The most important factor in almost every asset protection case is the timing between the time the assets were transferred and the time of the creditor’s claim. In TrustCo Bank v. Mathews, the court held that a plaintiff was barred from bringing a fraudulent transfer claim because the statute of limitations had run. Susan Mathews signed a personal guaranty in 2006. A few months later she transferred stock to a couple of Delaware asset protection trusts. The plaintiffs brought a fraudulent transfer claim against the trusts on March 1, 2013 and the court ruled that the claim was barred because the statute of limitations on fraudulent transfers had run. This case is interesting because the transfer actually occurred after Susan had incurred an obligation. Because the transfer occurred after the obligation, the transfer probably would have been voidable as a fraudulent transfer if not for the statute of limitations. In other words, the planning worked only because of the timing between the date of the transfer and the date of the fraudulent transfer action.
Category: Asset Protection and Estate Planning Blog
What is a 541 Trust®?
We use the 541 Trust® name to refer to an irrevocable asset protection trust built upon a foundation of generations of proven legal precedent. A 541 Trust® is a domestic, irrevocable, non-self-settled trust carefully designed to provide the best asset protection while at the same time affording maximum flexibility. The 541 Trust® is not a new school of thought nor is it based on foreign laws. We have carefully researched generations of legal precedent right here in the U.S. to find strategies that have always worked and design our trusts in compliance.
Assets owned by you are within reach of your creditors. Likewise, absent a fraudulent transfer, assets not owned by you cannot be reached by your creditors. If asset protection is a key goal in your estate planning, you must somehow remove the assets from your personal ownership. The best way to remove assets from your ownership is through the use of a properly crafted irrevocable trust. Because our trusts are drafted in compliance with U.S. laws, and are supported by generations of legal precedent, they provide the best possible protection.
Public policy and generations of legal precedent are clear: you cannot settle a trust for your own benefit and at the same time shield the trust assets from your potential creditors. Offshore Trusts and Domestic Self-Settled Asset Protection trusts (DAPTs) are self-settled, which is a fatal chink in the supposed armor of these types of trusts. Even though some states and offshore jurisdictions purport to allow self-settled asset protection trusts, it is important to see what the courts have made clear–the only court cases dealing with Offshore Trusts or DAPTs have shown that they fail to protect the assets.[i] Despite an abundance of promotion and marketing, self-settled trusts (DAPTs and Offshore Trusts) have zero wins when challenged in court. The Uniform Trust Code states that a creditor of a settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit.[ii] In other words, if a settlor who is also a beneficiary has access to trust cash, property, vehicles, etc., so does a creditor. It is hard to argue that an Offshore Trust or a DAPT is the best solution based on their dismal record when challenged in court.
Generations of legal precedent have made clear that the only type of trust which has withstood the test of time as a proven method of asset protection is a non-self-settled trust (a.k.a. a third party trust or our 541 Trust®). This means that the settlor of the trust creates the trust for beneficiaries other than him/herself.[iii]
Our 541 Trust® protects assets from a person’s potential future liabilities by removing the assets from the person’s legal and personal ownership. Rather than employing new strategies which have not been tested or strategies which rely on the laws of foreign jurisdictions, the 541 Trust® is designed using methods which have been successfully tested in lawsuits, bankruptcy, and IRS audits in the U.S. legal system. The 541 Trust® has been proven to work better than offshore trusts and other asset protection strategies. Frankly, the name of the trust is of little importance. The important part of the 541 Trust® is its craftsmanship. Our years of experience and dedication to building trusts upon a tried and tested legal foundation is the key value to our asset protection trusts. After all, what good is a trust if it fails when challenged? The legal precedent speaks for itself.
[i] In re Mortensen, Battley v. Mortensen, (Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011), Waldron v. Huber (In re Huber), 2013 WL 2154218 (Bk.W.D.Wa., Slip Copy, May 17, 2013), Dexia Credit Local v. Rogan 624 F. Supp 2d 970 (N.D.Ill. 2009), 11 U.S.C. 548(e), More offshore self-settled trust cases HERE.
[ii] Uniform Trust Code Section 505, Restatement (Second) of Trusts Section 156(2), and Restatement (Third) of Trusts Section 58(2).
[iii] “By establishing an irrevocable trust in favor of another, a settlor, in effect, gives her assets to the third party as a gift. Once conveyed, the assets no longer belong to the settlor and are no more subject to the claims of her creditors than if the settlor had directly transferred title to the third party.” In re Jane McLean Brown, D. C. Docket No. 01-14026-CV-DLG (11th Cir. 2002).
