensen Battley v. Mortensen, (Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011); Waldron v. Huber (In re Huber), 2013 WL 2154218  (Bk.W.D.Wa., Slip Copy, May 17, 2013).

Does an asset protection trust work in Bankruptcy?

Does an asset protection trust work in Bankruptcy?

If the debtor is in bankruptcy in a state that does not protect interests in DAPTs, the debtor’s interest in the DAPT will be part of the bankruptcy estate under 11 U.S.C. 541. The federal bankruptcy court will apply the choice of law rules of the forum state in which it sits. Klaxon Co. v. Stentor Elec. Mfg. Co., 313 U.S. 487 (1941).

By contrast, if the debtor is in bankruptcy in a state with Domestic Asset Protection Trust legislation, the assets in the DAPT will be protected under one condition. That condition is that the 10-year limitations period under 11 U.S.C. 548(e) has run.

This is summarized in the following table:

Will a Domestic Asset Protection Trust Protect Your Assets?

Debtor is Resident in State with NO DAPT Protection Debtor Is Resident in State with DAPT Protection
Outside Bankruptcy NO. Conflicts-of-laws tests allow local courts to apply local law to allow creditors to invade. YES. Local courts of DAPT state should respect DAPTs in all but the most abusive circumstances.
In Bankruptcy NO. Local law determines assets of self-settled trusts to be part of the bankruptcy estate. Maybe. 11 U.S.C. 548(e) creates a 10-year statute of limitations for transfers to self-settled trusts.

Asset Vault Trust

The Asset Vault Trust (aka, Special Power of Appointment Trust) is a type of special power of appointment trust. It is an old reliable tool that can be used to replace and improve on the concept of Foreign Asset Protection Trust or a Domestic Asset Protection Trust. Asset Vault Trusts can protect against estate taxes, provide flexibility in how the trust is taxed, and protect against potential creditors.

The concept of a power of appointment (a key part of the Asset Vault Trust) has been a part of the English common law for centuries. The concept is well recognized in all 50 states and in the federal tax laws.[5] Some minor variations in the law about powers of appointment have occurred over time. But, the basic legal principles about powers of appointment have never varied.

Terminology.

Before we dive into a detailed discussion, here are some key terms.

List of terms related to Domestic Asset Protection Trust

To understand an Asset Vault Trust, you need to know some terms.

A power of appointment enables a powerholder to name a recipient of certain property. The powerholder acts in a nonfiduciary capacity. The “donor” is the person who created the power of appointment. The “donee” is the person who may exercise the power. The “permissible appointee” is a person in whose favor a donee may exercise the power. An “appointee” is a person to whom a donee makes an appointment of appointive property. A “taker in default of appointment” is a person who will receive the property if the power is not exercised.[6]

A “general power of appointment” means a power of appointment exercisable in favor of the donee, the donee’s estate, or the creditors of the donee or the donee’s estate. It does not matter if the power is also exercisable in favor of others.[7] A power that is not general is a “special” or “nongeneral” power of appointment.

Asset protection and estate tax inclusion.

If property is subject to a presently exercisable general power of appointment, it is generally subject to the donee’s creditors. This is because courts consider such a power to be the same as ownership.[8] But, property subject to a special power of appointment is exempt from claims of the donee’s creditors.[9] Courts do not consider the donee of a special power of appointment to have a property interest in the property subject to the power. This is because the donee cannot exercise the power for the economic benefit of the donee.[10] Since the donee has no property interest, the property subject to the power of appointment is not included among the property of the donee. This holds true in the contexts of judgment collection, bankruptcy,[11] divorce, Medicaid qualification, estate tax exclusion[12] and other cases that involve the property of the donee.

A permissible appointee (including the donor) also has no property interest in a power of appointment.[13] After all, most special powers of appointment include everyone in the world as a permissible appointee, except for the donee, the donee’s estate, and the creditors of the donee and the donee’s estate. Thus, a court would have no grounds on which to include the interest of a permissible appointee for purposes of judgment collection, bankrupty, divorce, Medicaid eligibility, estate tax inclusion, or other determinations that involve the property of the donee.

An alternative to the Domestic Asset Protection Trust

This article will use the term “special power of appointment trust” to refer to an irrevocable trust with a special power of appointment that includes the donor as a permissible appointee.

The following are three hypotheticals that will help introduce the concepts raised in this article.

Man who has Domestic Asset Protection Trust

Abe has a Domestic Asset Protection Trust.

