[This article is a continuation of an article appearing in last month’s issues of The Barrister concerning protection of assets from creditors.]
Many lawyers and other professionals and owners of business are subject to suit by creditors, often because of the nature of the business activities in which they engage. This series of articles is designed to discuss various steps that can be taken to protect assets from claims of these creditors. Under the Fraudulent Transfer Act, it is critical that steps be taken well in advance of any incident that may lead to a claim or to the filing of a claim itself. Last month’s article discussed insurance, titling of assets, retirement plans, and assets used in a profession or business. This article will discuss Domestic Asset Protection Trusts (DAPTs) and reasons not to use Off-Shore Trusts.
DOMESTIC ASSET PROTECTION TRUST
Fifteen states have adopted legislation authorizing DAPTs. These include the following: Alaska, Delaware, Hawaii, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia and Wyoming. Statutes in each of these states vary. For purposes of this discussion, it will be assumed that the DAPT is established under the laws of Delaware.
The DAPT must be:[1]
- The trust must be irrevocable.
- Spendthrift Clause. The trust must contain a spendthrift clause.
- The situs of the trust must be Delaware for purposes of determining the trust’s validity, construction and administration.
- The trust must appoint at least one Delaware trustee.
- The assets must be custodied by the Delaware trustee in Delaware.
- The Delaware trustee must maintain records for the trust.
- Fiduciary Income Tax Returns. The Delaware trustee must prepare or arrange for the preparation of fiduciary income tax returns.
- Trust Administration. The Delaware trustee must materially participate in the administration of the trust.[2]
- Resident Trustee. The trustee must either be an individual who resides in Delaware or a corporation that is authorized to conduct trust business in Delaware and is regulated by the Delaware banking commissioner or a federal agency.[3]
- Any action to enforce a claim against a Delaware DAPT must be brought in the Delaware Court of Chancery. The Act also bars original actions and actions to enforce judgments, including judgments entered elsewhere.[4]
The grantor of a Delaware trust may retain the power to:[5]
- Consent to or direct investment changes;
- Veto distributions; and
- Replace trustees or advisors.
The grantor of a Delaware DAPT may have the following:
- Income and Principal. The ability to receive income and principal pursuant to a broad discretion or a standard determined by the Delaware trustees.
- Current Income. The right to receive current income distributions.
- Power of Appointment. A Special Limited Testamentary Power of Appointment.
- Payments on Death. The ability to provide for the payment of debts, expenses, and taxes on death.
The grantor of the Delaware DAPT may not serve as Trustee.[6] While individuals other than the grantor may serve as co-trustee even if they are not Delaware residents, the downside is that this may increase the ability of creditors to serve process in other states, and the possibility that a court may find that Delaware law does not control.
There are certain super creditors established under federal law, which trump state law. Super creditors include, but are not limited to:
- The Internal Revenue Service (IRS)
- The Securities and Exchange Commission (SEC)
- The Federal Trade Commission (FTC)
- Children seeking child support
- Alimony/Equitable Distribution. Only a spouse married to the grantor before the trust was created may invoke this exception.
If a Delaware DAPT is established as an irrevocable non-grantor trust without a Delaware beneficiary, the income accumulated and capital gains incurred for the non-resident will not be subject to Delaware income tax.[7]
With respect to situs, the Delaware Supreme Court declared in 1947 that, “In determining the situs of a trust for the purpose of deciding what law is applicable to determine its validity, the most important facts to be considered are the intention of the creator of the trust, the domicile of the trustee, and the place in which the trust is administered.”[8] In New Jersey, which has adopted the Federal Grantor-Trust Rules, the tax can be avoided by having the grantor agree to limit distributions to himself subject to approval of an adverse party. To avoid this income or capital gains tax, a Pennsylvania resident must use a type of Delaware DAPT known as a Delaware Incomplete Non-Grantor Trust (DING Trust). This is because Pennsylvania has not adopted the Federal Grantor-Trust Rules.
OFF-SHORE TRUSTS
While arguments can be made that off-shore trust provide advantages unavailable under a DAPT, there are also risks attendant in an off-shore trust. When establishing an off-shore trust, assets must be moved to that jurisdiction, such as the Cook Islands or the Cayman Islands, to insulate them from creditors. This is expensive and involves many logistical hurdles. Law of the foreign jurisdiction controls, which gives the advantage that the Full Faith and Credit Clause of the United States does not apply. Laws of those jurisdictions are specifically designed so that a creditor must file suit in the foreign jurisdiction under those laws and laws in these jurisdictions make it very difficult for a creditor to obtain a judgment. Trustee powers are very broad, which makes it difficult for a creditor to collect from trust assets. The problem is that trustee are often non-compliant, and there are instances where grantors of these trusts have been incarcerated for failure of the foreign trustee to comply with orders of U.S. courts.
[1] Del. Code Ann. tit. 12, §§3570(11)(a) , (b) & (c).
[2] Del. Code Ann. tit. 12, §3570 (8)(b).
[3] Del. Code Ann. tit. 12, §3570(8)(a).
[4] Del. Code Ann. tit. 12, §3572(a).
[5] Del. Code Ann. tit. 12, §3570(8)(d); Del. Code Ann. tit. 12, §3570(11)(b).
[6] Del. Code Ann. tit. 12, §§3570(8)(c), 3571.
[7] Del. Code Ann. tit. 30, §§1636, 1636(b).
[8] Louis v. Hanson, 36 Del. Ch. 235, 128A.2d 819, aff’d 357 U.S. 235.
