Depiction of man breaking into a safe

Can a trust protect you from creditors?

By Paul E. Deloughery, Esq. (October 2019)

Introduction

Trusts have long been the preferred method by which Settlors of even moderate wealth have avoided probate, allowed for control of assets in the event of incapacity, and passed their assets to named beneficiaries upon their death. Trusts allow the Settlor to dictate how beneficiaries receive money and property from the Trust, and irrevocable Trusts can afford the Settlors estate and gift tax benefits for assets likely to appreciate. However, even in the often-murky world of trust planning, and in the face of an increasingly litigious world, one important question remains: Can a Trust protect you from Creditors? As is often the case, the answer is that it depends on what type of Trust you are utilizing and how that Trust was funded. This article explores several popular types of trusts and determines whether any of them can be effective creditor protection tools.

Self-Settled Domestic Asset Protection Trusts are irrevocable trusts that are established by, and benefit, the same person or persons as who created the trust. As of October 2019, only nineteen states in the U.S. have enacted laws providing for asset protection for DAPTs. If you don’t live in one of those states, your DAPT trust is unlikely to give you any protection, because your home state’s court isn’t going to care what the Virginia or South Dakota statute says. And … if you reside in one of the listed states, a creditor can simply force you into an involuntary bankruptcy under U.S. Code § 548(e). So, the creditor protection offered by a DAPT is more psychological (if you believe a creditor will be scared away by the idea of you having such a trust) than real.

The caselaw shows that Offshore Trusts, or Trusts created pursuant to the laws of a jurisdiction outside of the U.S., can protect you from creditors. But they have proved to be inherently complex, expensive and risky. Revocable Trusts, generally used for simple estate planning purposes, do not offer asset protection for the Settlor, but may offer creditor protection for beneficiaries after the death of the Settlor if drafted correctly. “Plain vanilla” irrevocable trusts that benefit third parties and not you (the Settlor) can protect you from creditors. However, they may or may not protect your beneficiaries … depending on the language in the trust document. Also, with a standard irrevocable trust, the Settlor must divest himself/herself completely of the assets, and the annual administration can be expensive (if you use a professional trustee). Qualified Personal Residence Trusts (QPRTs) are useful and powerful trusts that protect your personal residence from creditors, but since a QPRT can only hold a personal residence, their usefulness is limited in scope. Finally, the Special Power of Appointment Trust offers you (the Settlor) the most flexibility while also protecting you from creditors.

Here is a simplified comparison of whether the various types of trusts can protect you from creditors:[1]

Type of Trust?Protected Outside Bankruptcy?Protected if Bankruptcy Filed Within 10 Years After Transfer to Trust?Can Be Unwound by Settlor?
Revocable “Living” TrustNo.No.Yes.
Self-Settled Spendthrift Trust (aka, Domestic Asset Protection Trust)Yes, if claim is filed in the court of one of the states that specifically permit these trusts. No.No.
Irrevocable Trust (Settlor not a beneficiary)Yes.Yes.No.
Qualified Personal Residence TrustYes.Yes.No.
Asset Vault Trust (aka, Special Power of Appointment Trust)Yes.Yes.Yes.

The various trusts will be discussed below.

Domestic Asset Protection Trusts (DAPTs)

DAPTs are irrevocable trusts established for the purpose of protecting any assets transferred to the Trust from any would-be creditors of the Settlor. DAPTs are considered “domestic” because they are established under the laws of one of the nineteen states that allow for domestic asset protection trusts. Currently, the states that allow creditor protection through a DAPT are Alaska, Connecticut, Delaware, Hawaii, Indiana, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Utah, Virginia, West Virginia, and Wyoming.

In an DAPT, the Settlor (i.e. the person transferring his/her assets to the Trust) cannot serve as Trustee. However, because the Trust is “self-settled”, the Settlor is named as a beneficiary of the Trust. If an DAPT is established in one of the states that have not enacted Asset Protection Statutes, and if the Settlor of the DAPT is also a beneficiary, then the Settlor’s creditors can file claims and receive judgments against the assets held in the DAPT. However, if the DAPT is properly established under the laws of one of the nineteen states that have adopted Asset Protection Trust statutes, then the Settlor can be a beneficiary of the trust, and his creditors cannot get to the assets inside the trust. That is, however, unless the creditor hires a smart lawyer who forces the debtor into an involuntary bankruptcy. In that case, the bankruptcy court can unwind transfers to the DAPT made within 10 years of the bankruptcy filing. (I don’t know about you, but having to wait 10 years to get protection from bankruptcy wouldn’t make me feel very protected!)