IRS Approved NING Trust provides Substantial Tax Savings
For many years, we have helped clients reduce income taxes by using a Nevada trust often referred to as a “NING Trust” (Nevada Incomplete Gift Non-Grantor Trust). In PLR 20131002, the IRS approved this concept by ruling that the trust qualified as a complex trust for income tax purposes and that gifts to the trust were incomplete for federal gift tax purposes. In other words, a person can transfer assets of unlimited value to a NING Trust without gift tax consequences. The income of the NING Trust is taxed at the trust level and does not flow through to the grantor. Because Nevada has no state income tax there is huge potential for income tax savings. Here are three examples of how a NING trust can save taxes:
A California resident can avoid the 13.3% California tax on investment assets or capital gains. For example, assume a California resident establishes a properly structured [NING] trust and contributes a $20 million stock portfolio that produces 8% taxable income per year. Over a period of 10 years, the California income tax saved could be $2,500,000. Over 20 years, the compounded savings from not paying California income tax could be $8,500,000. (See Gordon Schaller & The 13.3% Solution: of DINGs, NINGs, WINGs and Other ThINGs, LISI Estate Planning Newsletter #2191 (February 5, 2014)).
As another example, we have a client who placed his stock into a NING trust prior to a sale of his company. When the stock was sold by the NING trust, the client saved over $5,000,000 in state capital gains taxes. Later, when the trustee terminated the trust and distributed the assets back to the client, the client was not required to pay state capital gains tax on the distribution because the state does not tax capital gains distributed from a nonresident trust.
As a third example, a professional athlete transferred the majority of his investment portfolio to a NING trust. The athlete pays federal and state tax on his W-2 earnings and on the investments he holds outside of the NING trust. The athlete is not required to pay state tax on the investment income earned by the trust, and this allows the trust to grow free of state income tax.
Call 801-765-0279 for more information or click HERE to email us.
The information and examples above are provided as general information and may not be used as tax advice for any particular situation. Each person should seek individualized tax advice for their own situation.
Why Self-Settled Asset Protection Trusts Don’t Protect Assets
Don’t Self-Settle for Inadequate Asset Protection
Why Self-Settled Asset Protection Trusts Don’t Protect Assets
By: Randall Sparks, JD LL.M. and Lee S. McCullough, III, JD MAcc
Click HERE for pdf verison
Self-Settled Asset Protection Trusts are all the rage. They come in two main flavors: (1) The Domestic Asset Protection Trust (“DAPT”) and (2) the Offshore Trust, aka Foreign Asset Protection Trust (“FAPT”). To boost in-state trust business, about a dozen states have passed or are actively improving their self-settled asset protection trust statutes … and that number is growing. Although self-settled trusts are heavily promoted by asset protection attorneys across the county, all of the relevant court cases indicate that if asset protection is your goal, you should find a more viable option.
If self-settled trusts are inadequate for asset protection, why do attorneys go to such lengths to sell them? The answer is simple: Money. Asset protection promoters market them heavily promising maximum protection and make big profits in the process. They do this despite zero court authority in existence that upholds self-settled asset protection trusts. Promoters also ignore the many court cases showing that self-settled trusts simply don’t afford the promised asset protection benefits.
What is a Self-Settled Asset Protection Trust?
There are three parties to any trust agreement: (1) a Settlor, who creates the trust and funds it with assets, (2) a Trustee, who holds legal title to the assets in trust for the beneficiaries, and (3) the Beneficiaries, who are eligible to receive benefits from the trust. In most trusts, the Settlor and Beneficiary are different people. In a self-settled trust, the Settlor is also a Beneficiary. In concept, the idea is incredible: contribute any amount of property to the trust and while creditors can’t touch it, you can enjoy it as much as you want. The reality is that these arrangements just don’t work as advertised.
Public policy has long been clear that you cannot settle a trust for your own benefit and at the same time shield the trust assets from your potential creditors. The Uniform Trust Code states that a creditor of a settlor may reach the maximum amount that can be distributed to or for the settlor’s benefit.[1] In other words, if a Settlor/Beneficiary has access to trust cash, property, vehicles, etc., so does a creditor.
Offshore jurisdictions were the first to market self-settled trusts by promising protections in a foreign jurisdiction that is not bound by the laws of the United States. In 1997, Alaska was the first state to enact a DAPT statute. Since then, over a dozen United States jurisdictions have enacted DAPT statutes. However, creditor attorneys have developed successful techniques to pierce these trusts. By frequently siding with creditors in these cases, courts have rebuffed the zeal of offshore and domestic jurisdictions to establish and promote self-settled trusts as superior asset protection tools.
