The Use and Abuse of Domestic Asset Protection Trusts

Originally published Summer 2004

We live in an era of unprecedented litigiousness where doctors, lawyers, accountants and business owners frequently become defendants in lawsuits seeking damages in the tens of millions of dollars. Clients concerned about these potentially devastating liabilities are increasingly inquiring about the efficacy of establishing an asset protection trust (APT) as a part of a comprehensive estate plan to provide a measure of protection for their family’s core savings.

An APT is an irrevocable, self-settled spendthrift trust that protects a portion of an individual’s assets from creditors. Since the late 1970s, APTs have been formed by U.S. citizens in offshore jurisdictions including Bermuda, the Isle of Man, the Cook Islands and various Caribbean nations. Until recently, no U.S. jurisdiction extended spendthrift protection to trusts in which the grantor had retained an interest, at least to the extent of such retained interest. APTs have now been authorized in five U.S. jurisdictions: Delaware, Alaska, Nevada, Rhode Island and Utah. The remainder of this article will focus on domestic APTs, rather than offshore APTs.

Some commentators question whether APTs are ethical since their raison d’être is to protect a portion of the donor’s assets from creditors and, at the same time, allow the grantor to retain at least a limited interest in the trust. The honest answer is that APTs present a conundrum in which the law must balance two conflicting objectives: free alienation of property and protection of creditor’s rights. This article will focus on the essential elements of a valid APT and the process that must be undertaken to strike a proper a balance between these two competing objectives.

Although domestic APT statutes vary in their details, they all share some common elements:

• transfer to an irrevocable trust

• resident trustee

• specific incorporation of state law

• inclusion of a spendthrift clause

• grantor’s retained interests

• tail periods for extinguishing claims

Transfer to Irrevocable Trust. The transfer of assets must be to an irrevocable spendthrift trust. It may be a direct transfer from the grantor to the trustee or may result from the grantor’s exercise of an inter vivos power of appointment over an existing trust.

Resident Trustee or Qualified Trustee. The trustee is typically an independent individual, bank or trust company resident in the state. Some states (e.g., Delaware) permit an out-of-state co-trustee. The grantor must not serve as the trustee, but may serve as an investment advisor and may reserve a veto power over distributions.

The trustee must maintain custody of some or all of the trust corpus, must maintain trust records, prepare fiduciary income tax returns, or materially participate in the administration of the trust.

Trust Protector. Many APTs have a trust protector, a fiduciary who may veto distributions and investments or remove and replace the trustee. The trust protector adds an additional layer of checks and balances in the management of the APT.

Incorporation of State Law. The trust instrument must expressly incorporate that state’s law to govern the trust’s validity, construction and administration. For example, any claim involving a Delaware APT can only be brought in that state’s court.

Spendthrift Clause. The trust instrument must include a spendthrift provision prohibiting the attachment or assignment of any beneficiary’s interest in the trust.

Grantor’s Retained Interests. The typical APT permits the grantor to retain the following defined interests:

• discretionary distributions of income and/or principal

• veto power over distributions

• special testamentary power of appointment

However, the Delaware Act permits the following additional retained interests:

• mandatory right to trust income

• income or principal from a Charitable Remainder Trust

• unitrust distribution (up to five percent)

• receipt of principal at the trustee’s sole discretion or pursuant to an ascertainable standard

• right to remove the trustee or investment advisor

• right to serve as an investment advisor

• use of real property under a Qualified Personal Residence Trust

• not limited to individuals – corporations and partnerships may create an APT

Tail Periods. There are certain "tail periods" that begin to run upon the grantor’s transfer of assets to the APT. At the expiration of the tail period, the enforcement of nearly all future creditors’ claims is barred. Claimants who bring suit within the relevant tail period must prove the existence of a "fraudulent transfer."

Most APT statutes provide that future creditors (those creditors whose claims arise after the trust was created) must bring their claim within four years from the date of transfer to the trust. Existing creditors (those creditors whose claims arose before the trust was created) must bring their claim within the later of four years from the date of transfer to the trust or one year after the creditor discovered (or should have discovered) the existence of the trust.¹

Fraudulent Transfer. A creditor who brings a claim within the relevant tail period must prove that the transfer to the APT was a "fraudulent transfer." Fraudulent transfer or fraudulent conveyance provisions exist under both the federal Bankruptcy Code and state law. Most states have adopted a version of the Uniform Fraudulent Transfers Act.

An existing creditor may establish a fraudulent transfer if the grantor made the transfer without receiving reasonably equivalent value in exchange for the transfer; and the grantor was insolvent at the time (or the grantor became insolvent as a result of the transfer).

A future creditor may establish a fraudulent transfer if the grantor made the transfer:

(1) With the actual intent to defraud any creditor; or

(2) Without receiving reasonably equivalent value in exchange for the transfer; and the grantor:

(a) was engaged in a transaction for which his remaining assets were unreasonably small in relation to the transaction; or

(b) intended to incur (or believed he would incur) debts beyond his ability to pay as they became due.

The first test is a subjective "badges of fraud" test. Relevant lines of inquiry include whether the grantor has been sued or threatened with suit, whether the grantor effectively retained control over the assets, whether the grantor transferred substantially all assets to the APT, and whether the transfer to the APT occurred shortly before or after the grantor incurred a substantial debt. The essence of this test is whether the grantor could reasonably have anticipated the future creditor’s claim upon funding the APT.

