Domestic Asset Protection Trusts

a possible solution...
Offshore Trusts have been used for many years to shield assets from potential creditors. There are many tax and legal problems in additional to the high costs and international risks of non-US legal entities. Therefore, Domestic, meaning US based, Asset Protection Trusts are being adopted.

What is an Asset Protection Trust

A Domestic Asset Protection Trust is a trust established in a US state designed to shield the trust assets from the creditors of the beneficiary. The idea is that placing assets into a trust can preserve them for the use of the beneficiary while shielding them from most creditors.

Can Trusts Protect Assets from the Reach of Creditors?

Virtually all U.S. jurisdictions hold that trusts created for third parties are generally not reachable by the beneficiaries' creditors. That means if a parent establishes a spendthrift trust for a child it should effectively shield the assets from the child's creditors. Five states (Delaware, Alaska, Nevada, Rhode Island and Utah) now recognize irrevocable self-settled spendthrift trusts. This means a person may place personal assets into an appropriately created trust and have those assets protected from creditors.

Bias Against Domestic Asset Protection Trusts

There is a bias against DAPTs and many people believe that self-settled trusts are generally created with evil intent. All U.S. jurisdictions have rules to set aside fraudulent transfers. Two recent cases illustrate the application of these rules: U.S. v. Engh, 330 F.3d 954 (7th Cir. 2003) and Nastro v. D'Onofrio, 263 F. Supp. 2d 446 (D. Conn. 2003). Since all five of the domestic asset protection trust states have fraudulent transfer rules, a creditor should be able to reach assets that were the subject of an improper transfer to a DAPT. However, domestic asset protection trusts that do not run afoul of the fraudulent transfer rules should be effective.

Who Should Establish an Asset Protection Trust?

The worst possible candidate for asset protection planning is a person who has or is about to incur a large obligation and wants to hide assets to avoid satisfying this debt.

The "best candidate" for a domestic asset protection trust would be the client who:

1. has no current creditor problems (or at least assets substantially in excess of what is needed to cover current and foreseeable claims);

2. is worried about claims that might arise in the future;

3. has assets that aren't needed to meet current and foreseeable living expenses; and

4. does want frequent access to the assets which are to be protected.

What is the Tax Impact of DAPTs?

the creator of a DAPT can choose to structure the trust as a completed gift for federal gift tax purposes while still excluding the trust principal from his or her gross estate for federal estate tax purposes if the settler can only receive distributions from the trust in the absolute discretion of an independent trustee. Conversely, the trustor of a DAPT can intentionally prevent a completed gift by retaining a special testamentary power of appointment.

From an income tax standpoint, the domestic asset protection trust will be treated as a grantor trust unless the distributions to the trustor must be approved by an adverse party such as a child who would receive the assets not distributed to the trustor. Domestic asset protection trusts are being utilized to avoid state and local income and intangible taxes. Nevertheless, no case has yet upheld the effectiveness of domestic asset protection trusts.

How Can an Asset Protection Trust be Used?

Here are some examples of possible uses of the domestic asset protection trusts:

1. to shield a gift or inheritance that is received outright rather than in trust;

2. to protect children who receive significant assets at the age of majority;

3. to protect officers and directors from heightened risks or to allow them to use "blind" domestic asset protection trusts to comply with security law restrictions while keeping the ability to benefit from the trust assets;

4. to avoid state income or intangible taxes;

5. to protect the assets of clients who are mentally, physically or financially vulnerable;

6. to protect assets from claims of future spouses and avoid providing the type of financial disclosure that is required to implement effective prenuptial agreements;

7. to protect personal injury awards (see In re Jordan, 914 F.2d 197 (9th Cir. 1990) for an example of where such a trust would have been helpful);

8. to protect CRTs and other estate planning vehicles such as GRATs, QPRTs, etc. Mr.Nenno pointed out that trustors may be more likely to engage in sophisticated estate planning transfers if they know that the funds might still be available to them in the event of an emergency;

9. nonresident aliens may use domestic asset protection trust before they immigrate to the US to remove assets from their estates while still retaining the ability to get funds back in the event of a future need or catastrophe; and

10. to provide protection for offshore or ineffective domestic self-settled trusts. Mr.Nenno noted that careful consideration must be taken to determine if such a move will cause the trustor/beneficiary to make a completed gift.