Insurance, diversification and hedging strategies are common methods for mitigating risk. These instruments or strategies can successfully protect clients' financial plans from devastation by a host of scenarios including adverse market actions, overconcentration of certain positions, and even the untimely death or disability of a family member. But there is another type of risk that many advisors do not adequately address and that should capture more attention--the risk of being sued.
With millions of lawsuits filed each year, the U.S. is the most litigious nation in the world! Considering that the high-net-worth investors you serve possess the very same "deep pockets" that are so often the target of litigation, it's not hard to understand why wealthy clients cite litigation as one of their greatest concerns. And although asset protection is a very complex and dynamic area of law--requiring the counsel of a qualified attorney--understanding asset protection strategies and how to implement them can help you identify areas where risk may be lurking.
Asset protection trusts
The asset protection trust has long been an effective mechanism for transferring assets from a grantor to a separate irrevocable trust (Oklahoma allows for a revocable trust) with the goal of preventing future creditors from getting at those assets in the event of an unfavorable legal judgment. Trust provisions, along with the laws of the trust's domain, afford asset protection while allowing the grantor to retain a level of control over trust assets.
There are two classes of asset protection trust: offshore and domestic. Offshore asset protection trusts have existed for decades, whereas the domestic version originated only in the late 1990s. Both arrangements provide valuable benefits, but each has specific issues that must be taken into consideration.
Those unfamiliar with offshore asset protection planning tend to immediately envision small tropical islands with banks that create "tax-friendly" arrangements for the wealthy. Such arrangements exist, but the concept of offshore asset protection relies on the unlikeliness of a foreign jurisdiction to enforce a judgment sought by a U.S. creditor. Not only may the foreign jurisdiction disregard the claim but, due to the location of the assets, there is also a higher probability that a U.S.-based creditor may not even try to claim an interest. The idea of entering into litigation in a foreign jurisdiction is a significant deterrent.
Although it is certainly a powerful strategy, the offshore asset protection trust does pose some concerns. The first is that the assets are offshore. Yes, location of the assets in a foreign jurisdiction does provide the sought-after protection of such an arrangement, but the trust is also subject to the political structure of the foreign jurisdiction. There are several "friendly" jurisdictions with currently stable governments, but some clients may be uneasy about subjecting their assets to the laws of a foreign jurisdiction or the control of a foreign trustee.
A second concern is the possibility of adverse income tax consequences. Visions of foreign tax havens aside, a foreign asset protection trust is subject to the complex U.S. income tax reporting for foreign trusts. The additional complexity and scrutiny may be more than some clients are willing to undergo.
Domestic asset protection trusts
The rise of the domestic asset protection trust began in the late 1990s. A few select states--most notably Alaska, Delaware and Nevada--passed statutes allowing for the self-settled asset protection trust, an irrevocable trust funded by a grantor for his or her benefit. But similar to an offshore trust, the grantor's interest in the domestic asset protection trust is restricted by specific trust provisions. These provisions, drafted to conform to state statutes, provide the mechanism for defending a creditor claim against the grantor's trust interest.
With favorable domestic statutes available, clients may be more comfortable implementing a domestic asset protection trust. A domestic trust is less complex to set up than its offshore counterpart because it is not subject to foreign trust reporting rules. So all things being equal, it would be hard to argue against the domestic trust as the asset protection strategy of choice...Unfortunately, all things may not be equal when comparing offshore to domestic trusts.
First, because many state asset protection statutes were enacted relatively recently, the courts have not set enough precedents to serve as guidance for attorneys. Unlike the offshore version, the domestic asset protection trust has not been thoroughly "tested" for effectiveness in many circumstances. Second, there is a question as to the effectiveness of a state statute enacted in a favorable jurisdiction against a judgment obtained in a non-favorable asset protection jurisdiction. For instance, would a Pennsylvania court disregard a creditor's claim to assets because the grantor's choice of trust law was that of Delaware? The answer is not clear. There are also many questions about how federal bankruptcy laws may interact with state asset protection statutes.
Because Alaska, Delaware and Nevada are known as jurisdictions with anti-creditor statutes, those states have seen a significant increase in their share of trust business. In recognition of this good fortune, other states--including Utah, South Dakota, Missouri, Oklahoma and Tennessee--have passed similar anti-creditor statutes with an eye to attracting trust business.
Although ultimately, the courts will decide whether a domestic or offshore protection trust is more effective, the method of funding a trust can doom its effectiveness from the start. If the trust is funded in anticipation of pending litigation or of other creditor claims, the grantor is deemed to have made a fraudulent conveyance--defined by the Uniform Fraudulent Transfer Act as a transfer with intent to hinder, delay or defraud creditors. Such funding would render the trust wholly ineffective, and creditors could easily reach its assets.
Without fraudulent conveyance laws, unscrupulous debtors could routinely transfer their assets to other parties once the debt has been assumed, leaving a creditor without means for recovery. That is why when discussing asset protection with clients, it is imperative to emphasize that asset protection strategies are not an option if there is anticipation of a judgment or claim.
In conclusion, asset protection trusts have become a very popular means of proactively addressing unforeseen risks, but there are issues to consider in implementing this strategy. Asset protection is a dynamic area of the law that continues to evolve. Wealth management practices familiar with asset protection strategies can partner with qualified legal professionals to ensure that client plans remain on track. The ability to identify and address risk will be viewed as an invaluable service to clients who have so much to lose.
Gavin Morrissey, JD (firstname.lastname@example.org) is the director of advanced planning at Commonwealth Financial Network in San Diego.