Abe creates a self-settled Domestic Asset Protection Trust using Nevada law and naming his sister, a resident of Nevada, as the trustee. Abe names himself, his wife, and their children as the beneficiaries. He gives his sister (the trustee) the power to withhold distributions or to sprinkle distributions among the beneficiaries as she determines in her sole and absolute discretion. Abe funds his self-settled asset protection trust at a time and in a manner that is not considered a fraudulent transfer.

Ben has Foreign Asset Protection Trust

Ben has Foreign Asset Protection Trust.

Ben creates a self-settled Foreign Asset Protection Trust in the Cook Islands. He names a Cook Islands trust company as trustee. Ben names himself, his wife, and their children as the beneficiaries. He gives the trust company the power to withhold distributions or to sprinkle distributions among the beneficiaries as it determines in its sole and absolute discretion. Ben funds his self-settled asset protection trust at a time and in a manner that is not considered a fraudulent transfer.

 

Catherine has an Asset Vault Trust

Catherine has an Asset Vault Trust.

Catherine creates a special power of appointment trust naming her brother as the trustee. Catherine names her husband and children as the beneficiaries. However, she does not include herself as a potential beneficiary. She gives her brother the power to withhold distributions or to sprinkle distributions among the beneficiaries as she determines in her sole and absolute discretion. Catherine also gives her brother a special power of appointment to appoint assets to any person other than himself, his estate, or the creditors of himself or his estate. Catherine funds her special power of appointment trust at a time and in a manner that is not considered a fraudulent transfer.

In all three scenarios, the trustee has power to withhold assets or sprinkle assets among the spouse and children of the settlor. In all three scenarios, the trustee can transfer all, part, or none of the assets of the trust to the settlor at any time and for any reason.

The differences are seen when Abe, Ben and Catherine are sued, and a judgment is entered against them. The creditor’s attorneys will ask Abe, Ben and Catherine if any of them is the beneficiary of any trust. Abe and Ben will both have to reply that they are the beneficiaries of self-settled trusts. Their creditors will then be able to commence an examination of the trusts and an attempt to confiscate the trust assets.

Catherine, on the other hand, will correctly answer that she is not a beneficiary of a trust. Even if creditors discover that Catherine once created a trust, they will have no claim to the trust assets because Catherine is not included as a beneficiary.

How will the trust be taxed?

Image of IRS logo

FAPTs, DAPTs and special power of appointment trusts can all be designed to avoid gift tax at the time of the initial transfer. This is done by making the gifts to the trust incomplete for gift tax purposes.[14] For example, the settlor could retain the ability to name new beneficiaries or change the interests among the beneficiaries (unless the power is held by the grantor not individually, but as a fiduciary and is limited in scope).[15]

All three types of trusts can also be designed as intentionally defective grantor trusts. An intentionally defective grantor trust (aka, a “grantor trust”) is a trust that is excluded from the settlor’s estate for gift and estate tax purposes but whose income is attributed to the settlor for income tax purposes. FAPTs, DAPTs and Asset Vault Trusts (aka, Special Power of Appointment Trusts) can all include grantor trust provisions. The name comes from the fact that the settlor intentionally includes a “defect” in the trust document that causes the income to be taxable to the settlor (or “grantor”). The purpose of an intentionally defective grantor trust is to protect assets from estate taxes in addition to protecting assets from the potential future creditors of the settlor. An intentionally defective grantor trust is typically used to own life insurance or other appreciating assets. In order to ensure that the assets of the trust are not included in the settlor’s estate, the settlor is not included as a beneficiary of an intentionally defective grantor trust.

However, an Asset Vault Trust has additional benefits. The concept of an intentionally defective grantor trust can be greatly improved if the settlor grants a special power of appointment allowing a donee to appoint assets to any person other than the donee, the donee’s estate, or the creditors of the donee or the donee’s estate. The grant of a special power of appointment to a non-adverse party is one way to cause an irrevocable trust to be treated as a “grantor trust” for income tax purposes.[16] This power allows the donee potentially to appoint the assets of the trust back to the settlor. The donee should not be a person who is also a beneficiary of the trust, or the exercise of a special power of appointment may result in a taxable gift.[17] The fact that the settlor and the settlor’s spouse are included as permissible appointees is insufficient to cause the trust assets to be included in their taxable estate because most everyone in the world is a permissible appointee.[18]

Example. Sarah and John both create an intentionally defective grantor trust, and both transfer significant assets to the trust by gift and by sale in order to remove the assets from their taxable estates. Sarah’s trust also includes a special power of appointment allowing her brother to appoint assets to any person other than himself, his estate, or the creditors of the brother or his estate. If the estate tax is repealed, if Sarah falls on hard times, or if she decides that she does not want her children to receive a large inheritance, Sarah’s brother can simply appoint the assets to her at any time. John’s trust does not include this special power. Thus, he has no way to benefit from the assets in the trust, and the trustee has no power to give them back to him.

