Best Practices: Matters of Trust
Protected Class
Melissa Phipps
10/01/2004

Wealth manager Marc Singer spends his days avoiding liability—not for himself, but for his affluent clients. His firm, Singer Xenos Asset Management, in Coral Gables, Fla., serves the needs of physicians, many of whom are part of the estimated 50 percent of doctors in southern Florida who refuse to pay for exorbitantly expensive medical malpractice insurance. Going bare, as it is known, may keep Singer’s clients ahead of the game financially, but it leaves them extremely vulnerable to potential lawsuits. So it is not surprising that Singer has lately become an ad hoc expert in asset protection—strategies for keeping wealth out of the reach of potential future creditors, now and for generations to come.

TOP VIEW
As offshore asset protection trusts come under increasing scrutiny from the federal government, their domestic counterpart is gaining favor among families seeking financial shelter. A handful of states, including Delaware, Alaska and Nevada, have adopted legislation that builds roadblocks similar to offshore trusts, forcing creditors to try their cases in these grantor-friendly environs. The domestic version is also a more cost-effective alternative.
A growing number of real estate developers, business owners, corporate board members, inheritors and other wealthy individuals are seeking hedges against litigious predicaments. In a 2003 survey of individuals with $5 million to $25 million in assets, conducted by Connecticut-based research firm Prince and Associates, 75 percent of the respondents claimed their greatest fear with respect to protecting their wealth was that someone would take advantage of a child or grandchild for financial gain. Sixty-eight percent stated they were “very” concerned that they would become the target of an unfounded lawsuit brought by someone they know—an ex-business partner, for instance, or an ex-spouse. These fears were especially pointed among individuals with more than $25 million in assets.

In efforts to mollify these concerns, affluent families are turning more frequently to domestic asset protection trusts. These trusts extend beyond the needs of doctors and other professionals confronting liability issues: They can also be used to safeguard recent inheritors, vulnerable family members with substance abuse problems, individuals anxious to secure family wealth prior to marriage, and even personal injury victims whose awards would otherwise be exposed.

Traditionally, our last line of defense for our wealth in these situations has been the offshore asset protection trust. The federal government, however, has complicated this strategy: Not only has the passage of the Patriot Act increased disclosure and due diligence requirements for clients with offshore accounts, but the IRS has grown suspicious of the uses of these trusts. As offshores have come under closer scrutiny, a handful of states have reformed their laws to create domestic asset protection trusts. These vehicles offer a level of protection previously available only in offshore jurisdictions, but at a fraction of the cost. As with many other types of trusts, the assets that fund these entities transfer out of our estate and beyond the reach of our creditors. In contrast to typical trusts, however, the individual creating and funding a domestic asset protection trust—the grantor—can also be a beneficiary of trust distributions. This tactic provides the grantor with creditor protection, as well as a share of the trust’s assets.

While some experts question the firmness of the legal ground on which domestic asset protection trusts stand, no case law yet recorded threatens their validity. Moreover, they are becoming the next-best defense for those of us seeking an onshore shelter. Proponents of these trusts argue that the game of asset protection has less to do with evading creditors than creating barriers to assets. “Whether these trusts hold up or not is the second question,” contends Singer. “The first question is whether there are enough obstacles to make it so difficult for someone to sue you, that they would rather not.”

Evasive Action
Offshore jurisdictions, such as the Cook Islands and Bermuda, have offered self-settled spendthrift trusts for years. But in 1996, U.S. lawmakers mitigated the appeal of keeping money offshore by revoking all of the legitimate income tax benefits of doing so. One year later, Alaska became the first state to introduce the domestic trust. Delaware quickly followed suit, as has Nevada, Missouri, Rhode Island and Utah.

Offshore asset protection trusts are still considered more effective at hindering creditors, mainly because they make it so much more difficult for creditors to even attempt to reach the trust. Offshore trusts force a plaintiff to pursue an action overseas, which is both expensive and extremely complicated. The plaintiff’s burden of proof also remains much higher in these distant jurisdictions, while the statute of limitations remains shorter. Nevertheless, we must be aware that, in light of current global events, moving our money offshore could attract unwanted attention from authorities. “You don’t want to show up on the radar of Homeland Security,” Singer advises. “Even if you are not doing anything illegal, most people of substantial wealth don’t want to be on that radar.” Additionally, because offshore trusts no longer retain their tax or estate-planning advantages, a U.S. court is more likely to regard them as creditor-evasion vehicles.