Court Cases Defeating Domestic Asset Protection Trusts (DAPTs)
When it comes to self-settled trusts, there is an elephant in the room and that elephant has a name: Bankruptcy. In states that don’t recognize self-settled trusts, a debtor’s interest in a self-settled trust is subject to bankruptcy.[2] The Mortensen case made clear that Federal Bankruptcy Law can even defeat a self-settled trust in states that recognize, protect, and advocate self-settled trusts.[3] In Mortensen, an Alaska resident created a self-settled trust under Alaska’s DAPT statute under ideal circumstances: he was solvent and there were no judgments against him. Several years later he ended up in a bankruptcy court sitting in Alaska. The court applied Federal Bankruptcy Law instead of Alaska law ruling that the trust assets were reachable by the creditors in the bankruptcy under Section 548(e) of the Federal Bankruptcy Code.[4]
Another problem with a DAPT is a potential lawsuit arising in a state that does not recognize or protect self-settled trusts. In Dexia Credit Local v. Rogan, the Seventh Circuit Court ruled that despite the debtor’s trust having been created in a DAPT state, Illinois law applied instead.[5] Another huge blow to DAPTs came on May 17, 2013 in Waldron v. Huber where, among other things, Washington State law applied rather than Alaska law where the DAPT was formed.[6] The result was that the trust assets were not protected. Based on the Dexia Credit and Huber cases, one shouldn’t expect that a self-settled trust will be upheld in a state that does not allow them. Numerous other cases indicate that a court can apply the law of the state where the court is located and not recognize the laws of the state where an entity was formed.[7]
If self-settled trusts don’t work in bankruptcy and don’t protect against laws of DAPT unfriendly states, then you can just avoid declaring bankruptcy and avoid contacts outside of your DAPT friendly state, right? Not so fast. Unfortunately, even if you are careful not to get sued in the wrong state and manage to avoid voluntary bankruptcy, your creditors could file an involuntary bankruptcy petition against you. The court cases and the bankruptcy code have shown that even though a self-settled trust is created pursuant to a DAPT statute, the trust is still vulnerable.
Court Cases Defeating Offshore Trusts, aka Foreign Asset Protection Trusts (FAPTs)
Many asset protection promoters claim that offshore trusts are impermeable, in contrast to the absence of a single court case to support their claims. Why do they sell a product that has such an abominable record? It’s a calculated risk that the resulting liability of a few failed trusts that are actually challenged will be vastly overshadowed by those that are never tested. In other words, they know that the majority of their clients will never get sued or go bankrupt. For those who are sued or face bankruptcy however, if the trust is self-settled, its assets are not protected.
Although promoters of FAPTs claim foreign laws protect you because the trust is not subject to the jurisdiction of U.S. Courts, there are many court cases showing how offshore trusts fail. For example, it is well established that an offshore trust cannot protect onshore assets.[8] Numerous other cases show that even though a court in the United States may not have jurisdiction over the FAPT, they have jurisdiction over the debtor and can order the debtor to repatriate the trust assets or face incarceration for contempt. In In re Lawrence the debtor was jailed for over six years for refusing to repatriate assets, in Bank of America v. Weese the debtors paid settlement of over $12,000,000 in order to avoid incarceration, and in U.S. v. Plath the debtor was held in contempt for refusing to obey the court order to disclose details about offshore accounts despite the fact that there was no fraudulent transfer.[9] These are just a few lowlights of the long list of failed FAPT strategies.
For a time, offshore trust peddlers used US v. Grant as the one court case that supported their strategy, because it was the single case where a court did not hold the debtor in contempt. The purported steel bulwark of the Grant opinion came crashing down when, in the Spring of 2013, a Florida court ruled against the very strategy FAPT promoters touted, dealing a huge blow to the offshore asset protection industry.[10] In Grant, Raymond Grant created two self-settled trusts offshore (FAPTs), one for his own benefit and one for the benefit of his wife. Raymond funded both FAPTs at a time when he was solvent and had no known claims against him, once again ideal circumstances. Years later, Raymond died and the IRS obtained a $36 million dollar judgment against Raymond’s wife Arline. The U.S. moved to hold Arline in contempt of court for failing to repatriate the assets in the offshore trusts to pay the tax liability. Initially, the court refused to do so because Arline had never exerted control or received benefits from these trusts. But later when it was proven that Arline had received funds from the trust through her children’s accounts, the court issued a permanent injunction prohibiting Arline and her children from ever receiving any benefits from the trusts. Ultimately a very expensive “asset protection” strategy kept the assets protected from creditors, but also out of reach of those the trust was created to benefit. If your goal is to protect assets from both creditors and yourself, an offshore trust may be a great fit. If, however, you seek any self-settled benefits at all, look elsewhere.
Solution – Non-Self-Settled Trust
The alternative to the self-settled trust is simple, remove the one aspect of the trust that creates all of its vulnerability; make the trust non-self-settled. A non-self-settled trust, aka third party trust, has the support of state and federal statutes, the federal bankruptcy code, and an overwhelming number of court cases. Since the Settlor is not a beneficiary, the creditors of the Settlor cannot reach the trust assets, even in bankruptcy.[11] A properly drafted third party trust can still benefit the settlor without disrupting the asset protection. The settlor could potentially benefit from the trust through a spouse who is a beneficiary. For example, the settlor could live in a trust owned residence free from rent so long as the spouse is a beneficiary.[12] The settlor could be an income only beneficiary and still protect the trust principal.[13] The settlor could also maintain flexibility by appointing a trust protector or through the use of a special power of appointment.
