March 29, 2012

5 Problems With Domestic Asset Protection Trusts

Attorney Jim Duggan questions efficacy of structures that protect assets from creditors

Domestic asset protection trusts have entered advisors’ estate planning discussions with some of their high-net-worth clients over the past decade.

DAPTs, which protect assets from creditors, are seen by some as a more palatable alternative than offshore structures with a similar purpose, but estate planning experts question whether this is the case.

“For those who are not ready to make the cognitive leap offshore, then a DAPT is absolutely better than nothing,” Jim Duggan, an attorney with Duggan Bertsch LLC in Chicago, said in a statement.

However, because of uncertainties that surround DAPTs, “the plaintiff will be expending significant dollars to litigate in unchartered territory, and litigation risk can often provide ample deterrence,” he said.

Alaska was the first state to enact an anti-creditor trust act, and since then a handful of other states, including Delaware and Nevada, have enacted identical legislation, according to the Asset Protection Corp.

These states allow a person to form a trust for his own benefit to protect against creditors—something prohibited in all other states. With DAPTs, creditors have a shortened period of time to challenge a transfer to such a trust. And it is harder for a creditor to prove that a transfer to the trust was a fraudulent transfer.

While DAPTs are relatively easy to set up, these structures have to meet certain criteria in order to be valid. According to the American Bar Association, a DAPT:

  • Must be irrevocable or unchangeable
  • Should appoint a trustee with the discretion to administer the trust
  • Must appoint a corporate or individual trustee that is a resident of the jurisdiction where the trust is formed
  • Must contain a “spendthrift” clause, which restricts the transferability of a beneficiary’s interests in the trust property—whether voluntary or involuntary—before the trustee actually distributes the property to the beneficiary.

Duggan raises five principal concerns advisors and clients should understand before implementing a DAPT.

man reading1. Conflict of Laws

In the U.S., each state has its own body of law. This creates a difficulty, Duggan said, because in any case involving a fact pattern in which the parties, the conduct or the assets are from different states, the first challenge for the courts is to decide which state’s law should control the case.

Since only a quarter of states currently have DAPT statutes, it is probable that states where litigation is taking place are those in which DAPTs are expressly prohibited as being against public policy. In a conflict-of-law analysis, it is difficult to envision any judge in a non-DAPT state agreeing to apply the laws of the DAPT state, Duggan said. Therefore, the conflict-of-law analysis alone creates enough uncertainty with DAPTs that many practitioners advise against them.

gavel2. Full Faith and Credit Clause

Once the conflict-of-law analysis has been resolved and a judgment has been rendered, enforcement of the judgment becomes the next challenge. In short, Duggan said, State A must respect the legal judgments from a court of competent jurisdiction in State B. This is necessary if “sovereignty” is to retain its meaning.

But what happens when State A holds that DAPTs are against public policy and State B holds that they are valid? If the judgment comes from State A, is State B obligated to give deference and enforce? Some argue “yes,” others “no,” creating more uncertainty.

justice scale with money3. Statutory Exceptions

If the conflict-of-law analysis and the full faith and credit clause are ultimately resolved in a defendant’s favor, the statute of the DAPT state itself creates further problems and uncertainties, Duggan said. The exceptions to the DAPT statutory protections will render the DAPT useless in many cases since unlike their offshore counterparts, most DAPT statutes have some “uncomfortable” carve-outs.

Depending on the state involved, the DAPT statutes allow for creditors to invade the trust to pay out claims related to certain tort claims, child support, alimony, property division and tax evasion, among others. Since these exceptions may, in the end, serve to “swallow the rule,” many view DAPTs as strong only in name but not in substance.

gavel with money4. Legal Standards

Variations in the legal standards a court applies when making determinations with respect to a DAPT or Offshore Asset Protection Trust are also of critical importance, according to Duggan. Key differences in the legal standards applied are fraudulent conveyance “lookback,” and fraudulent conveyance burden of proof.

In addition, he said, it is important to note that the OAPT jurisdictions also generally offer several features unavailable in the DAPT jurisdictions:

  • The plaintiff must post a bond to file suit (to prevent frivolous lawsuits)
  • The loser must pay the victor’s fees
  • Contingency fee arrangements are strictly prohibited.

USA map/flag5. Governed by U.S. Law

Duggan said that perhaps the greatest deficiency of DAPTs is that they are necessarily governed by U.S. law. The DAPT fails to achieve the jurisdictional separation required to fully protect the asset from the caprices of the U.S. court system, and as long as the DAPT is governed by U.S. laws, it will have vulnerabilities that are simply not present offshore. It is perhaps this certainty of U.S. governance that creates the greatest uncertainty in the end.

“For those who can embrace a more global planning structure, the Offshore Asset Protection Trust remains the stronger of the two options,” he said.

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