Creditor Protection Aspects of Trusts and Trust Devices - Module 3 of 6

Module 3: Asset Protection and Trusts

Protecting trust assets from potential creditors for distribution to family members is an important goal of virtually every irrevocable trust. Fortunately, the creditor protection rules regarding trusts are quite favorable and allow trusts to become excellent vehicles for protecting trust assets from the creditors of the grantor, the trustee and the beneficiaries.

Fraudulent Transfers

However, before we discuss how trusts can be used to protect trust assets, we must first discuss the major and overriding exception - the fraudulent transfer rule. The fraudulent transfer rule prevents trust grantors from gifting away assets to avoid existing creditors. The general rule of thumb is that if the grantor already has creditor problems before the trust is established, there’s probably little that can be done to shield assets from those creditors. Family obligations such as equitable distribution, alimony and especially child support, are similarly difficult or impossible to evade through trusts or other creditor protection devices.

The rules regarding fraudulent transfers come from case law, the Uniform Fraudulent Transfer Act and the United States Bankruptcy Code for cases that involve bankruptcy filings.

 There are two types of fraudulent transfers:

-          “Actual” fraudulent transfers; and

-          “Constructive” fraudulent transfers.

Actual fraudulent transfers occur when the person who owes money transfers assets after the prospect of a debt arises with the purpose of frustrating the abilities of the creditors to get at those assets. For example, if a person has been in a car accident and fears being sued because of it, and then gifts assets to another person, this would likely be considered a fraudulent conveyance. Even though it is not clear that she will be liable based on the accident, removing assets due to potential liability for events that have already occurred is fraudulent.

The same thing is true for marital property division purposes. A person who fears losing assets or being subjected to alimony payments in a divorce proceeding and thus gifts assets to another person to avoid having to share those assets, has likewise engaged in a fraudulent conveyance.

The constructive fraudulent transfers rule was established because determining the intent of a debtor who gifts assets is not always possible. The Uniform Fraudulent Transfers Act states that a gift transfer can be considered fraudulent if the donor:

-          was engaged or was about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or

-          intended to incur, or believed or reasonably should have believed that he would incur, debts that are beyond his ability to pay as they become due.

It’s important to note that it is NOT considered a fraudulent conveyance to transfer property in anticipation of liability, which basis has not yet arisen. A doctor can, for example, convey her house to her husband due to a fear of one day being subjected to a medical malpractice claim. If the malpractice has not already happened, there should be no problem with making this transfer. In fact, this sort of maneuver is quite common a tool among professionals who are at high risk of malpractice lawsuits. It is only once the basis for liability has occurred (in the case of medical malpractice, this would be the treatment gone wrong) that one may no longer gift assets to shield them from potential creditors.

Asset Protection Trusts

Assuming a give to a trust is not a fraudulent conveyance under these rules, gifting assets to most trusts should protect those assets from potential creditors. There are two sets of creditors at issue here:

§  the creditors of the grantor; and

§  the creditors of the beneficiaries.

Creditors of the Beneficiaries

Let’s start with the creditors of the beneficiaries. Trusts are often established specifically as a vehicle to hold assets for the benefit of beneficiaries, who because of youth and experience, poor judgment or other risk factors, cannot be given their money outright. The good news is, that if the trust clearly states such, trust assets will generally not be vulnerable to the creditors of the beneficiaries. To ensure this, trusts often contain “spendthrift provisions,” which protect the trust assets from the creditors of the beneficiaries by denying the beneficiaries’ abilities to transfer assets to their creditors. This provision can be one sentence long and can be as simple as:

To the extent permitted by law, the beneficiaries interests will not be subject to their liabilities, creditor claims, assignment or anticipation.

This provision, however, is not in and of itself sufficient to ensure that the beneficiaries’ creditors cannot access the trust assets. Additional steps that should be taken include ensuring that the beneficiaries do not have access to trust assets unless that access requires the consent and actions of the trustee or other designated person and that the beneficiaries do not have powers to distribute assets to themselves.

If any beneficiary can distribute assets to himself, that beneficiary’s creditors will have access to the trust funds to the maximum extent over which the beneficiary has this power of appointment. So, for example, if one spouse establishes a trust and makes the other spouse the trustee and beneficiary, with the trustee having the blanket authority to distribute assets for the benefit of the beneficiaries, the spouse has power of appointment over the trust assets.

