DOMESTIC ASSET PROTECTION TRUSTS

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1 DOMESTIC ASSET PROTECTION TRUSTS John A. Terrill, II Heckscher, Teillon, Terrill & Sager, P.C. 100 Four Falls Corporate Center Suite 300 West Conshohocken, PA I. INTRODUCTION - 1 THE DOMESTIC ASSET PROTECTION TRUST AT FIVE YEARS--HAS ITS TIME ARRIVED? - 3 I TABLE COMPARING DOMESTIC ASSET PROTECTION STATUTES - 23 IV. TAX CONSEQUENCES OF DOMESTIC ASSET PROTECTION TRUSTS - 30 V. PLANNING WITH DOMESTIC ASSET PROTECTION TRUSTS - 37 I. INTRODUCTION It has long been true that trusts created for the benefit of persons other than the trustor of the trust can be drafted and administered in a way that may insulate the assets in the trust, both income and principal, from the claims of the creditors of a trust beneficiary. The concept of a "spendthrift trust" has been well settled in American jurisprudence and gives rise to a variety of planning techniques, all designed in part to protect trust beneficiaries from their own improvidence. This continues to be true notwithstanding the impact of cases such as Sligh v. First National Bank of Holmes County, 704 So. 2d 1020(Miss. 1997). Why, one may speculate, if this can be true of non-trustor beneficiaries, should it not also be true of trustor beneficiaries? The facile explanation is reliance on an easy citation to rules which, in most American jurisdictions, may be simplified to the following concept: "you cannot insulate yourself from your own creditors by a self-settled spendthrift trust." Notwithstanding a serious re-examination of this rule in a recent article by Professor Robert Danforth, it continues to be the case in most states that a creditor of an individual is readily able to attach all assets in a trust created by that individual, whether the trust was created before or after the claim arose, whether the trust is revocable or irrevocable, and notwithstanding the right to retain the trust assets by the trustor, even where the rights are exercisable only with the concurrence of an actively hostile trustee. Creditors' rights are deemed superior to those of other beneficiaries whether or not the creation of the trust violated applicable fraudulent spendthrift laws. It is this rule which has directly and indirectly given rise to the explosive growth of foreign asset protection trusts in jurisdictions which, either historically or by legislative change, revoked or modified the general rule.

2 The Foreign Asset Protection Trust in turn gave rise to the Domestic Asset Protection Trust which is enjoying its own rapid growth. This section of the outline explores this development in several parts. Part II consists of an outline prepared by Richard Bacon, Esquire, used with the author's permission, which was based in part upon Richard G. Bacon & John A. Terrill, II, Domestic Asset Protection Trusts Work Should They?, 26 Est., Gifts & Tr. J. 123, (2001). It explains some of the historical underpinnings of a self-settled trust doctrine, the legislative solutions and some of the actual and anticipated attacks on these trusts. Part III is a description in tabular form of the four principal Asset Protection laws in effect in this country in the states of Alaska, Delaware, Rhode Island and Nevada. Part IV is a summary of the gift tax, income tax and estate tax issues which arise in connection with these trusts; most of these issues are common to Foreign Asset Protection and Domestic Asset Protection trusts. trusts. Finally, Part V highlights a number of planning issues pertaining to Domestic Asset Protection THE DOMESTIC ASSET PROTECTION TRUST AT FIVE YEARS--HAS ITS TIME ARRIVED? I. A Very Short History A. Early English Law. Richard G, Bacon Richards, Layton & Finger One Rodney Square Wilmington, Delaware BACON@RLF.COM Wilt thou seal up the avenues of ill? Pay every debt, as if God wrote the bill. --Ralph Waldo Emerson 1. In considering domestic asset protection trusts, the history and development of trusts deserves substantial attention because the trust itself began as a device to avoid legal obligations. 2. As land was the principal form of wealth in the early development of English law, the system of land tenure was extremely important. Land tenure in medieval times took a

3 number of forms, but military tenure or tenure by knight service was the most important form of tenure for several centuries after the Norman Conquest in A holder by knight service originally had an obligation to provide military service, but with the passage of time the obligation was more frequently satisfied by the payment of money. Of course, it might be said that the land holder would be only too happy to avoid the obligations of tenure. Likewise, those persons who held in sub-tenure of various mesne tenants would be equally willing to avoid their own service obligations. B. The Avoidance of Service By Tenants. 1. Thus, after mesne tenants acquired the right to alienate their interest in the land, the alienation was often accomplished by sub-infeudation. Unlike an alienation by substitution, by which the new tenant simply assumed the obligations to the lord of the old tenant, sub-infeudation created a new tenure under which the new tenant held the land of the old tenant. Sub-infeudation was highly disadvantageous to the lords to whom the service of the alienating tenant was due, and sub-infeudation was abolished by the Statute Quia Emptores While this statute did give mesne tenants the right to alienate their interest in land without payment of a fine, it provided that the new tenant would hold of the overlord and not the tenant who had alienated his interest. 2. Sub-infeudation was but one attempt at the avoidance of service. A more sophisticated and--for a time--effective method came with the development of the use. In its simplest form, land would be held by A "for the use of B." In such an arrangement, B owed service to no one; moreover, in more complicated variations of the use, A might also owe little or no service. Some historians have concluded that much of the land in England came to be held by way of use. C. The Statute of Uses 1. The development and spread of uses was to the great displeasure of the king, who had wars that had to be paid for if they were to be fought, and in those times there were many wars. Thus, in 1535 Henry VIII was able to persuade Parliament to enact the Statute of Uses. However, the Statute of Uses did not ban uses. Rather, the Statute of Uses provided that the use would be executed so that in the example in the preceding paragraph, B would actually be required to render the service obligation that was incident to B's tenure. 2. Just as uses had been disliked by the king, many of the king's subjects were displeased by the Statute of Uses. The negative reaction of the king's subjects resulted in both a legislative and judicial response that led to the emergence of wills and trusts. In 1540, Parliament passed the Statute of Wills that allowed some interests in land to pass by will in addition to the modified feudal system of inheritance. In addition, the equity courts eventually provided relief from the Statute of Uses by means of decisions that various forms of trust were not subject to that statute. D. Other Laws Affecting Rights of Creditors. 1. As more personal property came into existence, other legislative enactments

