This Asset Protection Technique is Gaining New Respectability
It seems like an eternity ago, but I remember the day I first learned about something called an asset protection trust.
It was sometime in 1989, and I was living in Atlanta. My phone rang, and when I answered, I recognized the voice of a now-deceased lawyer that I was then working with closely.
“Did you hear about the new law the Cook Islands enacted?” he asked me. I told him I knew nothing about it. At the time, I didn’t even know where the Cook Islands were.
It turned out that the Cook Islands had turned the asset protection world on its head. Indeed, the amendments to its trust law marked a radical departure from the centuries-long history of the law of trusts.
The concept of a trust (first known as a use) developed in 11th century England, although similar devices had been part of the laws of ancient Greece and Rome. During the Crusades, a body of law was developed to enforce agreements under which a knight could temporarily convey property to another person. If the knight returned from the Middle East alive, he would get the property back. If the knight died in battle, the person holding the property would convey it to the knight's heirs.
Over the next few centuries, uses evolved. Landowners employed them to grant land to others for the temporary use of an intended beneficiary. This arrangement allowed landowners to avoid the estate tax the king imposed for the transfer of property to an heir.
In 1553, the English Parliament enacted the Statute of Uses to eliminate uses as a means to avoid paying estate tax. It was successful, but the English courts subsequently developed a body of law whereby a property owner (a settlor) could convey the title to property to someone else (a trustee) for the benefit of an heir (a beneficiary). The trustee managed the property without direct ownership. Modern trust law is based on this body of law.
However, creditors were often unable to collect debts against property that a debtor had placed in trust or in a trust-like arrangement. To preserve creditor rights, the English Parliament enacted the Fraudulent Conveyances Act in 1571. Today, this law is better known as the Statute of Elizabeth.
The Statue of Elizabeth voided all property transfers that had been made with the intention of delaying or hindering any creditor. A court could disregard the transfer and order the assets paid to the creditor.
This ancient statute is the basis of the common law concept of fraudulent transfer. That concept, along with the entire body of English “common law,” was eventually adopted into US law.
In the US and other common-law jurisdictions, “intent to defraud” has been interpreted broadly and has come to mean merely depriving creditors of timely access to property. US courts have even ruled that the principles of the Statute of Elizabeth apply to future unknown creditors.
Fast forward to 1989. The amendments to the Cook Islands International Trust Act effectively revoked the Statute of Elizabeth. The amended law locks out future unknown creditors. A trust “settled” (funded) before a creditor’s cause of action arose could not be ruled a fraudulent transfer.
This was a revolutionary development. But the amendments went further. They also declared that a trust would be protective even if the settlor was a beneficiary (an arrangement known as a “self-settled trust”). The amendments also included innovative provisions such as requiring a creditor to demonstrate fraudulent transfer beyond a reasonable doubt.
At the time, the perception in the US was that litigation was out of control. Mainly as a public safety measure, many states had expanded the concepts of “strict liability” and “joint and several liability.” The concept of strict liability holds that even if you're not at fault or had no intent to harm someone else, you may still be liable for damages in a lawsuit. Under the theory of joint and several liability, someone suing you can hold you fully financially responsible regardless of your individual share of the liability. If you're 1% responsible for a $10 million loss and have deep pockets, you might have to compensate the successful litigant the full $10 million!
What’s more, the principles of the Statute of Elizabeth were now incorporated into the federal bankruptcy code. All 50 states incorporated these principles as well by enacting their respective versions of model acts published by the Uniform Law Commission (ULC) – the Uniform Fraudulent Conveyance Act, and later, the Uniform Fraudulent Transfer Act. (The ULC promotes enactment of “uniform acts” across many areas of law.)
For all these reasons, the new law in the Cook Islands was wildly successful. By the early 1990s, doctors and other professionals were flocking to attorneys to set up Cook Islands asset protection trusts. In the meantime, other jurisdictions amended their own trust laws along the same lines. By the mid-1990s, a dozen offshore jurisdictions had similar legislation in effect.
In 1997, Alaska became the first US state to enact a law that attempted to overturn the Statute of Elizabeth. Delaware, Nevada, South Dakota, and other states followed suit. Today, 17 states have enacted domestic asset protection trust (DAPT) laws.
Naturally, creditors don’t like asset protection trust laws. Lobbying groups have pressured Congress and state legislatures to limit their effectiveness. Their first significant success was a 2005 amendment to the federal bankruptcy code. The amendment establishes a 10-year clawback period for asset transfers to a “self-settled trust or similar device.”
Then in 2014, the ULC amended the Uniform Fraudulent Transfer Act and renamed it the Uniform Voidable Transfers Act (UVTA). The comments that accompany the revisions state that any transfer to a self-settled spendthrift trust is voidable, with no time limit for a constructive fraudulent transfer claim. (A spendthrift trust is a trust that restricts the access of beneficiaries to assets in the trust. Beneficiaries receive distributions from the trust only if the trustee approves them. This arrangement limits access of the beneficiaries’ creditors to trust assets.)
The comments also state that a person living in a state that does not recognize DAPTs can never have asset protection by creating a DAPT in a state that does. Fifteen states have already enacted the UVTA amendments into law, with legislation pending in several more.
Around 2010, cases involving DAPTs started to be heard in US courts. And the results weren’t promising. Bankruptcy trustees successfully used the 2005 amendments to the federal bankruptcy laws to seize assets conveyed to a DAPT. But outside of bankruptcy, they were more effective, especially if the DAPT settlor lived in a state with DAPT legislation in effect.
When a debtor has set up a DAPT in a state that they are not a resident of, creditors will argue that the debtor is trying to avoid their home state’s “strong public policy” against self-settled trusts.
However, as more state legislatures enact DAPT statutes, the conflict of law between states that permit assets in a self-settled trust to be protected from creditors versus states that don’t could gradually become less of a problem. Since 17 states now recognize the DAPT concept, it is becoming more difficult for a court in a non-DAPT state to justify such a claim, unless state law or previous court decisions have upheld it.
Despite the increasing acceptance of DAPTs, there’s no question that an offshore asset protection trust (OAPT) provides superior protection. However, OAPTs are much more expensive to maintain than DAPTs. And they remain far more controversial.
Should you create a DAPT? If you live in a DAPT state, it could be an appropriate strategy. Talk to your attorney, or give us a call. We’d be happy to help.
Protecting your assets (and yourself) against any threat - from the government, the IRS or a frivolous lawsuit - is something The Nestmann Group has helped more than 15,000 Americans do over the last 30 years.
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