As with any trusts discussed here, the transfer of assets to an DAPT must not be fraudulent. Generally speaking, a fraudulent transfer to any trust (DAPT, offshore, or Special Power of Appointment) for the purpose of avoiding a creditor’s claim would occur if the would-be debtor has knowledge of the actual creditor’s claim or the imminence of a creditor’s claim, and transfers assets subject to that claim to a trust in order to protect those assets.

Most of the nineteen states that have enacted Asset Protection Trust Statutes have included provisions enabling some form of transfers that would otherwise be considered fraudulent or questionable. This brings us to the second issue with DAPTs, however. Over time, courts have been eroding the effectiveness of protections against fraudulent transfers from these state legislatures. In Toni 1 Trust v. Wacker, the Settlors lost a lawsuit to the Wackers in Montana, and subsequently transferred assets to an DAPT established under Alaska law. In response, the Wackers filed suit in Montana claiming a fraudulent transfer, and the Settlors argued in Alaskan Court that Montana did not have jurisdiction over the Alaskan DAPT. The Alaska Supreme Court ultimately ruled that Montana courts are not required to abide by Alaska’s law with regard to what remedies may be available to the creditor against the Alaska DAPT. This means that the Montana Court could have jurisdiction over the Alaska DAPT. This case and its progeny dealt a significant blow to the nineteen states that allow creditor protection for DAPTs because it enforces Creditor’s abilities to bypass those state law protections.

In short, DAPTs can be useful creditor protection tools if drafted properly pursuant to the laws of one of the nineteen jurisdictions that allow them (and assuming you are comfortable knowing that a bankruptcy court can unwind transfers made within 10 years of any bankruptcy filing). If you are sued by a creditor located in one of those nineteen states and had previously established and funded an DAPT in that same state, and if the creditor doesn’t think to force you into an involuntary bankruptcy, then you might be protected. However, if you are sued by a creditor in a state without an Asset Protection Trust statute, then creditor protection is severely limited even if you previously established and funded an DAPT in one of the nineteen states.

Offshore Asset Protection Trusts

Offshore Asset Protection Trusts are traditional trust agreements established under the laws of a foreign jurisdiction. For example, one of the most popular jurisdictions for establishing an Offshore Trust is the Cook Islands (in the South Pacific near New Zealand). Because an Offshore Trust is subject to the laws of the foreign country where it is established, U.S. Courts do not have jurisdiction over the Offshore Trust or its Trustees. Therefore, a judgment entered by a U.S. Court against the Trust’s Settlor generally will not attach to the assets held in an Offshore Trust. In this regard, an Offshore Trust can be a highly effective asset protection device, but they are not without their drawbacks.

First, Offshore Trust can be exorbitantly expensive to establish and administer, with drafting fees as high as $40,000 and annual Trustee fees of at least $5,000. Second, Offshore Trusts are especially vulnerable to bankruptcy proceedings, where Bankruptcy Courts in the U.S. have worldwide jurisdiction over the debtor’s assets, including any assets held in Offshore Trusts. Third, to best protect you from creditors, you (as the Settlor of the Offshore Trust) must divest yourself completely from any decisions regarding the administration of the Offshore Trust. Even the authority under the trust document to appoint a successor Independent Trustee will subject the Offshore Trust assets to U.S. Court jurisdiction. Fourth, transferring U.S. sourced or located assets to an Offshore Trust is inherently risky and may not afford creditor protection over those assets. For example, if a Settlor transfers U.S. real estate to an Offshore Trust, or even to an LLC which is then transferred to an Offshore Trust, U.S. based creditors may still be able to attach a judgment to that U.S. property. Finally, there are a string of cases defeating offshore trusts.

A good use of an Offshore Trust would be to have it serve as the General Partner of a limited partnership, or the managing member of an LLC. Even if a U.S. court were to enter a charging order against the debtor’s interest in the limited partnership or LLC, the creditor would not be able to compel the offshore manager or general partner to make a distribution without extensive litigation in the foreign jurisdiction.