If the trust has discretionary spendthrift language, the assets are also shielded from the creditors of the beneficiaries. If Raymond Grant had created a non-self-settled discretionary spendthrift trust for his wife Arline, instead of creating the two FAPTs that failed, the assets would have been protected from the IRS judgment and Arline and other trust beneficiaries could still have benefitted from the trusts. For example, the trust could have purchased a home for Arline to live in and paid Arline’s credit card bills.[14]
If true asset protection is the goal, consumers and especially promoters should remember the old adage that pigs get fat and hogs get slaughtered. The court cases make it clear that a non-self-settled trust provides proven asset protection, whereas a self-settled trust lays out the welcome mat, flips on the light, and leaves the front door wide open to creditors. If you self-settle, you settle for an inferior trust.
[1] Uniform Trust Code Section 505, Restatement (Second) of Trusts Section 156(2), and Restatement (Third) of Trusts Section 58(2).
[2] Federal Bankruptcy Code 11 U.S.C. 541. See also In re Simmonds, 240 B.R. 897 (8th Cir. BAP (Minn.) 1999).
[3] In re Mortensen, Battley v. Mortensen, (Adv. D.Alaska, No. A09-90036-DMD, May 26, 2011).
[4] 11 U.S.C. 548(e).
[5] Dexia Credit Local v. Rogan 624 F. Supp 2d 970 (N.D.Ill. 2009).
[6] Waldron v. Huber (In re Huber), 2013 WL 2154218 (Bk.W.D.Wa., Slip Copy, May 17, 2013).
[7] American Institutional Partners, LLC v. Fairstar Resources, Ltd. (where Utah law applied against a Delaware-formed LLC), 2011 WL 1230074 (D.Del., Mar. 31, 2011), Malone v. Corrections Corp. Of Am., 553 F.3d 540, 543 (7th Cir. 2009) (a district court in diversity applies the choice-of-law rules of the state in which it sits).
[8] In re Brooks, 217 B.R. 98 (D. Conn. Bkrpt. 1998) (where the offshore trust was disregarded because it was self-settled and the onshore assets were seized).
[9] In re Lawrence, 279 F.3d 1294 (11th Cir. 2002), Bank of America v. Weese, 277 B.R. 241 (D.Md. 2002), and U.S. v. Plath, 2003-1 USTC 50,729 (U.S. District Court, So. Dist. Fla. 2003).
[10] US v. Grant, 2013 WL 1729380 (S.D.Fla., April 22, 2013).
[11] Uniform Trust Code Section 505, Restatement (Second) of Trusts Section 156(2) and Restatement (Third) of Trusts Section 58(2), In re Jane McLean Brown, D. C. Docket No. 01-14026-CV-DLG (11th Cir. 2002), Shurley v. Texas Commerce Bank, 115 F.3d 333 (5th Cir. 1997).
[12] Revenue Ruling 70-155, Estate of Allen D. Gutchess, 46 T.C. 554 (1966), PLR 9735035.
[13] In re Jane McLean Brown, D. C. Docket No. 01-14026-CV-DLG (11th Cir. 2002).
[14] United States v. Baldwin, 391 A.2d 844 (1978) or U.S. v. O’Shaughnessy, 517 N.W.2d 574 (1994) (where the trust assets were not subject to tax lien because the trust was not self-settled).
California Court Throws Out Case Against Our Trust – Client Very Satisfied
On June 19, 2012, the Superior Court for the State of California for the County of Los Angeles sustained our motion to dismiss a lawsuit by Wilmington Capital LLC against The Big Whale Trust (an irrevocable trust created by McCullough).
The grantor had funded the trust with cash and real estate prior to the time the liability was incurrred. The grantor’s spouse and children were the trustees and beneficiaries of the trust. The trustees had made several distributions to the grantor’s spouse, but the grantor was not a beneficiary and the grantor had personally received no benefits from the trust.
Wilmington Capital LLC sued the trust because it had been unable to collect against the grantor and the grantor’s spouse. Wilmington Capital LLC had no evidence to claim that the trust was invalid, that the transfers to the trust were fraudulent, or that the grantor was the alter ego of the trust. Wilmington Capital LLC argued that they should have access to the trust because the grantor had retained a special power of appointment over the trust.
Because California law protects the assets of an irrevocable non self-settled discretionary trust (even when the grantor retains a special power of appointment), our client was able to have the case summarily dismissed without incurring significant legal fees.
The Big Whale Trust is a perfect illustration of the best way to create, fund and operate an asset protection trust. Copies of the court pleadings (including our Memorandum of Points and Authorities) are available upon request.
Bankruptcy Court – Our Trust Protects Client’s Home and Trust Assets
In 2009, our client, Todd H., transferred his home and some cash to one of our carefully drafted irrevocable trusts at a time when they were solvent and had no foreseeable liability problems. Todd’s wife was the trustee, and his wife and children were the beneficiaries. In 2010, Todd’s business went downhill along with the rest of the US economy. In 2011, Todd’s small business went bankrupt and he was also forced into personal bankruptcy. The transfer of the home to the trust was fully disclosed to the bankruptcy court, but the bankruptcy court excluded the trust and its assets pursuant to the federal bankruptcy code which provides that this type of trust is excluded from the bankruptcy estate. After losing everything else they owned in the bankruptcy, Todd’s family continues to live in the paid-off home that is owned by the trust.
