Asset Protection Law - Book Chapter DAPT

It is a long held legal principal that if you set up a trust for yourself, to the greatest extent that it is possible for you to benefit, your creditors can also benefit. For instance, if you set up a discretionary trust with yourself and other beneficiaries, since the trustee, in his discretion, can distribute 100% of the trust assets to you, your creditors have access to 100% of the trust assets. “Self-Settled” trusts are not creditor proof.

In order to entice money to their shores, offshore jurisdictions passed laws which forbade creditors from attacking the assets of self-settled trusts. For the same reason, several states have passed laws which, likewise, protect “domestic” asset protection trusts. Creditor protection (and estate planning, see below) drive the DAPT marketplace. Currently 12 U.S. states provide Domestic Asset Protections Trusts. The 12 are New Hampshire, Tennessee, Wyoming, South Dakota, Missouri, Oklahoma, Utah, Colorado and Rhode Island. In addition, the three states that are considered to have the best asset protection laws are Nevada, Delaware and Alaska.

The trust must be irrevocable.
The settlor may be only a discretionary beneficiary;
Requirement that a resident trustee act as trustee in the state. Neither the settlor nor a related party may be a trustee.
The trust instrument must contain a spendthrift or anti-alienation provision.
Some assets of the trust must be located in the jurisdiction where the trust is established.
Prohibit creditor action, with some exceptions which include fraudulent transfers, child support claims, spousal claims, and tort claims occurring on or before the date of the transfer to the trust.
Some part of the trust's administration must occur within that jurisdiction.

Creditor Protection For Self-Settled Trusts. In most states, creditors can reach the assets of a self-settled trust; not so in DAPT states.

Relaxed Fraudulent Transfer Standard. Because DAPT states vie for business with other DAPT states as well as offshore trusts, states that make it more difficult for creditors to prove fraudulent transfer will garner more business.

Trustees Are Subject To A U.S. Court’s Jurisdiction. Whereas an order of a U.S. court demanding that an offshore trustee perform an action will generally be ignored, a U.S. trustee can be compelled to follow a U.S. court order. With an offshore trust, the creditor would have to retry the case in the offshore jurisdiction which is expensive and generally leads nowhere.
Sister State Judgment. Sister states must render “full faith and credit” to judicial proceedings in other sister states. The creditor need not retry the case in order to prevail; however, this result is not certain. [See Hanson v. Denckla, 357 U.S. 235 (1958).]
Attempts To Make A “Choice Of Law” In Favor A DAPT State Will Probably Fail. Will a California judge apply Nevada law in favor of an Florida resident?
Full Faith and Credit. An offshore jurisdiction will not recognize a U.S. judgment. States are required by the “full faith and credit” clause of the U.S. Constitution to recognize the judgment of sister states. This means that a creditor only has to take its judgment and register the judgment without having to retry the case.
Supremacy Clause. Because of the Supremacy Clause of the Constitution, federal courts may not be bound by state law.
Lack of Secrecy and Discovery. A U.S. trustee, unlike a foreign trustee, is subject to a discovery order.
Bankruptcy. The 2005 changes to the Bankruptcy Code created a 10-year limitations period for transfers to self-settled trusts which are meant to hinder, delay or defraud creditors. This means that transfers to DAPTs will be suspect for the 10 years prior to the date that a bankruptcy petition is filed.

I have not seen court case that validates or invalidates DAPTs. Until case law validates them, many believe it is safer to use offshore trusts to protect assets that can be moved offshore. For assets that cannot be moved offshore, there are two lines of thought:

International Asset Protection Trusts (IAPTs) are set up in jurisdictions which do not respect U.S. judgments. Therefore, will the U.S. respect theirs?
DAPTs hold U.S. real estate under the law of U.S. states. Many believe they have a better chance of prevailing than do IAPTs holding real estate. [See Chapter 5, International Asset Protection Trusts.]

There is no case law which validates DAPTs. However, a creditor would have a difficult and costly time before the matter could be adjudicated. It remains to be seen whether traditional states will respect DAPTs. Because a DAPT gives the client leverage with creditor negotiations, a DAPT has value.

DAPT jurisdictions take advantage of the estate tax planning opportunities created by the relationship between debtor-creditor law and gift and estate taxation. DAPTs provide a unique opportunity to minimize estate and generation-skipping transfer taxes. These trusts are able to provide clients a solution to the fear of making substantial lifetime gifts and then running out of their life savings. DAPTS allow them to make substantial gifts (to remove rapidly appreciating assets out of their estate and yet maintaining their financial security.