4 addressed attempts at the avoidance of obligations. One such statute provided that "[a]ll deeds of gift of goods and chattels, made or to be made in trust to the use of that person or person that made the same deed of gift be void and of none effect." 3 Hen. VII ch. 4 (1487). A later and perhaps more well-known statute, the Statute of Elizabeth, 13 Eliz. ch. 5 (1571), was of like effect. 2. The Statutes of Henry VII and Elizabeth became an accepted part of English law and through the laws of English colonies, became a part of the law of virtually all of the states that were to make up the United States. It would be incorrect, however, to point to the Statutes of Henry VII and Elizabeth as evidence that English law consistently weighed against the avoidance of legal obligations by means of various conveyances. As briefly summarized above, the force of the law flowed back and forth as lord and tenant, obligor and obligee, exerted their respective influences in the legislative body and before the judiciary. Asset Protection Trusts--Matters of Policy A. Significance of the Historical Development of Trusts. 1. In the context of asset protection trusts, the most important point to take from the history of the trust is that the trust itself began its existence as one of a number of devices that were developed in order to provide those who had obligations with a means of avoiding those obligations. A proper understanding of the development of the trust provides a useful context in which to consider the very recent development of the asset protection trust, at least within the United States. 2. While by no means the sole means of creditor avoidance, asset protection trusts might fairly be considered as the most radical of several twentieth-century departures from trust law as it previously existed. Thus, it is appropriate to consider whether legislated asset protection trusts are sensible public policy, whether they will really work, and if so, how they will work. B. Asset Protection Trusts and Issues of Policy. 1. Legislative authorization of asset protection trusts marked a major change in centuries-old law. There is evidence, some of it anecdotal, that suggests that many persons, including estate and trust practitioners, are uneasy, if not offended, by the existence of asset protection trusts and view debt in the manner quoted from Emerson at the beginning of this outline. The misgivings of this group of persons raise the question whether asset protection trusts have any useful role in the legal system. 2. Misgivings about asset protection trusts--and other forms of liability avoidance--find voice in an article in the Yale Law Journal. Lynn M. LoPucki, "The Death of Liability," 106 Yale L. J. 1 (1996), that appeared just before the advent of the domestic asset protection trust. In "The Death of Liability," Professor LoPucki begins with the premise that [l]iability is crucial because it is one of only two principal means by which governments enforce laws. Id. at 3. Professor LoPucki goes on to declare that "[t]he system by which money judgments are enforced is beginning to fail, but notes that only tort and statutory liability are at the risk of

5 death. Id. at 4, 7. The depth of Professor LoPucki s concern about the death of liability can be seen in the comment that [t]hreatening to seize and incarcerate nonpaying debtors probably would be an effective means for the system to coerce the payment of liability, which is only partly tempered by the observation that imprisonment for debt remains wildly unpopular in the United States. Id. at As a preliminary matter, it should be recognized that there are forms of asset protection, many of them well-recognized and accepted as a matter of policy, that have little to nothing to do with the asset protection trust. These include such interests as tenants by the entirety, qualified plans and IRAs, and limited liability companies. 4. There is little doubt that at least to some extent, Professor LoPucki s assessment of reduced liability is correct. However, some might say that Professor LoPucki could easily have written a similar article with the title of "The Death of Responsibility." To this extent there may be both a corollary and a counterpoint to Professor LoPucki's argument in the ongoing reduction of an individual s responsibility for that individual s own conduct. Consider the case of Uniroyal Goodrich Tire Co. v. Martinez, 977 S. W. 2d 328 (1998). Martinez was injured while attempting to mount a tire on a wheel rim. As the opinion states at its beginning, the tire contained the following warnings: DANGER NEVER MOUNT A 16" SIZE DIAMETER TIRE ON A 16.5" RIM. Mounting a 16" tire on a 16.5" rim can cause severe injury or death. NEVER inflate a tire which is lying on the floor or other flat surface. NEVER inflate to seat beads without using an extension hose with gauge and clip on chuck. NEVER stand, lean or reach over the assembly during inflation. There was also a pictograph for those unable to read, but Martinez conceded that he had read the warnings. After noting the existence of the warnings, the Texas Supreme Court made the following statement with respect to Martinez conduct: "Unfortunately, Martinez ignored every one of these warnings." 977 S. W. 2d at 332. Given such a beginning to the opinion of the court, one who did not know the result in the case might be inclined to conclude that Martinez was not successful in his suit against Uniroyal. He was. The court stated that it must decide whether a manufacturer who knew of a safer alternative design is liable in strict products liability for injuries caused by the use of a product that the user could have avoided by following the product s warnings. Id. at 331. Having thus framed the issue, the court decided that the manufacturer was liable regardless of the warnings.