When do courts allow a trust to be pierced as an alter ego?
One way to attack an irrevocable trust is to prove that the trust is the alter ego of the grantor because the trust is operated in a manner so that it has no separate existence from the grantor. Some courts describe this as the grantor “exercising such control that the trust has become a mere instrumentality of the owner.” In re Vebeliunas, 332 F.3d 85 (2nd Cir. 2003).
In WILSHIRE CREDIT CORPORATION v. KARLIN, 988 F.Supp. 570 (1997), Allan and Mary Rozinsky established an irrevocable trust for their children and transferred their home to the trust. The Rozinskys paid rent equal to the amount of the mortgage, insurance, and monthly expenses. For a time, the trust also owned a beach home that the Rozinskys rented from the trust. The trustees were close friends and relatives who admitted that most of their decisions were made at the direction of the Rozinskys.
After a time, the Rozinskys became unable to make the rent payments and they issued promissory notes to the trust in the amount of the delinquent rent, although no payments were made on the promissory notes. The court held that under Maryland law, alter-ego will only apply where necessary to prevent fraud, and because no fraudulent transfer had occurred, the creditors could not reach the trust assets despite the control exerted by the settlors.
In UNITED STATES v. EVSEROFF, No. 00-CV-06029 (E.D.N.Y. April 30, 2012), Jacob Evseroff established an irrevocable trust and transferred his primary residence to it after having received notice of a tax deficiency of over $700,000. A series of family friends served as the trustees of the trust. Evseroff did not pay rent to the trust for the privilege of living in the residence, but he did pay the mortgage and expenses as he had when he owned the home. The trust never assumed the mortgage and it was never listed on the flood or fire insurance on the home.
The court held that a plaintiff may pierce the veil of a trust, under the laws of New York, if the plaintiff can show that “(1) the owner exercised such control that the corporation has become a mere instrumentality of the owner, who is the real actor; (2) the owner used this control to commit a fraud or ‘other wrong’; and (3) the fraud or wrong results in an unjust loss or injury to the plaintiff.” Because the transfers to the trust were found to be fraudulent, and because the facts indicated that Evseroff had dominated the trust, the court allowed the government to collect against the assets of the trust.
Lessons learned from these cases: (1) don’t wait until you have a liability problem to transfer assets to an asset protection trust, (2) appoint a trustee who will take control of the trust, and (3) don’t allow a person other than the trustee to control or dominate the trustee or engage in transactions with the trust on terms that are not commercially reasonable in an arms-length transaction.
Building a Better Asset Protection Trust/ as published in Estate Planning Magazine
Estate Planning Journal (WG&L)
Volume 38, Number 01, January 2011
Use ‘Powers’ to Build a Better Asset Protection Trust, Estate Planning Journal, Jan 2011
Use ‘Powers’ to Build a Better Asset Protection Trust
A creatively drafted special power of appointment can be used to increase flexibility, asset protection, and anonymity of a trust.
Author: LEE S. McCULLOUGH, III, ATTORNEY
LEE S. McCULLOUGH, III practices exclusively in the areas of estate planning and asset protection in Provo, Utah. He also teaches estate planning as an adjunct professor at the J. Reuben Clark Law School at Brigham Young University
An asset protection trust can provide a person with security and peace of mind by ensuring that some assets are protected against future potential liabilities. State and federal laws support the use of an asset protection trust that is designed and funded in an ethical manner. Fraudulent transfer laws prevent the use of an asset protection trust to hinder, delay, or defraud a creditor.
For the past several decades, most asset protection trusts have been based on the concept of a self-settled trust. 1 Historically, the general rule has been to deny asset protection to a self-settled trust. 2 This began to change when laws were passed in offshore jurisdictions, such as the Cook Islands and the Isle of Man, which protect the assets in a self-settled trust. Beginning with the Alaska Trust Act in 1997, 13 states now offer some degree of asset protection for a self-settled trust:
(1) Alaska.
(2) Colorado.
(3) Delaware.
(4) Hawaii.
(5) Missouri.
(6) Nevada.
(7) New Hampshire.
(8) Oklahoma.
(9) Rhode Island.
(10) Missouri.
(11) Tennessee.
(12) Utah.
(13) Wyoming.
Although this concept has dominated the discussion and the practice of designing asset protection trusts, it is not the only option. The special power of appointment, an old reliable tool, can be implemented to replace and improve on the concept of a self-settled trust.
The special power of appointment is perhaps the most powerful and unappreciated tool in estate planning and asset protection. While most estate planners regularly use special powers of appointments to add flexibility to trust documents, most fail to recognize many of the most powerful uses of this tool. Whether designing a trust solely to protect against potential creditors, or to protect against estate taxes as well, a special power of appointment can be used to build a better asset protection trust.
Powers of appointment are nothing new
The concept of a power of appointment has been a part of the English common law for hundreds of years. This concept is well recognized in all 50 states and in the federal tax laws. 3 Although some minor variations in the law pertaining to powers of appointment have occurred over time, the basic principles, which form the basis of this article, have never varied. These basic principles are summarized below.