The second test is a more objective test which calls for an examination of the sufficiency of the grantor’s assets in light of the circumstances at the time of the transfer.

If a creditor successfully challenges a transfer to an APT as being fraudulent, the creditor can recover its debt, plus any costs and attorneys’ fees allowed by the court. The existence of a fraudulent transfer as to one creditor will not inevitably invalidate the trust for all creditors. Each creditor must demonstrate as to its own particular circumstances that a transfer was fraudulent.

Exempt Creditors. For public policy reasons, two classes of creditors enjoy special status (except in Nevada and Utah) and are exempt from the provisions of APT statutes: (1) spouses and children, and (2) existing tort claimants. These creditors may reach trust assets without regard to any tail period and without having to prove the existence of a fraudulent transfer.

Trust assets will not be protected against child support claims or claims for alimony or marital property asserted by one who was married to the grantor at or before the time of the transfer to the trust. Since one does not acquire the status of "spouse" under this exemption if the grantor’s transfer pre-dates the marriage, an APT is a discreet alternative to a pre-nuptial agreement.

APT statutes do not insulate trust property from tort claimants (death, personal injury or property damage) on or before the date of the transfer to the trust where the injury is caused (in whole or in part) by an act or omission of the grantor or by someone for whom the grantor is vicariously liable.

Integration with Other Planning. An APT is not a stand-alone device. Rather, asset protection planning is part of an overall wealth preservation and management process that includes investment advice, insurance planning, income tax planning, estate planning and wealth protection.

Candidates for APTs include professionals; individuals exposed to lawsuits arising from negligence, intentional torts and contractual claims; officers, directors and fiduciaries; and real estate owners with exposure to environmental claims.

Federal Income Tax Treatment. If the grantor of an APT retains the right to receive discretionary income and principal distributions, the trust will be a grantor trust. Grantor trusts are disregarded entities and all trust income, whether received by the grantor, is taxed to the grantor. However, if distributions to the grantor must be approved by an adverse party, it could be a non-grantor trust, insulating the grantor from tax liability. PLR 200247013.

Gift Tax. A transfer to an irrevocable trust is not automatically a completed gift. If the grantor retains certain limited powers of appointment, completed gift status and the resulting potential gift tax consequences can be avoided. PLR 200148028. A transfer to an APT is a completed gift if the grantor surrenders control over assets. However, the inability of the grantor’s creditors to reach assets negates retained control. PLR 9837007.

Escaping Income Tax and Gift Tax. Two private letter rulings permit the grantor to escape both income tax and gift tax. In these rulings, the grantor was not deemed the owner of the trust due to the existence of adverse parties who exercised discretion in making distributions, protecting him from income taxation. The same rulings further held that the grantor did not make completed gifts to an irrevocable trust, due to the retention of a limited testamentary power of appointment. (PLRs 200148028 and 200247013.)

Estate Tax. Inclusion of the trust assets in the gross estate depends on the degree of control the grantor retains in the trust. A discretionary receipt of income or principal is not a retained interest in the trust, absent an understanding with the trustee, whereas other retained interests would compel inclusion in gross estate. §2036(a). The inability of creditors to reach trust assets negates the implied ability to revoke or terminate the trust. §2038(a).

Due to ethical constraints, as well as the potential for civil or even criminal liability under certain circumstances, attorneys must be extraordinarily cautious in accepting and counseling clients with regard to the establishment of an APT. It is imperative that attorneys be fully aware of the client’s financial and legal situation, which should be independently verified through due diligence procedures to uncover any existing, foreseeable or threatened claims. Due diligence involves an objective investigation of the client’s personal finances, business dealings, legal record and other relevant information.

Attorneys should also perform an analysis of the client’s financial solvency. This analysis includes the preparation of a net worth statement reflecting all of the client’s assets, subtracting all debts, liabilities, and claims, and subtracting assets that are already protected from creditors’ claims under federal or state law (e.g., homestead, qualified retirement plans, insurance and annuities).

There is no magic number or safe harbor percentage of assets that can be transferred to the trust. However, a larger transfer of assets to the APT reduces the client’s remaining solvency and increases the likelihood of scrutiny. Many commentators and practitioners recommend transferring less than one-third of the grantor’s net worth. The factors to consider include the dollar amount of assets transferred, the nature of the client’s business and professional activities, the potential source of any claims and any additional asset protection planning tools available to the client. The goal should be to leave sufficient wealth to satisfy existing and foreseeable creditors. Providing adequate reserves for such claimants diminishes the odds of a successful fraudulent transfer assertion.

Without the benefit of hindsight, it is impossible to determine what will be deemed an appropriate level of due diligence. Such determination will depend upon the specific facts and circumstances presented by each client. However, the potential consequences of a failure to conduct sufficient due diligence in planning for an APT warrants an abundance of caution.

The American litigation explosion of the later half of the 20^th century shows no signs of slowing down. Nowhere is it written, however, that an individual must preserve his or her assets for the satisfaction of unknown future claims and claimants. With the enactment of legislation in Delaware, Alaska, Nevada, Rhode Island and Utah expressly authorizing the establishment of domestic APTs, asset protection planning has entered a new era. APTs formed under the proper circumstances and with the requisite due diligence can be expected to play an increasing role in the estate planning process for professionals and business owners.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.