Level 4: Asset Protection Trusts
While trusts can shield property from the claims of the beneficiaries' creditors, the law is less clear as to whether the trust property can be protected from the grantor's creditors when the grantor is also a beneficiary of the trust. The oldest and most common asset protection trusts are those formed offshore (foreign asset protection trusts). But since 1997, several states have changed their laws to allow for asset protection trusts (domestic asset protection trusts).
Domestic Asset Protection Trusts. Several states, most notably Alaska, Delaware and Nevada, have all passed laws protecting assets in a domestic asset protection trust ("DAPT") from the debtor's creditors. In most states, including Michigan, if a debtor creates an irrevocable trust for his/her own benefit, the assets in that trust remain subject to the claims of the debtor's creditors. In contrast, DAPTs allow a debtor to create a trust for his/her own benefit, while providing creditor protection for the debtor.
Though the laws vary from state to state, most DAPT statutes have the following common features: 1) the transfer to the trust must not violate applicable fraudulent transfer laws; 2) the trust must be irrevocable; 3) the trustee, whether corporate or individual, must be a resident of the state in which the trust is formed; 4) some trust assets must be located or deposited in the DAPT state; and 5) the trust agreement must contain a "spendthrift" clause which restricts the transferability of a beneficiary's interest in the trust property. Moreover, each DAPT state has provisions allowing creditors a time period to make claims against the DAPT and requiring that the individual remain personally solvent after the transfer.
The 2005 changes to the Bankruptcy Code have created a new 10-year limitation period for transfers to DAPTs when made with the "actual intent" to hinder, delay or defraud present or future creditors. This effectively means that all transfers to DAPTs will be suspect for the 10 years prior to the date that a bankruptcy petition is filed. Because of this and because of the potential Constitutional challenges a DAPT may face (see below), DAPTs are viewed by many advisors as a "poor cousin" to their offshore counterparts.
It is important to note that DAPT statutes are relatively new and have not been exposed to rigorous court challenges. Although DAPT statutes appear to offer substantial asset protection, DAPT jurisdictions cannot be as protective a site for establishing trusts as an offshore jurisdiction (see below). The reason is that they are part of the United States and, therefore, are bound by the U.S. Constitution. By virtue of the "full faith and credit" mandate in the Constitution, a DAPT state's courts should be required to enforce judgments rendered against its own citizens under the laws of less debtor-friendly, non-DAPT states like Michigan. Whether they will remains to be seen.
Foreign Asset Protection Trusts. Foreign asset protection trusts ("FAPTs") are carefully designed trusts formed under the laws of a foreign jurisdiction to take advantage of local statutes favoring debtors. The Cook Islands, Cayman Islands, Bahamas, Belize and Nevis are very favorable jurisdictions for FAPTs. Although more expensive to establish and administer than DAPT, FAPTs are considered by many advisors to be the ultimate asset protection trust.
Properly structured, a FAPT allows the debtor to put assets beyond the reach of creditors and U.S. judgments, while allowing the debtor access to the assets held by the FAPT. The jurisdictions mentioned above do not honor foreign judgments, thereby requiring a creditor to retry the case in the foreign jurisdiction. Moreover, the applicable fraudulent conveyance laws in those jurisdictions require "proof beyond a reasonable doubt" that the trust was established to defraud creditors and, generally, have short statutes of limitations (i.e., two or three years). Thus, the barriers to bringing an action in a foreign jurisdiction are formidable for all but the most determined and well financed creditors. Since the debtor is usually a beneficiary of the FAPT, the debtor is taxed on all of the trust income. Therefore, no income tax savings are afforded by FAPTs. However, the jurisdictions referred to above do not impose any local taxes on trust income.
One of the more popular ways to take advantage of a FAPT is for the debtor to transfer his/her assets to a limited liability company. The debtor would retain a 1 % voting membership interest and would serve as the manager of the LLC. The other 99% non-voting membership interests would be transferred to the FAPT. The assets do not leave the U.S. until the debtor is actually threatened, at which time the LLC is dissolved and 99% of the LLC's assets are transferred to the foreign trustee of the FAPT.