5 Problems With Domestic Asset Protection Trusts

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.

1. 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.

2. 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.