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The Tax Advantages of Domestic Asset Protection Trusts

By Tax Facts Online

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What is a domestic asset protection trust? Why might an individual wish to establish an asset protection trust?

A domestic asset protection trust is an irrevocable trust that is established in a U.S. jurisdiction that is designed to protect the assets of the individual who creates the trust. These trusts are unique in that the individual who creates the trust and transfers assets to the trust is generally also a trust beneficiary, so that he or she retains the economic benefit of the assets that are transferred into the trust while simultaneously protecting those assets from the claims of creditors.

The reasons for establishing a domestic asset protection trust can vary. Some high net worth individuals may wish to establish the trust in order to protect assets from the claims of traditional creditors, while others establish these trusts in order to protect assets from the threat of future liabilities stemming from litigation. For example, individuals which high risk exposure levels, including doctors, lawyers and directors and officers of public companies, may wish to shield their assets from the threat of future lawsuits.

Others may wish to protect the assets that will eventually be inherited by a “spendthrift” heir, or a disabled individual. Asset protection trusts can also be used as a tool in marital planning, perhaps replacing a prenuptial agreement by placing certain assets beyond the reach of a future spouse.  While asset protection is generally the primary motive in establishing these trusts, the irrevocable nature of the trust also means that the trust assets can be excluded from the settlor’s estate.

Not every state has enacted a statute that authorizes domestic asset protection trusts. Some states do not allow establishment of these trusts because of the public policy concerns over allowing an individual to establish a trust in order to shield assets from the valid claims of creditors. However, many individuals will establish domestic asset protection trusts in states that do authorize these trusts, such as Delaware or Alaska, regardless of whether the individual actually resides in that state.

What are the important elements of an effectively designed domestic asset protection trust?

First, a domestic asset protection trust must be irrevocable in order to effectively protect the assets of the trust creator against the claims of future creditors. The trust settlor is named as a trust beneficiary (additional beneficiaries may also be named), resulting in what is known as a self-settled trust. Second, a trustee (whether an individual or a corporation) who is a resident of the state in which the trust is established must be appointed and given discretionary authority over trust administration and distributions. Third, importantly, a domestic asset protection trust must contain a “spendthrift” clause in order to protect the trust settlor’s assets against the claims of creditors.

What issues should an individual consider when establishing a domestic asset protection trust?

It is important for an individual considering a domestic asset protection trust to remember that the validity of the arrangement may be challenged in court regardless of whether the trust that meets all of the requirements discussed above. Since these trusts are relatively new, issues surrounding their validity have not been extensively litigated, so a variety of potential grounds for challenge still exist.

Because of the public policy concerns surrounding these trusts, and the fact that not every state authorizes their creation, a creditor may challenge the validity of a trust established in a state other than the settlor’s state of residence by claiming that the laws of the settlor’s state of residence should apply. The trust must clearly specify which state law will govern. Further, in order to minimize the potential success of such a claim, a trustee who is resident in the state where the trust was formed must be chosen—merely directing a nonresident trustee to apply the laws of the state could be insufficient. If possible, the assets should actually be transferred to the state in which the trust is formed (meaning that real estate located in another state may not be an ideal trust asset).

A valid and enforceable asset protection trust should avoid even the appearance that the assets were fraudulently transferred into the trust in order to evade the claims of a specific creditor.  The issue may result in litigation even if the settlor could reasonably foresee that the claim or liability would arise in the future. The settlor should also be aware that most state laws will not allow a domestic asset protection trust to shield assets from claims for child support.

— Related on ThinkAdvisor: 23 Days of Tax Planning Advice: 2017

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