Evaluating Foreign and Domestic Asset Protection Trusts

Trusts, at their most basic level, are established with the of goal administering an individual’s assets over time according to his or her wishes. To legally accomplish this goal, trust documents, or deeds, provide a fiduciary arrangement that allows for a third-party trustee to hold and distribute these assets on behalf of beneficiaries. Trust deeds seek to empower their fiduciaries, where possible, to reduce the estate tax liability, bypass probate, and protect estate property from creditors.

In the past, creditors of a trust could reach trust assets to satisfy their claims if the grantor retained the right to benefit from the trust. As creditor claims and litigation intensified over time, asset protection trusts became an attractive option to resist such creditor claims. Asset protection trusts are irrevocable self-settled trusts in which the grantor can also be the beneficiary. As detailed below, these trusts can provide significant creditor protection.

Irrevocability serves as the key protection function for asset protection trusts. Historically, asset protection trusts could only be legally satisfied internationally. Thus, foreign jurisdictions have typically dominated this space. However, there has been a growing shift in the U.S. from a number of states to provide legal flexibility to allow the establishment of asset protection trusts domestically.

As of this writing, 19 states have passed legislation authorizing asset protection trusts in one form or another. Domestic asset protection trusts (DAPTs) and foreign domestic asset protection trusts (FAPTs) have certain advantages and disadvantages. Practitioners should have a good understanding of the differences between the two when determining which is most appropriate to accomplish a client’s goals.

Foreign Asset Protection Trusts

The primary advantage of a FAPT over a DAPT is the foreign jurisdiction itself. Because the trust and the trustee are domiciled in a foreign jurisdiction, they are often not required to respect and enforce U.S. judgments. Accordingly, U.S. courts often have difficulty asserting jurisdiction over the trustee in order to execute judgments. Thus, creditors may often be required to relitigate in the country of formation, which can be incredibly difficult as many of these jurisdictions have extremely favorable trust law, which bars many claims against the trust. Even if a creditor succeeds in bringing a case against the trust, costs and administrative hurdles increase and the likelihood of an enforceable judgment remains low.

Specifically, with respect to claims, foreign jurisdictions typically have shorter limitation periods for bringing such claims. They will often have more narrow definitions of fraudulent transfer claims against an asset protection trust. Most FAPT jurisdictions impose a “beyond a reasonable doubt” standard of proof as opposed to the U.S. “clear and convincing” or preponderance of evidence” standards, a significantly higher legal bar to clear. Finally, FAPTs often contain favorable trust provisions such as flight clauses, duress clauses, or “excluded person” clauses which may further reduce likelihood of an adverse judgment against the trust. Some of the most favorable foreign jurisdictions for forming a FAPT include the Cook Islands, the Cayman Islands, Nevis, and Bermuda.

While FAPTs provide certain protections that DAPTs cannot, they are not without drawbacks. FAPTs can be expensive, because proper formation often necessitates tax and legal advisors in multiple jurisdictions (e.g., the U.S. and the country of trust formation). FAPTs also require additional tax and legal reporting in the U.S. For example, Forms 3520 and/or 3520-A may need to be filed on an annual basis depending upon the facts. Foreign trust reporting and regulatory requirements can be complex and time consuming, with substantial penalties for failing to comply.

Moreover, FAPTs may in some instances run a risk of being deemed a U.S. trust, thus negating their benefit. This can occur, for example, in cases where a U.S. court is able to assert personal jurisdiction over the trustee or if the trust is funded with U.S. real property or securities that are subject to the court’s control. Careful planning is essential to ensuring FAPTs are not deemed subject to U.S. jurisdiction.

Lastly, though FAPTs make the assets hard for creditors to reach, these assets may also be difficult for the settlor and beneficiaries to reach in the case of misconduct or insolvency of a foreign trustee. In these cases, it can be very difficult, time consuming, and costly to change the trustee of an offshore trust.

Domestic Asset Protection Trusts

In this light, DAPTs may prove a more suitable option depending upon the goals of the settlor, size of the corpus, and nature of the assets. Perhaps the most obvious advantages of a DAPT is the cost. The fees charged for establishing a DAPT typically approximate half of their foreign counterparts. Annual cost of reporting (i.e., Forms IRS 3520 and 3520-A) is mitigated as well.

Additionally, in cases where assets funding the trust are U.S. situs (i.e., U.S. real estate), there would be a strong likelihood that the trust (even if FAPT) would be deemed under U.S. jurisdiction. Here, a DAPT has the same legal protection as an FAPT.

Finally, a risk of large fines and/or imprisonment may be present in FAPT instruments. There have been several cases in which U.S. courts have relied on civil contempt remedies to force debtors to physically repatriate assets held by FAPTs. These decisions have resulted in fines and, in several instances, incarceration.

Notably, several U.S. states have modified their laws to encourage the use of a DAPT over a FAPT. In particular, Nevada and South Dakota have some of the more favorable asset protection trust provisions within their statutes. For example, both states have a two-year statute of limitations under which a fraudulent transfer may be set aside for a future creditor. They also require a “clear and convincing” burden of proof rather than a “preponderance” standard used in other states. These features put them on par with many foreign jurisdictions.

While the evolution of state law continues to encourage DAPT formation, it is important to recognize that domestic legal precedent remains in its infancy as compared to foreign trusts. U.S. courts continue to wrestle with DAPT issues on an ongoing basis and some legal uncertainty is to be expected given the relative newness of this area. However, the current trend supports the notion that states are continuing to revise their laws to incentivize DAPT use.

Takeaway

The choice of a DAPT or a FAPT will undoubtedly depend on each client’s unique facts and individual risk tolerance. But it is clear that DAPTs are making strides to become a more competitive and compelling option. Individuals seeking to form asset protection trusts should consult with their tax and legal advisors to understand their options and make an informed decision with respect to trust jurisdiction, to most efficiently achieve their individual asset protection goals.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Jack C. Millhouse is an international tax manager at FGMK LLC in Chicago. Melissa M. Meyer is a senior associate in Chicago.