In most cases, however, the complexity, cost of establishment and administration, the limiting requirement regarding the Settlor’s participation, and the inherent risk of dealing with a foreign trust company and the laws of a foreign country make the Offshore Trust the choice only in limited circumstances.

Revocable “Living” Trusts

Revocable Trusts are the preferred document for even modest estate plans, because they offer the Settlor the ability to avoid probate, can help administer inheritances to young or irresponsible beneficiaries after the Settlor’s death, and can help manage the Settlor’s assets if the Settlor becomes incapacitated during his life without the need for a guardianship. However, while a Revocable Trust has the advantage of flexibility (it can be changed or even cancelled), it won’t protect you from creditors.

A Revocable Trust, sometimes referred to as an Inter Vivos (i.e. during life) Trust, is a trust established by the Settlor and which lays out the Settlor’s estate plan. In order to avoid probate, the Settlor would transfer his assets to the name of the trust while he is alive. However, as long as the Settlor has the ability to revoke, revise, or otherwise change the terms of the Trust, the assets held by a Revocable Trust are still considered property of the Settlor. For this reason, creditor judgments against a Settlor personally can attach to any property held by the Settlor’s Revocable Trust.

However, once the Settlor passes away, that Settlor’s Revocable Trust then becomes irrevocable by reason of his passing. At that point, if (a) the trust assets are held in trust for the Settlor’s beneficiaries, like a special needs child, or a child in a rocky marriage, and if (b) certain dispositive language is used to address how those beneficiaries would receive distributions from the Trust, those assets are protected from that beneficiary’s creditors. In order to protect you from creditors, the Trustee should be an independent Trustee (i.e. one that is not related or otherwise subordinate to the beneficiary, like a Bank or Trust Company, or a very trusted family member). The terms of the Trust should state that the Trustee has the discretion to make distributions to that beneficiary but is otherwise not required to make distributions to that beneficiary. If a beneficiary has issues with a creditor, then the Trustee would simply exercise its discretion to refrain from making distributions, and the beneficiary’s creditor would not be able to attach to the trust assets.

If drafted properly, a Revocable Trust can extend powerful creditor protection to the Settlor’s beneficiaries after the Settlor has passed and the Revocable Trust has, by its terms, become irrevocable. However, if you’re trying to protect yourself (the
Settlor) from your creditors, a Revocable Trust is not considered useful.

Irrevocable Trusts for Third Party Beneficiaries

Irrevocable Trusts for Third Party Beneficiaries are very similar to Revocable Trusts, discussed above, but the obvious and important distinction is that Irrevocable Trusts are irrevocable immediately upon establishment, without regard to the Settlor’s passing. The Settlor establishes an Irrevocable Trust, incorporating provisions in the trust about how and when beneficiaries may receive distributions. Once signed, the Trust terms are irrevocable and cannot be changed. When the Settlor’s assets are transferred to the Irrevocable Trust, the Settlor no longer owns those assets, as they are owned by the Irrevocable Trust. This concept of ownership is clearly in contrast with what happens when the Settlor of a Revocable Trust transfers his assets to the Revocable Trust and is still considered the owner of the assets, and this distinction is what makes the Irrevocable Trust a potentially useful creditor protection vehicle.

The most important thing to remember when considering establishing an Irrevocable Trust to protect you from creditors is to draft the trust in a way that will not result in you (the Settlor) or a beneficiary having control over the assets or the administration of the Trust that would give rise to creditor issues. To accomplish this, the Irrevocable Trust should state that distributions to the beneficiary are made only as a result of the Trustee’s discretion, and that the beneficiary should not have the authority or right to request or demand a distribution from the Trust. If the beneficiary has a right to money from the trust, then so do that beneficiary’s creditors.

To protect the Irrevocable Trust’s assets from the beneficiary’s creditors, the Trustee of the Irrevocable Trust must also be an independent Trustee. This means that the Trustee cannot be a relative of the Settlor’s or the beneficiary’s, nor a subordinate party of the Settlor’s or beneficiary’s, like an employee or child. To accomplish this, it is advised that the Settlor of an Irrevocable Trust appoint a corporate or professional Trustee, like a Bank, a Trust Company, an Attorney, or an Accountant.