Internal Revenue Code §2036(a)(1) provides the general rule that "[t]he value of the gross estate shall include the value of all property to the extent of any interest therein of which the decedent has at any time made a transfer …, by trust or otherwise, under which he has retained for his life … or for any period which does not in fact end before his death…the possession or enjoyment of, or the right to the income from, …property…".

Section 2036(a)(1) causes inclusion in the decedent's gross estate of the value of property held in a trust in which the decedent retained a discretionary interest. In Paolozzi v. Commissioner, 23 T.C. 182 (1954) the Tax Court stated that under Massachusetts law "…petitioner's creditors could at any time look to the trust of which she was settlor-beneficiary for settlement of their claims to the full extent of the income thereof”. The reason for inclusion under §20236(a)(1) is the fact that the property transferred by the decedent remained subject to his creditor's claims under the law of the jurisdiction which governs the trust. The IRS' theory is that if the transferor's creditors can reach the transferor's interests in the transferred property, then the transferor could incur liabilities, not pay those debts and watch the creditors successfully pursue the transferred assets. If this factually were to happen, it arguably follows that the transferor retained the "right" to the use, possession, or enjoyment of the property.

The converse of the foregoing is that where transferred property is not subject to the claims of the decedent's creditors, it is not includible in the decedent's gross estate. The Service has adopted this result in the gift tax context in Rev. Rul. 76-103, 1976-1 CB 293, wherein they stated that if and when the grantor's dominion and control of the trust assets ceases, such as by moving the situs of the trust to a state where the grantor's creditors cannot reach the trust assets, then the gift is complete for gift tax purposes under the rules set forth in section 25.2511-2 of the regulations.

The ability to transfer property to a trust, retain a discretionary interest in that trust, and yet have the transfer deemed a completed gift for gift tax purposes and, therefore, excluded from the transferor's gross estate at death eliminates the his concern that the transferred property may be needed to maintain his standard of living.

The idea of using an asset protection trust to obtain estate tax savings can be incorporated into other types of trusts used for estate planning including irrevocable life insurance trusts (ILITs) wherein the transferor desires to retain access to the policy's cash value.

The benefits of self-settled DAPTs, which are normally created for creditor protection, can also be used for estate and gift tax planning. This is so because self-settled DAPTs permit the tax benefits of making giftswhile at the same time ameliorating a client’s discomfort with transferring property which may be required to maintain his lifestyle.

Planners have raised concerns regarding the use of DAPT planning. Whereas many offshore trust laws provide that judgments foreign to their jurisdiction are to be given no force or effect, planners question whether the courts of another state in the U.S. agree that DAPT laws are to be applied? In determining the law applicable to a trust instrument, the courts have stressed the distinction between immovables and movables. [See 5A, Austin Wakeman Scott & William Franklin Fratcher, The Law of Trusts, §554 (4th ed. 1987).]

Personal Property. The Restatement (2d) Conflicts 1969, section 273(b) and comment c, state that personal property owned by an inter vivos trust is governed by the local law designated by the settlor in the trust. When a settlor specifically states the governing law to be followed in the trust document regarding movables, the courts will generally follow the settlor’s intent. [See Dunkley v. Peoples Bank & Trust Co., 728 F. Supp. 547, 555-556 (W.D. Ark. 1989) (the settlor could designate the governing law although the state has no connection with the creation and administration of the trust).]

Real Property. The Restatement (2d) Conflicts section 280, however, stated that real property is governed by the law of the property's situs. If the Restatement (2d) is followed, creditors may attach a settlor's beneficial interest in a DAPT that contains real property not located within the DAPT state's boundaries.

Standards such as "the most significant relationship to the occurrence test," "the state of dominant interest test," and "the fundamental policy underlying the controversy test" have all been advocated. For example, in In re Portnoy, 201 BR 685 - Bankr. Court, SD New York 1996 the bankruptcy court held:

Whereas under normal circumstances, parties are free to designate what state's or nation's law will govern their rights or duties, when another state or nation has a dominant interest in the transaction at issue, and the designated law offends the fundamental policy of that dominant state, the court may refuse to apply foreign law.

In Portnoy, the judge disregarded the Restatement (2d) and combined the dominant interest theory with the fundamental policy theory in reaching a decision to apply the law of the debtor's residence.

NRS 166.070 states that unless the writing shall declare to the contrary, expressly, the construction, operation and enforcement of all spendthrift trusts, heretofore or hereafter created in this state, shall be governed by the principles stated in NRS §§166.080-166.150, inclusive, to the same effect as if they were written therein. The trustee of a spendthrift trust is required to disregard and defeat every assignment or other act, voluntary or involuntary, that is attempted contrary to Nevada law.