Key terminology. Familiarity with the following terms is crucial to an understanding of the strategies discussed below:
A power of appointment is a power that enables the donee of the power, acting in a nonfiduciary capacity, to designate recipients of beneficial ownership interests in the appointive property. 4The “donor” is the person who created the power of appointment.The “donee” is the person on whom the power is conferred (and who may exercise the power).The “permissible appointees” or “objects” are the persons for whom the power may be exercised.An “appointee” is a person to whom an appointment has been made.A “taker in default of appointment” is a person who will receive the property if the power is not exercised. 5
A power of appointment is “general” to the extent that the power is exercisable in favor of the donee, the donee’s estate, or the creditors of the donee or the donee’s estate, regardless of whether the power is also exercisable in favor of others. 6 A power that is not general is referred to as a “special” or “nongeneral” power of appointment.
Basic rules pertaining to asset protection and estate tax inclusion. Property that is subject to a presently exercisable general power of appointment is generally subject to the creditors of the donee because it is a power that is equivalent to ownership. 7 On the other hand, property subject to a special power of appointment is exempt from claims of the donee’s creditors. 8 The donee of a special power of appointment is not considered to have a property interest in the property subject to the power because it cannot be exercised for the economic benefit of the donee. 9 Because the donee has no property interest, the property subject to the power of appointment is not included among the property of the donee for purposes of judgment collection, bankruptcy, 10 divorce, Medicaid eligibility, estate tax inclusion, 11 or other determinations that involve the property of the donee.
Similarly, a permissible appointee (including the donor) has no property interest in a power of appointment. 12 Any attempt to include the interest of a permissible appointee for purposes of judgment collection, bankrupty, divorce, Medicaid eligibility, estate tax inclusion, or other determinations that involve the property of the donee would be a logical and practical impossibility because most special powers of appointment include everyone in the world as a permissible appointee, except for the donee, the donee’s estate, and the creditors of the donee and the donee’s estate.
Replacing the self-settled asset protection trust
An irrevocable trust with a special power of appointment that includes the donor as a permissible appointee (referred to herein as a “special power of appointment trust”) can be used to replace and improve on the concept of a self-settled asset protection trust. Both the self-settled asset protection trust and the special power of appointment trust can be designed so that gifts to the trust are incomplete for gift tax purposes 13—and thus not subject to gift tax at the time of the initial transfer. Both of these trusts can also be designed as a grantor trust for income tax purposes so that income from the trust is taxed to the settlor. If the tax treatment for these two trusts is the same, and the ability to benefit the settlor is the same, what is the difference between a self-settled asset protection trust and a special power of appointment trust?
The pros and cons of these two alternatives may be summarized as follows:
(1) No case law supports the asset protection provided by a self-settled asset protection trust because the statutes that allow asset protection for a self-settled trust are relatively new and untested. On the other hand, the inability of a creditor of a permissible appointee to reach the assets of a special power of appointment trust is supported by centuries of common law that is consistent throughout all 50 states in addition to federal bankruptcy courts. 14 In addition, the asset protection provided by a special power of appointment trust is supported by the logical and practical impossibility of ascribing trust liability for all permissible appointees when that class includes every person on earth other than the donee, the donee’s estate, and the creditors of the donee and the donee’s estate.
(2) The common law rule, followed by the majority of states, is that the assets of a self-settled trust are available to the claims of the settlor’s creditors. 15 Many commentators believe that a state that does not grant asset protection for self-settled trusts will not uphold the laws of a state that does grant asset protection for self-settled trusts, because doing so would violate the first state’s public policy. 16 The asset protection provided by a special power of appointment trust is not dependent on the state where the parties reside or the state where the matter is adjudicated.
(3) Many commentators question whether a self-settled asset protection trust will hold up in a bankruptcy court. At least two bankruptcy courts have held that the recognition of an offshore self-settled trust would offend federal bankruptcy policies. 17 A person who files bankruptcy is typically required to disclose any trust in which he or she is included as a beneficiary. In addition, the 2005 changes to the Bankruptcy Code have created a new ten-year limitations period for transfers to self-settled trusts that are meant to hinder, delay or defraud creditors. 18 Even if a bankruptcy court is unable to bring the assets of a self-settled trust into the bankruptcy estate, the court could dismiss the debtor’s case and deny the debtor a discharge under the bankruptcy laws. In contrast, the special power of appointment trust should be irrelevant to a bankruptcy proceeding because the settlor has no beneficial interest in the trust.
(4) Many of the state statutes that grant some form of asset protection for a self-settled trust also include exceptions that allow creditors to seize the assets of a self-settled trust for child support, alimony, transfers made within certain time periods, government creditors, bankruptcy, or certain torts. 19 In contrast, no statutory exceptions allow a creditor of a permissible appointee to reach the assets of a special power of appointment trust.