Where the trust grantor would like to make her spouse or child the trustee and potential beneficiary of the trust (a common occurrence), this problem can be avoided in several ways, including:

1.    Appointing a co-trustee to serve along with the spouse or child.

2.    Requiring the spouse or child trustee to obtain the consent of another trust beneficiary or outside party (often called a “trust advisor” or “trust protector”) before distribution can be made to or for the benefit of the trustee.

3.    Limiting the trustee’s authority to distribute assets by an “ascertainable standard,” such as requiring that the distributions be made only for the beneficiaries’ “health, education, maintenance and support.”

Standard trust provisions should also be used to ensure that no person has any power or authority if that power would be deemed a “general” power of appointment.

Benefits Eligibility

Most people are happy to receive cash gifts. Still, if not planned properly, sudden cash infusions can have negative impacts on beneficiaries who are receiving means-tested government assistance. A sudden infusion of cash for example can make a person ineligible for programs such as Medicaid, food stamps and Section 8 housing assistance. Cash inheritances can therefore sometimes be counterproductive to the interests of the family.          

One common planning device to preserve the eligibility of the beneficiaries is to take assets that would otherwise be distributed to them outright and instead placed them into trusts for their benefit. The trust provisions can be tailored accordingly. For example, if a trust is designed to maintain the Medicaid benefits eligibility of the beneficiary, then the trust should not provide for her healthcare. If it does, the Department of Social Services may take the position that the trust assets are “available resources” for that beneficiary; thus, making her ineligible for Medicaid assistance.

Self-Settled Spendthrift Trusts

Protecting trust assets from the creditors of the beneficiaries is comparatively straightforward. Much more complex, however, is protecting trust assets from the creditors of the grantor who also seeks to remain a potential beneficiary of the trust. Most states’ rules provide that trust assets that are subject to the grantor’s beneficial enjoyment are vulnerable to the grantor’s creditors. For example, Texas law provides:

If the settlor is also a beneficiary of the trust, a provision restraining the voluntary or involuntary transfer of his beneficial interest does not prevent his creditors from satisfying claims from his interest in the trust estate.

Similar statutes appear in the books of New York, California, Florida and most other states.

If the grantor does have a beneficial interest in his trust, his creditors may collect the trust assets to the maximum possible extent of his interest. If the trust may distribute up to $10,000 per year to the grantor, then his creditors may collect up to $10,000 per year from the trust, even if the trust requires the consent of a trustee to make those payments to the grantor.

So, in these states, grantors are faced with the choice of completely giving up all beneficial interests in their trusts or subjecting their trusts to vulnerability to their creditors.

There are, as of late 2017, 16 states, however, that allow “self-settled spendthrift trusts” that are protected from creditors of the grantor even though the grantor is a potential beneficiary. While the list of such states initially included only states famous for “trust-friendly” regulations, such as Delaware, Alaska and Nevada, the list has been expanding with Virginia, Ohio, Mississippi and West Virginia joining the group in the past five years.  

For people who live in the other states and want to establish a self-settled spendthrift trust that is protected from creditors, there are two possible solutions, each with its drawbacks:

o   Establish a self-settled spendthrift trust in a foreign country that has rules that protect these trusts from the grantor’s creditors; or

o   Establish a self-settled spendthrift trust in one of the states that allow and protect these trusts.

Foreign Trusts

Many small countries near the United States are happy to have the business of American trust dollars invested in their economies. Many, therefore, have established trust-friendly rules designed to attract such trusts, including rules that protect the trust assets from the grantor’s creditors. These countries include the Bahamas, Bermuda and the Cayman Islands.

Trusts established in these countries can provide excellent protection against the creditors of the grantor. The courts of these countries will naturally follow their own laws and refuse access to the grantor’s creditors. American courts, even if they are so inclined, would find difficulty in forcing the Caymanian bank, for example, to turn over trust assets to creditors. There may even be certain additional tax advantages to establishing trusts in these countries. Therefore, this is certainly one viable solution for American grantors to use.

Nevertheless, there are several pitfalls involved in this strategy.

The first issue is cost. An attorney who is an expert in the laws of the host country will probably have to be retained to oversee the formation and execution of the trust. Additionally, the foreign banks may charge significant fees to hold and manage the trust accounts and foreign governments may charge various income or excise taxes on the transfer or holding of the trust funds.

The second issue is possible instability. While American banks are usually insured by the FDIC and investors in American securities are protected by various securities rules, the same is not be true in all foreign jurisdictions. Possible bank failure or other mishaps may occur, which the grantor may be unable to remedy using the American court system.          

