It’s unfortunate that, in industry parlance, self-settled spendthrift trusts have come to be called “domestic asset protection trusts” (DAPTs). I say “unfortunate” because these trusts are generally formed in states that have modern and expansive trust statutes that offer grantors many benefits other than simply protecting assets from creditors.
A few of these benefits include: (1) preventative protection for young adults inheriting a significant amount of wealth, (2) prenuptial planning, (3) planning for immigrating non-U.S. taxpayers, (4) transfer and income tax planning for grantors, and (5) privacy from prying eyes. Properly established, there’s no reason why the use of these trusts should carry any unique legal exposures.
Here are some best practices to get the most out of DAPTs:
Avoid Voidable Transactions
Almost all potential legal exposure surrounding DAPTs emanates from the possibility that a plaintiff may claim the transfer of property into the trust amounts to a fraudulent conveyance—now called a “voidable transaction” under many states’ laws. A voidable transaction is one in which the transfer is made with the “intent to hinder, delay or defraud a creditor.” Voidable means that the remedy is to undo the transfer. So, the first and foremost DAPT best practice is to avoid voidable transactions. Voidable transaction rules apply to creditors: (1) who exist and are in-play, and (2) who exist, but haven’t yet surfaced; however, the rules don’t apply to future “unforeseeable” creditors. It stands to reason that, if there are no future “unforeseeable” creditors on the horizon, lawyers and their grantor clients needn’t be concerned about legal impediments to transfer and can reap the benefits of setting up their irrevocable trusts in a DAPT state.
Badges of Fraud
Most DAPT law arises in the context of fraudulent conveyance “badges of fraud.” Essentially, the badges are designed to be circumstantial evidence implying that a fraudulent conveyance has occurred. These badges have developed in the law because the “intent” factor necessary for a fraudulent conveyance is often difficult to ascertain.
But, the badges can be misleading and often don’t accurately indicate whether the transfer is intended as a fraudulent transfer. Taking proper precautions to avoid even the appearance of a fraudulent conveyance may ensure that the funds in the trust can be accessed in the event the grantor later suffers an unforeseeable change in circumstance.
The following steps may aid in establishing that an unintended fraudulent conveyance badge hasn’t occurred.
- Personal discussions between the drafting attorney and the grantor will help ensure she understands she’s giving up legal ownership of the property being placed in the trust. It’s a fundamental premise that the trust funds be used only as a last resort for rainy days or as a way to effect estate planning transfers.
- The grantor shouldn’t put all or even most of her assets into the DAPT. To do so could open the door for an unforeseen creditor to allege the transfer is a sham by claiming the assets merely have been hidden pending their ultimate use for living expenses. Generally, it’s recommended that trust transfers be for no more than 40 percent to 50 percent of the grantor’s liquid assets.
- The grantor shouldn’t expect that there’s some implicit understanding that whenever she requests funds, the trustee will automatically exercise its discretion to honor the request. I recommend that a distribution advisor be appointed to assist in this process and that the grantor’s relatives be avoided for all roles.
One of the strongest defenses to an attack on the trust is that the court in the trust state has case jurisdiction, not the court in the plaintiff’s home state This is partially accomplished by having as many trust elements as possible located in the trust state, including, whenever possible, the trustee, the trust advisors and the trust assets. For example, the drafting attorney may recommend that trust-held bank and brokerage accounts be administered inside the trust state.
- The drafting attorney should have the grantor execute an affidavit of solvency stating that, after transferring the assets into the trust, she’ll be able to meet her liabilities, known claims andIor potential claims. This will focus the grantor on her future trust usages and help protect all the parties.
So, when it comes to DAPTs, don’t get baught up in “asset protection” and ignore the myriad other benefits. These benefits are so extensive that it’s fair to make the case that all irrevocable trusts should be formed in selected DAPT states, even if asset protection isn’t a consideration.