The Delaware legislature has drafted a very creative solution to the conflict of laws issue. Basically, the Delaware legislature states in Section 3572(g) that if a non-Domestic Venue court attempts to apply their state’s law instead of Delaware’s law regarding the validity, construction or administration of a Delaware spendthrift trust, the trustee will be automatically jettisoned and a new successor trustee will be appointed as set forth in the trust or appointed by the Delaware Court of Chancery. This “new successor trustee” will not be subject to the jurisdiction of a non-Domestic Venue Court. As a result, a creditor would be forced to then bring an action in a Delaware Court and, of course, the Delaware Court will apply Delaware law as set forth in the trust instrument.

An irrevocable spendthrifted DAPT created in a debtor friendly state such as Nevada or Delaware by an out-of-state person domiciled in a creditor friendly state such as California can obtain the full asset protection benefits of the designated state set forth in the trust document under the conflict-of-laws rules if the creator follows some basic principles:

First, it is important not to place land directly into the trust. It is better to transfer real estate into a limited liability company, which, in essence, converts an immovable property to a movable property. Such a transformation results in a much stronger position from a conflict-of-laws point of view.
Second, it is important to make certain that the settlor’s intent as to the designated state is clearly set forth in the trust document.
Third, in order to strengthen the “substantially related” test and to increase contacts with the designated state it is strongly recommended that any entities formed by a settlor such as a Limited Liability Company should be created in the same state as the trust.

When creating a DAPT consider the Due Process Clause of the 14th Amendment in light of the Full Faith and Credit Clause of the U.S. Constitution. In many cases an attack on a DAPT will be either the second phase of a lawsuit or a second suit entirely.

1. The first action will be the cause, cast in tort or contract, that gave rise to the liability, and will result in a judgment.

2. The second phase of the creditor’s attack will be a post-judgment enforcement proceeding, usually against the trust, in an effort to satisfy the judgment.

[Asset Protection Strategies, Planning with Domestic and Offshore Entities, Alexander A. Bove, Jr., editor; A Closer Look at U.S. Asset Protection Trusts, Chapter 1, Elizabeth M. Schurig, Amy P. Jetel, at 28.]

In this second phase post-judgment proceeding, the judgment creditor will attempt to enforce the judgment against the DAPT pursuant to the Full Faith and Credit Clause of the U.S. Constitution. However, the trustee will allege that the trust company does not have sufficient minimum contacts or a single act of solicitation with the non-DAPT jurisdiction and will assert that to enforce the judgment would be a denial of due process right pursuant to the 14th Amendment of the U.S. Constitution.

The DAPT trustees will allege that due process forbids the rendition of a judgment within the United States unless the State of rendition has judicial jurisdiction… A judgment rendered in violation of these requirements is void in the State of rendition itself, and due process forbids the recognition and enforcement of such a judgment in sister States.

In analyzing the Due Process of Law Clause and its impact on the Full Faith and Credit Clause, a threshold issue is whether or not the trustee is a necessary party. The general rule is that the court must have jurisdiction the trustee or the trust property in order to determine trust issues. States may enact statutes that indicate that the trustee is a necessary party. In the landmark U.S. Supreme Court case of Hanson v. Denckla, 357 U.S. 235, 244-245 (1958), the Court found that the state of Delaware was entitled to conclude that Florida law made the trust company an indispensible party and was therefore under no obligation to give the Florida judgment any faith and credit, even against parties over whom Florida’s jurisdiction was unquestioned.

The general rule is that a trustee will most likely be considered a necessary party when a non DAPT state plaintiff attempts to enforce a judgment against a DAPT trustee. If a state statute asserts that a trustee is a necessary party; it will be even more difficult for a plaintiff to enforce a judgment absent personal jurisdiction over the trustee.

In Hanson (supra), certiorari was granted to both the Delaware Supreme Court and the Florida Supreme Court. Florida held that Florida had personal jurisdiction over the nonresident Delaware Trust Company. The U.S. Supreme Court stated that the Florida court did not have in rem jurisdiction over the corpus of the trust or personal jurisdiction over the trust company. Without such jurisdiction, it had no power under Florida law to pass on the validity of the trust. The U.S. Supreme court affirmed the Delaware Supreme Court in holding that it was not bound to give Full Faith and Credit to the invalid Florida judgment.