Although Irrevocable Trusts can be useful in protecting the Settlor’s assets from the Settlor’s creditors and creditors of the trust beneficiary, there are significant drawbacks. First, the fraudulent transfer concepts mentioned above apply to transfers to Irrevocable Trusts as well. If the Settlor knows that a creditor’s judgment against his exists or is imminent, the transfer of the Settlor’s assets to an Irrevocable Trust in an attempt to avoid collection by that creditor may be found fraudulent by a Court, and the Court could unwind the transfer and allow the creditor to take the assets. Second, the transfer of assets to an Irrevocable Trust is considered a completed gift, which requires filing a gift tax return for the year of the transfer. This may adversely affect the overall estate plan of a Settlor with a high net worth. Third, an Irrevocable Trust can be expensive to establish and expensive to administer. Depending on how the trust is set up from an income tax standpoint, it may require its own annual income tax return.[2] Plus, costs for professional trustee services can be substantial. Fourth, and most significantly, transferring assets to an Irrevocable Trust means the Settlor loses all control and ownership of the assets permanently, which may not be a preferred result.

Qualified Personal Residence Trusts

A Qualified Personal Residence Trust (QPRT) is an irrevocable trust designed to limit or reduce the value of a personal residence in the Settlor’s estate. The Settlor establishes the QPRT, to be administered over a definite term of years, and deeds a personal residence (may be a vacation home or a principal residence) to the Trust. The terms of the trust specify that the Settlor may use the residence during the term of the Trust. After the term has expired, the Trust may deed the residence out to the Trust beneficiaries (usually, the Settlor’s children or descendants) or may continue to be held in a separate trust for the beneficiaries. The Trust may also specify that the Settlor has the right to lease the property from the Trust beneficiaries after the expiration of the initial term, so the Settlor essentially has a lifetime right to occupy the residence.

The benefits of a QPRT are simple, but compelling. Because the residence is held in an irrevocable Trust, the residence is protected from the Settlor’s creditors and may not be used to pay the Settlor’s creditors. Also, since this is a standard estate planning technique, it will be more difficult for a creditor to argue that the Badges of Fraud exist, such as a lack of full and fair consideration received in exchange for transferring the house to the trust. Despite this creditor protection, the Settlor may continue to reside in the residence while it is owned by the Trust, and may choose how to maintain, or even renovate or redecorate, the residence. A QPRT also helps reduce estate and gift tax implications for high-net worth clients. By deeding the residence to a QPRT, and by delaying the distribution to the QPRT beneficiaries for the length of the QPRT term, the Settlor removes any appreciation of the value of the residence from the value of the Settlor’s estate while reducing the value of the gift to the Settlor’s beneficiaries.

There are, however, some drawbacks to implementing a QPRT. First, if the Settlor does not survive to the expiration of the QPRT Terms, the entire transaction is unwound, and the value of the residence is included in the value of the Settlor’s estate. So, the longer the QPRT term, the greater the gift and estate tax benefits, but with these greater tax benefits comes a higher risk of the Settlor dying before the expiration of the QPRT term. Second, a QPRT can only hold a personal residence and nominal “seed” money as assets, so although it can protect you from creditors, a QPRT can only protect residential real estate and a small amount of cash from the Settlor’s creditors.

Special Power of Appointment Trusts

A Special Power of Appointment Trust, or SPA Trust, is similar to a plain vanilla irrevocable trust. (It’s a Trust to which the Settlor transfers his assets, and thereafter the Settlor retains no interest in the assets transferred and retains no authority or power under the terms of the Trust regarding its administration.) However, the terms of the SPA Trust designate someone with the ability to transfer the assets of the SPA Trust to anyone other than Settlor, the Settlor’s estate, the Settlor’s creditors, or creditors of Settlor’s estate. This ability to transfer assets to a limited list of recipients is called a Special Power of Appointment.

Magellan Law’s version of SPA Trust, which we call an Asset Vault Trust, gives this Special Power of Appointment to the Settlor. We believe this provides the best compromise of asset protection and flexibility.

It is theoretically possible to create a SPA Trust in which a third party (perhaps the Trust Protector) has the power to transfer the trust assets back to the Settlor. However, this creates a risk of court finding that the trust is an alter ego of the Settlor. “Alter ego” means that the trust is basically one and the same as the Settlor, so the court can simply disregard the trust and order the Trust Protector to transfer the trust assets to the creditor.