While moving assets offshore may still stir cocktail party conversation, many individuals and families have become increasingly apprehensive about doing so. “I’ve seen fewer people going offshore, and more people setting up asset protection trusts in U.S. jurisdictions,” says Michael Duffy, a wealth advisor with JP Morgan Private Bank in Atlanta.

The money put into a self-settled trust should be thought of as a retirement or emergency fund. You don’t intend to use it right away.
Domestic asset protection trusts are designed to place roadblocks in the paths of creditors similar to those associated with offshore trusts. Domestic trusts force a creditor attempting to siphon assets from the trust to conduct any legal action in the grantor-friendly state where the trust is domiciled. In such states, the law clearly favors the trust, making the creditor’s efforts to prevail far more challenging. And unlike their offshore counterparts, domestic trusts provide legitimate estate-planning benefits. Transferring assets into these trusts effectively removes those assets—and their future appreciation—from the grantor’s estate. The grantor, meanwhile, retains some access to the assets, providing a middle ground for younger grantors who seek the protection of a trust but are reluctant to make an outright gift. “The upside is fantastic,” declares Gideon Rothschild, an estate attorney with Moses & Singer in New York. “If you don’t need the money, it’s out of your estate. If you ever do need the money, you may have the ability to access it. There’s no downside, except paying your trustee fee every year.” Because they require a greater degree of due diligence, offshore trust fees can run $20,000 to $25,000 to set up, compared to approximately $5,000 to $12,000 in the United States. Ongoing management fees, however, can vary widely.

States of Affairs
A grantor or beneficiary need not reside in a specific jurisdiction to domicile a trust there. Indeed, many trusts are, as a matter of course, domiciled in Delaware, Nevada or Alaska, because of the liberal trust legislation adopted by these states. Only our independent trustee (in most cases a bank, asset manager or trust company) need be based in the same state as the trust; and most trust companies have conveniently established themselves in these states to take advantage of this regulation. The states have mimicked one another in drafting their laws, so little distinction exists between them. Alaska was the first state to pass the legislation, and the state’s geographic isolation adds an obstacle to creditors. Nevada has a shorter statute of limitations for a plaintiff to bring a claim of fraudulent conveyance—two years, compared to the other states’ four-year statutes—and is rising in esteem among estate planners, particularly those on the West Coast who prefer to hold trusts in the same time zone. However, many estate planners and attorneys prefer domiciling trusts in Delaware, because of the state’s long history of trust law and its commerce- and corporation-friendly Chancery Court. Of course, residents in any of these trust-favorable states are advised to domicile asset protection trusts where they live.

When we decide how to fund our trust, Duffy notes, we should deposit no more than one-third to one-fifth of our assets. We should also retain sufficient funds outside of the trust in order to avoid repeated requests to the trustee for cash. “You don’t want to establish a pattern of going to the trustee for a distribution,” Duffy suggests. “That will indicate to a court that the trust is being used mainly for your benefit, and it will be considered a fraudulent transfer. If the courts even smell that there is some type of implicit agreement between the trustee and the grantor, they will pierce the trust.” Under these same rules, this type of trust will not adequately shield us if we face pending litigation or have a known or existing creditor. Additionally, a court would consider a case obvious fraud if funding the trust were to render the grantor insolvent.

Although an independent trustee controls and distributes the assets in the trust, we, as the grantor, can provide detailed instructions for the management of our assets when we draft the documents. We might, for example, indicate that the trust pays the grantor 7 percent in interest per year, plus principal as needed. But as with any other irrevocable trust, the grantor surrenders control of the assets that fund the trust.

Duffy recently set up a domestic asset protection trust in Delaware for the benefit of two sisters who had recently come of age and into a large inheritance. The women were concerned that their new wealth would draw predators searching for deep pockets, so a portion of their inheritance was put into a trust where the assets would grow under professional management. The trust was drafted to allow the women to access trust assets to purchase first homes, pay for continuing education and make other large investments. The sisters’ approach underscores the fact that good stewardship, rather than simply the safeguarding of assets, should be the ultimate aim of such a trust. “The money put into a self-settled trust should be thought of as a retirement or emergency fund. You don’t intend to use it right away. It is there to grow and be used in unforeseen circumstances,” Duffy explains. “The asset protection is just gravy.”

Illustration by James Steinberg.