The Tax Advantages of Domestic Asset Protection Trusts

First, a domestic asset protection trust must be irrevocable in order to effectively protect the assets of the trust creator against the claims of future creditors. The trust settlor is named as a trust beneficiary (additional beneficiaries may also be named), resulting in what is known as a self-settled trust. Second, a trustee (whether an individual or a corporation) who is a resident of the state in which the trust is established must be appointed and given discretionary authority over trust administration and distributions. Third, importantly, a domestic asset protection trust must contain a “spendthrift” clause in order to protect the trust settlor’s assets against the claims of creditors.

What issues should an individual consider when establishing a domestic asset protection trust?

It is important for an individual considering a domestic asset protection trust to remember that the validity of the arrangement may be challenged in court regardless of whether the trust that meets all of the requirements discussed above. Since these trusts are relatively new, issues surrounding their validity have not been extensively litigated, so a variety of potential grounds for challenge still exist.

Because of the public policy concerns surrounding these trusts, and the fact that not every state authorizes their creation, a creditor may challenge the validity of a trust established in a state other than the settlor’s state of residence by claiming that the laws of the settlor’s state of residence should apply. The trust must clearly specify which state law will govern. Further, in order to minimize the potential success of such a claim, a trustee who is resident in the state where the trust was formed must be chosen—merely directing a nonresident trustee to apply the laws of the state could be insufficient. If possible, the assets should actually be transferred to the state in which the trust is formed (meaning that real estate located in another state may not be an ideal trust asset).

A valid and enforceable asset protection trust should avoid even the appearance that the assets were fraudulently transferred into the trust in order to evade the claims of a specific creditor.  The issue may result in litigation even if the settlor could reasonably foresee that the claim or liability would arise in the future. The settlor should also be aware that most state laws will not allow a domestic asset protection trust to shield assets from claims for child support.

— Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017