The alter ego doctrine developed from the law of corporations and allows a creditor to disregard the corporate form (also known as “piercing the corporate veil”) either by using an owner’s assets to satisfy a corporation’s debt or by using the corporation’s assets to satisfy the individual’s debt. See State v. Easton, 647 N.Y.S.2d 904, 908-09 (N.Y. Sup. Ct. Albany Cnty. 1995). The essence of the alter ego theory is that the entity in question really has no separate existence; it is merely a tool of someone or something else. See Bridgestone/Firestone v. Recovery Credit Servs., 98 F.3d 13, 17-18 (2d Cir. 1996).

An Asset Vault Trust is a superior way to protect you from creditors, and also provides maximum flexibility because the you (the Settlor) can never be the Trustee, beneficiary, Trust Protector or recipient of the assets under the Special Power of Appointment. However, the Trust Protector can be given the ability to amend the trust and make the Settlor the beneficiary. (Again, care must be taken here so that there is no basis for a claim that the arrangement is the Settlor’s alter ego.) Also, the Settlor can always unwind the arrangement when the Settlor is not burdened by creditor issues by “appointing” (transferring) the assets to a spouse or someone else with an understanding that those assets would be transferred back.

In a SPA Trust, the Settlor is neither a beneficiary nor a Trustee of the Trust, and so the assets in the SPA Trust are not considered assets of the Settlors, for creditor purposes. This means that a creditor of the Settlor’s cannot get to the assets held by the SPA Trust. Contrast this with the self-settled aspects of the Domestic Asset Protection Trust discussed above, where creditors outside the nineteen states could get to the trust assets because the Settlor was the beneficiary of the Trust. Because the assets held in a SPA Trust are not considered assets owned by the Settlor, a Settlor going through bankruptcy is not required to disclose assets held in a SPA Trust on bankruptcy disclosures.

When creating a plain vanilla irrevocable trust or a SPA trust, the Settlor can choose how the trust will be taxed. By default, such trusts are separate entities for income tax purposes. Because an Irrevocable Trust is considered a separate entity, it requires its own tax return annually and typically reaches much higher income taxes than an individual person. For instance, a married couple filing jointly will pay the highest income tax rate of 37% only when their combined income exceeds $600,000, whereas an Irrevocable Trust will pay the highest rate of 37% when its income exceeds $12,500. However, such trusts could be made “intentionally defective grantor trusts”. That means that certain provisions are included to that the trust assets are considered assets of the Settlor’s for income tax purposes while still considered separate (protected) trust assets for creditor protection purposes. If the trust is a “grantor trust,” the Settlor will pay the taxes on any income produced by the Trust assets, and a separate return for the Trust is not necessary.

Similarly, it is possible to choose whether the assets in either type of trust are considered a completed gift for transfer tax purposes. This gives planning opportunities for clients with higher amounts of wealth.

Conclusion – Special Power of Appointment Trusts Are the Best Way to Protect You from Creditors

Figuring out how to protect you from creditors is an important and all too often overlooked component of a your financial and estate plan, and it deserves the attention of the your advisors and attorneys. Although there are several trust options to choose from when planning for asset and creditor protection, some are overly expensive, complex and risky, like the Offshore Trust, and some are largely ineffective, like the Revocable Trust. Others, like the Domestic Asset Protection Trust, only work in limited jurisdictions, and under limited and very specific circumstances. Still others, like the Irrevocable Trust for Third Party Beneficiaries, require the complete divestiture of assets from the Settlor, and can be expensive to administer and tax inefficient. While a Qualified Personal Residence Trust offers creditor protection and tax benefits for residential real estate, it cannot hold other assets and therefore has a very narrow scope. Also, it is not easily unwound. The SPA Trust offers the Settlor the most benefits under the broadest circumstances; they are relatively inexpensive to establish and administer, the trust assets may be transferred back to the Settlor (or someone the Settlor trusts, like a spouse) at a future date, the trust assets are completely secure from the Settlor’s creditors, and the annual administration expenses can be very minimal.

Disclaimer

The information in this article was of a general nature. It was not intended as legal advice and did not create an attorney client relationship. If you want legal help, you can contact us at 602-443-4888.

 

[1] The information on this table assumes that (a) the settlor did not engage in a fraudulent transfer and (b) that the settlor does not maintain control over the trust assets, which would justify the court in piercing the trust’s protective “veil.”

[2] An irrevocable trust could be made a “grantor” trust so that it is disregarded from a tax standpoint.