The U.S. Supreme Court failed to find the “minimal contacts” set forth in International Shoe v. Washington, 326 U.S. 310, 319 (1945). The defendant trust company had no office in Florida, and transacted no business there. None of the trust assets had ever been held or administered in Florida, and the record disclosed no solicitation of business in that State either in person or by mail

Hanson (supra) remains a strong precedent today when it comes to defending attacks on trustees by out-of-state parties who fail to establish personal jurisdiction. The U.S. Supreme Court and many state courts support the notion that a sister state must establish minimum contacts or a single act of solicitation in order to obtain proper personal jurisdiction over a trustee and trust assets and that there must not be an improper interference with important interests. Compare the jurisdictional issues in Hanson to the current DAPT trust companies that are soliciting business by mail, in person, and by telephone in all 50 states. Persons establishing DAPTs often sign the trust instrument in the state where they reside and then mail it to the trust company. Based on these facts, many trust companies are availing themselves of the laws of the potential forum states by soliciting and doing business there. Therefore, a state that has not adopted DAPT legislation can have jurisdiction.

Of utmost importance for asset protection purposes is the selection of a corporate trustee who maintains a strong policy of minimizing contacts with non asset protection states and does not maintain branch offices or solicit business there. Additional layers of protection can also be added by forming limited liability companies in the asset protection state and by having all documents executed in the asset protection state.

How will a bankruptcy filed in federal court affect the integrity of the DAPT formed and administered under state law? Under the Supremacy Clause of the U.S. Constitution, federal law preempts state law. Will a bankruptcy court apply federal law (or the law of some other state) in determining the validity of a self-settled spendthrift clause in a domestic asset protection trust? U.S. Bankruptcy Code Section 541(c)(2) states that:

A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non-bankruptcy law is enforceable in a case under this title.

Authority for this section stems from the 10th Amendment to the Constitution. The phrase “applicable non-bankruptcy law can mean state or federal law other than bankruptcy law. As set forth in the Third Restatement, the statutory language “restriction on the transfer of a beneficial interest”, excludes spendthrift trusts from the bankruptcy estate. Therefore, the trust assets will not become part of the debtor’s bankrupt estate and will not be administered or liquidated by the debtor’s bankruptcy trustee. In the DAPT arena, we are particularly interested in self-settled spendthrift trusts.

In order to determine if Section 541(c)(2) is applicable, the debtor or beneficiary must meet a three part test:

Based on applicable case law, the first two elements are typically readily met by those seeking the protection of Section 541(c)(2). But, is the restriction enforceable under non-bankruptcy law. In Patterson v. Shumate, 504 U.S. 753 (1992), the Supreme Court had to determine whether an anti-alienation provision contained in an Employee Retirement Income Security Act of 1974 (ERISA) pension plan constituted a restriction on transfer enforceable under “applicable non-bankruptcy law,” and whether a debtor could exclude his interest in such a plan from the property of the bankruptcy estate. The Court held that the text of Section 541(c)(2) did not support petitioner’s contention that “applicable non-bankruptcy law” was limited to state law, and concluded:

The natural reading of the provision entitles a debtor to exclude from property of the estate any interest in a plan or trust that contains a transfer restriction enforceable under any relevant non-bankruptcy law. Nothing in Section 541 suggests that the phrase “applicable non-bankruptcy law” referred, as petitioner contended, exclusively to state law. The text contains no limitation on “applicable non-bankruptcy law” relating to the source of law.

Since Patterson, the Circuit Courts have largely agreed that state and federal restrictions on alienation can satisfy Section 541(c)(2

In In re Roth, 289 B.R. 161 (Bankr. D. Kan. 2003), the bankruptcy court held “that Congress meant to exclude from the estate those assets of “spendthrift trusts” traditionally beyond the reach of creditors under state trust law.” [Id. at p.165]. In the Ninth Circuit, the court held that a valid spendthrift trust created under state law was excluded from a bankruptcy estate under Section 541(c)(2). [In re Moses, 167 F.3d 470 (9th Cir. 1999).]

The general rule under state law in non DAPT jurisdictions is that self-settled spendthrift trusts will be included under Section 541(c)(2) in the bankruptcy estate, as self-settled trusts are unenforceable under applicable non-bankruptcy law. The rationale is that a debtor should not be able to escape claims of creditors by creating a spendthrift trust and naming the debtor as beneficiary.

There are presently no cases concerning how courts might rule on self-settled trusts in DAPT states regarding Section 541(c)(2). Some DAPT states have clarified through legislation that the spendthrift provisions in their self-settled trusts DAPTs meet the criteria described in Section 541(c)(2). Asset protections states such as Nevada, Delaware and Alaska have drafted very powerful statutes which will make it extremely difficult for creditors to interfere with state law and the Section 541(c)(2) exemption provided for spendthrift trusts.

DAPT Book - Chapter 4

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