This splitting of legal and equitable title traditionally shields trust assets from creditors of (1) the trustee, who has no legal right to use or distribute trust assets other than for the benefit of the beneficiaries; or (2) beneficiaries, who have no legal ability to demand or direct distributions or convey title to trust assets. Traditional trusts typically have a “spendthrift” provision which protects trust assets by restricting the beneficiary from assigning future income or trust assets to creditors (thereby prohibiting a creditor of a beneficiary from attaching trust income or assets). The traditional trust, for instance, allows parents and others to make protected gifts to children.
Self-settled trusts are distinct in that they are funded by a grantor who retains the benefit of trust assets. Only legal title is conveyed to a third-party trustee to put trust assets (theoretically) outside the reach of creditors. Several offshore jurisdictions and 16 U.S. states have enacted statutes permitting such arrangement. In these jurisdictions, the grantor may "have his cake (protection) and eat it (the assets) too." The grantor/beneficiary enjoys the fruits of the trust assets but has no legal right to transfer title or direct proceeds to creditors. Self-settled trusts are therefore often referred to as “asset protection trusts.”
Domestic asset protection trusts, or DAPTs may have their place in certain asset protection plans, but they still remain largely untested by the courts. Indeed, several non-DAPT states consider such trusts anathema to public policy. Often overlooked in predicting the effectiveness of an asset protection strategy is giving due consideration to which state’s law may ultimately be called upon to test it.
Consider the case of a resident of Washington (which offers no DAPT) who forms a DAPT for his own benefit in Alaska (which does have a statute permitting DAPTs). He names himself as a beneficiary and his son as co-trustee (along with an Alaska trust company). The grantor/beneficiary then proceeds to transfer a significant portion of his assets, including title to financial accounts, automobiles, and real estate interests into the trust.
How effective is this arrangement when creditors come knocking in Washington? The debtor will rightly claim that he technically does not own any of the trust assets, as legal title now resides in the trustee. This is similar to what actually occurred in the case of In re Huber, where the settlor of the Alaska trust lost everything due to his failure to consider local law and policy.
In Huber, a bankruptcy court in the State of Washington relied on Washington law to essentially disregard a DAPT formed in Alaska. The court looked to several factors suggesting the trust was a sham. The court cited the fact that the beneficiary did not reside in Alaska, one of the trustees was not in Alaska, and perhaps most importantly (as discussed below), trust assets were not located in Alaska. The court also noted Washington’s “strong public policy” against self-settled asset protection trusts. The bankruptcy trustee was therefore entitled to disregard the trust and seize trust assets (as personal assets of the grantor/creditor).
Huber offers insight into the factors to consider in using DAPTs for asset protection planning.
Practically, we learned that keeping trust assets and a trustee in a non-DAPT state exposed trust assets to the local court where the assets were located. Had the assets and trustee resided beyond the reach of the court, only the grantor/beneficiary would have remained in the court’s jurisdiction. Without a legal title, the beneficiary would have no ability to turnover trust assets to creditors. Thus, we can surmise that leaving assets in a DAPT state (with the trustee), pursuant to a properly drafted trust agreement (limiting beneficiary control over trust assets) would likely have substantially restricted court intervention benefitting creditors.
By focusing merely on technical legalities and failing to recognize the practical ability of a court to reach the trustee and trust assets, the Huber DAPT was never designed to hold up in stormy weather and was thus doomed to fail. Practical considerations, such as the law and policy of the state where a DAPT might ultimately be tested, should always be respected.
For individuals and their advisors considering DAPTs for wealth preservation, carefully consider the details that might ultimately be examined if you (or your lawyer) are compelled to defend the structure in court. It is best to engage experienced counsel and consider factors that might influence the plan's efficacy. These may include not only the state of formation, but also the state in which you live and work (and are thus most likely to be sued), the identity and location of the trustee, whether there are multiple beneficiaries, and the types of assets you wish to protect. For instance, cash and other liquid assets can be relocated to more protective jurisdictions, but real estate is always at risk of being subjected to local law. Often overlooked is the fact that courts that enter judgments generally prefer to see those judgments enforced. The prudent planner should therefore assume that any DAPT will one day be subjected to intense judicial scrutiny and plan accordingly.
The information provided here is not legal advice and does not purport to be a substitute for advice of counsel on any specific matter. For legal advice, you should consult with an attorney concerning your specific situation.