This option to return assets to the settlor may be especially useful if Congress eventually increases the estate tax exemptions while maintaining the step-up in basis for property included in a decedent’s taxable estate. The special power of appointment that is included in Sarah’s trust would allow her brother to appoint sufficient assets back to her to take full advantage of the step-up in basis at her death to the extent of her available estate tax exemption.

Is the trust supported by case law?

Statutes about Domestic Asset Protection Trust

Domestic Asset Protection Trust statutes.

Statutes that allow asset protection for a Domestic Asset Protection Trust are relatively new and untested. For that reason, there are few cases supporting the asset protection of such trusts. On the flipside, centuries of case law support the inability of a creditor of a permissible appointee to reach the assets of a special power of appointment trust. This is consistent throughout all 50 states and in federal bankruptcy courts.[19] Also, a special power of appointment trust has the benefit of basic logic. The class of permissible appointees includes everyone except the the donee, the donee’s estate, and creditors of the donee and the donee’s estate.

Will the trust work in a non-DAPT state?

The majority of states still follow the common law rule that the assets of a self-settled trust are available to the claims of the settlor’s creditors.[20] A state that does not grant asset protection for self-settled trusts will probably not uphold the laws of a Domestic Asset Protection Trust state, because doing so would violate the first state’s public policy. A trust is generally governed by the law of the jurisdiction designated in the trust agreement unless that jurisdiction’s law is contrary to a strong public policy of the jurisdiction having the most significant relationship to the matter at issue.[21]

In contrast, the asset protection provided by a special power of appointment trust is not dependent on the state where the parties reside or the state where the matter is adjudicated.

Will the trust hold up in bankruptcy court?

U.S. Bankruptcy Court sign

At least two bankruptcy courts have held that the recognition of an FAPT would offend federal bankruptcy policies.[22] A person who files bankruptcy is typically required to disclose any trust in which he or she is included as a beneficiary. In addition, the 2005 changes to the Bankruptcy Code have created a new ten-year limitations period for transfers to self-settled trusts that are meant to hinder, delay or defraud creditors.[23] Even if a bankruptcy court is unable to bring the assets of a self-settled trust into the bankruptcy estate, the court could dismiss the debtor’s case and deny the debtor a discharge under the bankruptcy laws. In contrast, the special power of appointment trust should be irrelevant to a bankruptcy proceeding because the settlor has no beneficial interest in the trust and it is not self-settled.

Are the trust assets open to scrutiny by others?

magnifying glass

Adverse parties such as plaintiff’s lawyers, creditors, and government agencies can ask if a person is a beneficiary of a trust in order to determine whether the trust assets may be attached or considered for various purposes. This may affect a person’s eligibility for certain programs or benefits. It can also cause psychological stress to the settlor. However, a special power of appointment trust is immune to this kind of scrutiny because the settlor is not a beneficiary.

How will a judge view the trust?

A self-settled trust governed by the laws of an exotic, foreign country often carries with it a negative stigma and a perception of wrongdoing. This is also arguably the case with a Domestic Asset Protection Trust created outside one of the states that supposedly permit it.

Upon learning that a person is a beneficiary of a self-settled trust in a foreign jurisdiction (whether another state or another country), judges, juries, and government agencies are likely to view the person as a criminal who is attempting to avoid the law. In contrast, a special power of appointment trust established in a domestic jurisdiction for the benefit of a person’s family has the appearance of an ordinary measure established by a law-abiding citizen for estate planning purposes.

Are there limitations on where the trustee can reside?

Both an FAPT and DAPT require the appointment of a trustee or co-trustee in the designated FAPT or DAPT jurisdiction. On the other hand, a special power of appointment trust does not require the appointment of a corporate trustee or a trustee that is located in a certain jurisdiction. There’s no reason you can’t name your parent or sibling, regardless of their state of residence.[24]

Is there a risk of assets being distributed contrary to the settlor’s wishes?

With a self-settled trust, the trustee has a fiduciary duty to the beneficiaries and this ensures that the trustee will not distribute the assets to persons that the settlor did not intend.[25] However, if the trustee has a discretionary power to sprinkle assets among the potential beneficiaries, there is still a chance that the trustee will not distribute the assets according to the wishes of the settlor. The following additional safeguards could be implemented to protect against persons receiving trust property contrary to the settlor’s wishes.

  • The settlor of the Asset Vault Trust (aka, Special Power of Appointment Trust) could appoint one or more co-donees who are required to act together.
  • The settlor of the Asset Vault Trust could limit the class of permissible appointees.
  • For all three trusts, the settlor could appoint a trust protector with power to approve or veto a planned distribution or exercise of a power of appointment. The settlor could grant a trust protector the power to remove and replace a trustee or the donee of a power of appointment.

