Domestic Asset Protection Trusts: Equal to Their Offshore Brethren?

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The Domestic Asset Protection Trust (DAPT) is the onshore response to concerns surrounding offshore asset protection vehicles, but are the onshore and offshore varieties of asset protection equivalent? Despite the surface similarities between DAPTs and asset protection vehicles based in the Caribbean and other offshore hotspots, the degree of creditor protection offered by them can be very different.

After a brief discussion of the history of DAPTs, this article examines the battle tactics used by creditors to break DAPTs and access trust assets.

A Short History of Domestic Asset Protection Trusts

Alaska took the asset protection lead in the U.S. in 1997 when it created a trust framework having several tax and asset-preservation advantages that, together, are more advantageous to trust settlors than the traditional trust laws of the other states. Interested in bringing significant assets and banking and trust administration business into the state, Alaska’s DAPT legislation requires that trusts have an Alaska operating nexus—although the settlor does not need to claim Alaska as his domicile.

Recognizing the opportunity to generate business in their borders, Delaware, Nevada and Rhode Island followed Alaska’s lead and drafted their own DAPT statutes. Colorado, Hawaii, Missouri, New Hampshire, Oklahoma, South Dakota, Tennessee, Utah and Wyoming jumped into the DAPT business, although there may be significant differences between the degree of creditor protection and tax advantages offered by each state.

And regardless of the state where a DAPT is formed, the U.S. situs (location) of the trust gives creditors, including the IRS, easier access to trust assets.

Creditor Battle Tactics

DAPTs are an ambitious attempt to give U.S. trusts some of the desirable characteristics of offshore trusts, but the creditor protection and tax planning aspects of the trusts are subject to potential technical legal challenges that have not yet been fully resolved—resulting in a degree of uncertainty for DAPT settlors. What follows is a discussion of the basic battle tactics employed by creditors attacking a DAPT:

  1. Fraudulent Transfer;
  2. Choice of Law;
  3. Improper Implementation.

Fraudulent Transfer

Most DAPT statutes will allow a creditor to access trust assets when the settlor made a fraudulent transfer of assets to the trust to defraud the creditor. So where there are current or foreseeable future liabilities of the settlor at the time the trust is created, creditors may be able to attack a DAPT as a fraudulent transfer. And even where there were no current or foreseeable liabilities at the trust’s inception, creditors often resort—rightfully or wrongfully—to the fraudulent transfer attack.

Fortunately, the fraudulent transfer attack can often be neutralized by using competent counsel to draft and fund the trust. Generally, a statute of limitations will often bar creditors from attacking a DAPT after some period of time has passed. And some states (e.g., Nevada) require creditors to bring a fraudulent transfer challenge within a period of time after the transfer is made or the creditor discovers the transfer was made to the trust.

As discussed in the next section, the time limitation on a creditor’s attack will depend on which state’s laws apply—the state where the settlor resides or the state where the trust was formed.

Choice of Law

When possible, creditors like to transplant a DAPT battle to a new battlefield by arguing that the law of the state where the settlor resides should apply to the trust and not the state where the DAPT was formed. Assuming that the settlor lives in a state that doesn’t have a DAPT statute, moving the battle to the settlor’s home state will often permit the court to say that the trust assets are accessible by the creditor.

But generally, this attack only will work only where the court considering the case has jurisdiction over the trustee. An Ohio court applying Ohio law can say that a South Dakota DAPT is creditor-accessible, but if the Ohio court doesn’t have jurisdiction over the DAPT’s trust, the creditor has little hope of breaking the trust.

Alter-Ego Theory

The final tactic used by creditors to attack a DAPT is to argue that the trust is a sham—that the settlor, trustee, and other parties involved with the trust have acted as if the trust doesn’t exist. In other words, the creditors argue that the trust is a trust in name only and should not be respected by the courts.

Although the court that finds the trust to be a sham may not have jurisdiction over the trustee of the trust, if the court finds that the trust is a sham, the court can move against the settlor by finding him or her in contempt of court for failing to turn over assets held in the trust. A finding of contempt can land the settlor in jail indefinitely until he or she turns over the assets.

A DAPT is particularly vulnerable to an alter-ego attack if formalities of the trust aren’t respected (e.g., drafting of a trust agreement) or the trustee’s discretion is less than absolute. If the trustee’s discretion is absolute under the trust agreement, but the trustee and the settlor have an outside agreement that restricts the trustee’s discretion, a court is more likely to find that the trust is a sham.

Conclusion

Each of the three creditor battle-tactics listed above can also be used against offshore asset protection vehicles, but the attacks may be blunted by national borders. On the other hand, DAPTs have the advantage of not being as likely to raise red flags with the IRS and don’t subject the trust settlor or beneficiaries to FBAR filing requirements.

Whether to use an asset protection vehicle and, if appropriate, where to locate the trust, is a highly complex calculus that should only be attempted with the assistance of competent legal counsel.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s partner, AdvisorFX, for a free trial.

See also The Law Professor's blog at AdvisorFYI.

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