(5) Plaintiff’s attorneys, creditors, and government agencies often ask if a person is a beneficiary of a trust in order to determine whether the trust assets may be attached or taken into account for various purposes. This opens the trust up to inspection and evaluation by an adverse party, and it may affect a person’s eligibility for certain programs or benefits. The special power of appointment trust is immune to this kind of scrutiny because the settlor is not a beneficiary, and most every person in the world is a permissible appointee.
(6) A self-settled trust governed by the laws of an exotic and foreign jurisdiction often carries with it a negative stigma and a perception of wrongdoing. Upon learning that a person is a beneficiary of a self-settled trust in a foreign jurisdiction, judges, juries, and government agencies are likely to view the person as a criminal who is attempting to avoid the law. In contrast, a special power of appointment trust established in a domestic jurisdiction for the benefit of a person’s family has the appearance of an ordinary measure established by a law-abiding citizen for estate planning purposes.
(7) The self-settled asset protection trust requires the appointment of a trustee or co-trustee in one of the jurisdictions where self-settled trusts are allowed (with some jurisdictions requiring the use of a corporate trustee 20); the special power of appointment trust does not require the appointment of a corporate trustee or a trustee that is located in a certain jurisdiction.
(8) One may argue that the self-settled trust is safer than the special power of appointment trust because the trustee has a fiduciary duty to the beneficiaries and this ensures that the trustee will not distribute the assets to the wrong people. 21 However, if the trustee has a discretionary power to sprinkle assets among the potential beneficiaries, there is still a chance that the trustee will not distribute the assets according to the wishes of the settlor. The settlor of a special power of appointment trust could use the following measures to ensure that the donee of the power does not exercise it inappropriately:
The settlor could appoint one or more co-donees who are required to act together.The settlor could limit the class of permissible appointees.The settlor could appoint a trust protector with power to approve or veto the exercise of a power of appointment.The settlor could grant a trust protector the power to remove and replace a donee.
To illustrate the differences between a self-settled asset protection trust and a special power of appointment trust, consider the following example:
Scenario 1. Dawn creates a self-settled asset protection trust naming her brother as the trustee. She names herself, her spouse, and her children as the beneficiaries. She gives her brother the power to withhold distributions or to sprinkle distributions among the beneficiaries as he determines in his sole and absolute discretion. Dawn funds her self-settled asset protection trust at a time and in a manner that is not considered a fraudulent transfer.
Scenario 2. Michael creates a special power of appointment trust naming his brother as the trustee. Michael names his spouse and children as the beneficiaries, but he does not include himself as a potential beneficiary. He gives his brother the same power to withhold distributions or to sprinkle distributions among the beneficiaries as he determines in his sole and absolute discretion. Michael also gives his brother a special power of appointment to appoint assets to any person other than himself, his estate, or the creditors of himself or his estate. Michael funds his special power of appointment trust at a time and in a manner that is not considered a fraudulent transfer.
In both scenarios, the brother of the settlor has power to withhold assets or sprinkle assets among the spouse and children of the settlor. In both scenarios, the brother of the settlor can transfer all, part, or none of the assets of the trust to the settlor at any time and for any reason.
Now assume that both Dawn and Michael are sued, and a judgment is entered against them. The creditor’s attorneys will ask both Dawn and Michael if either is the beneficiary of any trust. Michael will correctly answer that he is not a beneficiary of a trust. Even if creditors discover that Michael once created a trust, they will have no claim on the trust because Michael is not included as a beneficiary. Dawn, on the other hand, will have to reply that she is the beneficiary of a self-settled trust, and her creditors will then commence an examination of the trust and an attempt to confiscate its assets.
Improving an intentionally defective grantor trust
An intentionally defective grantor trust is a trust that is excluded from the settlor’s estate for gift and estate tax purposes but whose income is attributed to the settlor for income tax purposes. The name comes from the fact that the settlor intentionally includes a “defect” in the trust document that causes the income to be taxable to the settlor (or “grantor”). The purpose of an intentionally defective grantor trust is to protect assets from estate taxes in addition to protecting assets from the potential future creditors of the settlor. An intentionally defective grantor trust is typically used to own life insurance or other appreciating assets. In order to ensure that the assets of the trust are not included in the settlor’s estate, the settlor is not included as a beneficiary of an intentionally defective grantor trust.
The concept of an intentionally defective grantor trust can be greatly improved if the settlor grants a special power of appointment allowing a donee to appoint assets to any person other than the donee, the donee’s estate, or the creditors of the donee or the donee’s estate. The grant of a special power of appointment to a non-adverse party is one way to cause an irrevocable trust to be treated as a “grantor trust” for income tax purposes. 22 This power allows the donee potentially to appoint the assets of the trust back to the settlor. The donee should not be a person who is also a beneficiary of the trust, or the exercise of a special power of appointment may result in a taxable gift. 23 The fact that the settlor and the settlor’s spouse are included as permissible appointees is insufficient to cause the trust assets to be included in their taxable estate because most everyone in the world is a permissible appointee. 24
Example. Sarah and John both create an intentionally defective grantor trust, and both transfer significant assets to the trust by gift and by sale in order to remove the assets from their taxable estates. Sarah’s trust also includes a special power of appointment allowing her brother to appoint assets to any person other than himself, his estate, or the creditors of the brother or his estate. If the estate tax is repealed, if Sarah falls on hard times, or if she decides that she does not want her children to receive a large inheritance, Sarah’s brother can simply appoint the assets to her at any time. John’s trust does not include this special power. Thus, he has no way to benefit from the assets in the trust, and the trustee has no power to give them back to him.