Are there exceptions to the types of claims that can be protected against?

Some states with Domestic Asset Protection Trust statutes include exceptions that allow creditors to seize the assets of a self-settled trust for child support, spousal maintenance, transfers made within certain time periods, government creditors, bankruptcy, or certain torts.[26] However, regarding Asset Vault Trusts, no statutory exceptions allow a creditor of a permissible appointee to reach the assets of such a trust.

Conclusion

Domestic Asset Protection Trusts are not as wonderful as they may seem on the surface. And besides, Special Power of Appointment Trusts (which we call Asset Vault Trusts) provide greater flexibility, greater asset protection, and greater anonymity. A special power of appointment is an old familiar tool. It allows a person to make an irrevocable gift without giving up the possibility that the assets given can be returned.

[1] A “self-settled” trust is one in which the settlor is included as a beneficiary of the trust. “Self-settled trust” is not defined in the Internal Revenue Code. Per Black’s Law Dictionary, it is “[a] trust in which the settlor is also the person who is to receive the benefits from the trust, usu. set up in an attempt to protect the trust assets from creditors.” BLACK’S LAW DICTIONARY 1654 (9th ed. 2009).

[2] A.R.S. §44-1004 defines “fraudulent transfers” as to present and future creditors. Generally speaking, a transfer made with actual intent to hinder, delay or defraud any creditor of the debtor or without receiving a reasonably equivalent value in exchange for the transfer or obligation will be considered fraudulent, thereby allowing a court to make the trust assets available to the creditor. Also, a trust that is not respected as a separate legal entity from the debtor may be attacked in what is called reverse veil piercing, alter-ego, constructive trust, or the sham transaction theory.

[3] See RESTATEMENT (SECOND) OF TRUSTS, section 156.

[4] A list of cases may be found at https://magellanlawfirm.com/court-decisions-defeating-offshore-trusts/.

[5] See RESTATEMENT OF PROPERTY sections 318-369 (1940), RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSERS sections 11.1-24.4 (1986), RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS section 17.1, and IRC Section 2041.

[6] Id. at section 17.2.

[7] Id. at section 17.3.

[8] Id. at section 17.4.

[9] Id. at section 22.1.

[10] See RESTATEMENT (THIRD) OF TRUSTS section 56 comment b (2003).

[11] See 11 U.S.C. section 541.

[12] See Sections 2041 and 2514.

[13] See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS, Section 17.2. Also see In re Hicks, 22 BR 243 (Bkrptcy. DC Ga., 1982) and In re Knight, 164 BR 372 (Bkrptcy. DC Fla., 1994).

[14] A transfer to a trust is “incomplete” for gift tax purposes if the settlor retains a power to veto distributions proposed by the trustee. See Reg. 25.2511-2(c).

[15] Treas. Reg. Sec. 25.2511-2(c).

[16] See 26 U.S. Code Section 674.

[17] See Reg. 25.2514-1(b)(2).

[18] Section 2042(2) provides that a reversionary interest could cause the trust assets to be included in the settlor’s estate if the value of the reversionary interest immediately before the insured’s death exceeds 5% of the value of the trust. Because the special power of appointment is exercisable in the donee’s absolute discretion, the value of the reversionary interest is less than 5% of the value of the trust. See Reg. 20.2042-1(c)(3). If it can be shown that the settlor and the donee had an express or implied understanding that distributions would be made to the settlor, then the assets of the trust could possibly be included in the settlor’s estate under Section 2036(a)(1).

[19] See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS Section 17.2. Also see In re Hicks, 22 BR 243 (Bkrptcy. DC Ga., 1982) and In re Knight, 164 BR 372 (Bkrptcy. DC Fla., 1994).

[20] See 26 U.S. Code Section Sections 2041 and 2514.

[21] See Uniform Trust Act section 107 and Restatement (Second) of Conflict of Laws sections 273 and 280.

[22] See In re Portnoy, 201 B.R. 698, and In re Brooks, 217 B.R. 98.

[23] 11 U.S.C. section 548(e).

[24] Be sure to check how your Asset Vault Trust will be taxed by the trustee’s state of residence.

[25] By definition, a trustee has a fiduciary duty to the beneficiaries of a trust, while a donee of a power of appointment acts in a nonfiduciary capacity and has no duty to the beneficiaries or permissible appointees. See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1.

[26] See Utah Code 25-6-14, Delaware Code Section 3573, Oklahoma Statutes Title 31, section 11.

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