Third, American tax law imposes strict and burdensome reporting requirements on foreign trusts. The foreign trust and its beneficiaries may be required to file various annual reports and returns with the IRS. These requirements, which were established to prevent offshore hiding of assets and avoidance of income tax, can be complex and compliance can cost a significant amount in accountant’s and/or attorney’s fees. As a practical matter, these requirements often make the foreign asset protection trust idea inefficient for relatively small trusts.

Domestic Asset Protection Trusts

The other possible solution is to establish a self-settled spendthrift trust in a state that protects these from the creditors of the grantor.  To distinguish it from the foreign asset protection trust strategy outlined earlier, these trusts are sometimes known as “Domestic Asset Protection Trusts.” The states that allow and protect Domestic Asset Protection Trusts are sometimes therefore known as “DAPT states.”

There is nothing inherently preventing the person who lives in a non-DAPT state from establishing a trust in a DAPT state. After all, the right to travel and do business in different states is considered a fundamental right under the United States Constitution. Still, the dangers of the strategy lie in its potential ineffectiveness. By leaving the trust in the United States, you are inherently subjecting it to the American court system. There are three possible pitfalls in relying on the enforceability of the laws of the DAPT state in which you establish the trust.

To illustrate these, let’s assume they grantor living in Texas establishes a self-settled spendthrift trust with herself as a potential beneficiary that the trust is established, set up and administered in Nevada.

Jurisdiction. If the courts of the state in which the grantor lives can get jurisdiction over the trust, it will probably do so. In our example, even though the trust is administered in Nevada, Texas courts will try to enforce judgments brought by Texas creditors if the Texas courts can get jurisdiction over the trust. For example, even if the trust is nominally a Nevada trust, if the funds are held in a financial institution in Texas or the trustee lives in Texas, those factors may allow the Texas court to establish jurisdiction over the trustee or the trust assets.

It is therefore best strategy to minimize, to the extent practical, all connections between Texas and the trust. The assets can, for example, he held in a Nevada bank without a Texas branch. The trustee can be a financial institution in Nevada. It is even common to create a business entity, such as an LLC, in the DAPT state that will hold the trust assets. The more steps that are taken in this regard, the more difficult it will be for the courts in the non-DAPT state to assert jurisdiction over the trust assets.

Full Faith and Credit. The United States Constitution requires all states to give “full faith and credit” to the judgments of other states. This seemingly presents a challenge for grantors living in non-DAPT states who want to employ this strategy. In our example, creditors of the grantor may bring an action in Texas and get a judgment in Texas and then bring an action to enforce the judgment in Nevada, seeking to attach the Nevada trust assets.

Still, if the trust is established properly, this should not be an overwhelming concern. While the Nevada court must enforce judgments rendered by the Texas court, assuming the trust is properly set up, the courts of both states will not have authority over the same party. Texas will have personal jurisdiction over the grantor, but no jurisdiction over the trust. Nevada has jurisdiction over the trust, but not over the grantor. Therefore, the Texas judgment against the grantor is meaningless against the trust and the creditors will not be able to get a Texas judgment against the trust, because it has no sufficient nexus to Texas. This illustrates the practical power of separating the grantor from the trust from a legal perspective.

Choice of Law. A domestic asset protection trust established in a state like Nevada is worthless unless the Nevada courts will apply the Nevada law, rather than, for example, Texas law. It is therefore important that the trust contain a “choice of law” provision, expressly stating that the laws of the DAPT state apply. Otherwise, if the grantor and the beneficiaries all live in Texas, even a Nevada court might determine the Texas law should apply, since Texas contains the greatest nexus to the parties that are relevant to the trust.

Even with the choice of law provision requiring that the trust follow Nevada law, for example, the inquiry is not over. The Second Restatement of Conflicts of Laws provides that a trust may choose the laws under which it is governed, if the state whose laws are chosen “has a substantial relation to the trust and that the application of its law does not violate a strong public policy of the state with which… the trust has its most significant relationship.” In other words, the trust must have a substantial relationship with the chosen state and the public policy of another state cannot be violated.

To establish a strong enough nexus with the DAPT-state to ensure a substantial relationship, the same steps we discussed earlier should suffice. For example, if the Nevada trust is managed by a Nevada bank as trustee and the trust assets are kept in a financial institution in Nevada, there’s little doubt that Nevada has a substantial relationship with the trust. Moreover, it would be difficult to argue that Texas public policy is violated if Nevada law applies to a Nevada trust, managed by a Nevada entity in a Nevada financial institution. The same steps that protected the trust under the other inquiries should suffice to satisfy this one.