This option to return assets to the settlor may be especially useful if Congress eventually increases the estate tax exemptions while maintaining the step-up in basis for property included in a decedent’s taxable estate. The special power of appointment that is included in Sarah’s trust would allow her brother to appoint sufficient assets back to her to take full advantage of the step-up in basis at her death to the extent of her available estate tax exemption.
Conclusion
Although a special power of appointment is an old familiar tool, it may be used in creative ways to add greater flexibility, greater asset protection, and greater anonymity to a trust. In fact, it may accomplish what was otherwise impossible in that it allows a person to make an irrevocable gift without giving up the possibility that the assets that were given might be returned.
1
A “self-settled” trust is one in which the settlor is included as a beneficiary of the trust.
2
See RESTATEMENT (SECOND) OF TRUSTS, section 156.
3
See RESTATEMENT OF PROPERTY sections 318-369 (1940), RESTATEMENT (SECOND) OF PROPERTY: DONATIVE TRANSERS sections 11.1-24.4 (1986), RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1, and IRC Section 2041.
4
RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1.
5
Id. at section 17.2.
6
Id. at section 17.3.
7
Id. at section 17.4.
8
Id. at section 22.1.
9
See RESTATEMENT (THIRD) OF TRUSTS section 56 comment b (2003).
10
See 11 U.S.C. section 541.
11
See Sections 2041 and 2514.
12
See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) Section 17.2. Also see In re Hicks, 22 BR 243 (Bkrptcy. DC Ga., 1982) and In re Knight, 164 BR 372 (Bkrptcy. DC Fla., 1994).
13
A transfer to a trust is “incomplete” for gift tax purposes if the settlor retains a power to veto distributions proposed by the trustee. See Reg. 25.2511-2(c).
14
Supra note 12.
15
Supra note 2.
16
A trust is generally governed by the law of the jurisdiction designated in the trust agreement unless that jurisdiction’s law is contrary to a strong public policy of the jurisdiction having the most significant relationship to the matter at issue. See Uniform Trust Act section 107 and Restatement (Second) of Conflict of Laws sections 273 and 280.
17
See In re Portnoy, 201 B.R. 698, and In re Brooks, 217 B.R. 98.
18
11 U.S.C. section 548(e).
19
See Utah Code 25-6-14, Delaware Code Section 3573, Oklahoma Statutes Title 31, section 11.
20
See Utah Code 25-6-14; Oklahoma Statutes Title 31, section 11.
21
By definition, a trustee has a fiduciary duty to the beneficiaries of a trust, while a donee of a power of appointment acts in a nonfiduciary capacity and has no duty to the beneficiaries or permissible appointees. See RESTATEMENT (THIRD) OF PROPERTY: WILLS AND OTHER DONATIVE TRANSFERS (Tentative Draft No. 5, 2006) section 17.1.
22
See Section 674.
23
See Reg. 25.2514-1(b)(2).
24
Section 2042(2) provides that a reversionary interest could cause the trust assets to be included in the settlor’s estate if the value of the reversionary interest immediately before the insured’s death exceeds 5% of the value of the trust. Because the special power of appointment is exercisable in the donee’s absolute discretion, the value of the reversionary interest is less than 5% of the value of the trust. See Reg. 20.2042-1(c)(3). If it can be shown that the settlor and the donee had an express or implied understanding that distributions would be made to the settlor, then the assets of the trust could possibly be included in the settlor’s estate under Section 2036(a)(1).
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Why Our Trusts are Better than an Offshore Trust
Why You Can’t Rely on a Wyoming LLC for Asset Protection Purposes
For many years, asset protection planners have believed and promoted the idea that an out-of-state resident could take advantage of the strong charging order laws in another state by filing their LLC in another state. Recent cases show that this does not work.
In American Institutional Partners, LLC v. Fairstar Resources, Ltd., 2011 WL 1230074 (D.Del., Mar. 31, 2011), a Utah resident established several Delaware LLCs with the hope that they could take advantage of the better charging order statute in the State of Delaware. When the Utah resident was sued in a state court in Utah, the Utah court stated “that Utah law applies to all execution proceedings in this matter, including the foreclosure of a member’s interest in a limited liability [company], whether such company is domestic or foreign.” In other words, the Utah court used their own law and ignored the law of the state where the LLC was filed.
This means that you shouldn’t believe those who heavily advertise the use of a Wyoming LLC for asset protection purposes, because if you are sued in a state outside of Wyoming, the court will probably use their own law and you won’t get the benefits of a Wyoming LLC.