Given the litigious nature of American society, a common concern voiced by business owners and professionals is how they might protect their hard-earned assets from the reach of creditors. While possessing adequate liability insurance is a must, successful individuals and business owners should not rely upon insurance protection alone.
As a fundamental principle of debtor-creditor law, you cannot shield your assets from existing creditors, whether or not a judgment has been entered or a lawsuit has been commenced. If, however, the “waters are calm” at the time you seek to engage in protective planning, there are a number of planning tools that can help keep your assets out of the reach of unanticipated future creditors.
One common planning tool that provides no asset protection is a standard revocable trust. Under this type of trust the “trustmaker” retains full access to the assets, so the trustmaker’s creditors retain the same right to access. An irrevocable income only trust, which is commonly used for Medicaid planning, does allow the trustmaker to shield the principal from any future creditors, since the trustmaker has made an irrevocable gift of the principal assets funded into the trust.
Many people, however, prefer to have greater access to all of their assets, including both income and principal. Under the laws of New York and most other states, it is not possible to create a creditor-protected irrevocable trust that would permit the trustmaker to be a beneficiary of both trust income and principal. But with Alaska leading the way in 1997, there are now eight states -- Alaska, Delaware, Nevada, South Dakota, New Hampshire, Wyoming, Colorado and Utah -- that have passed legislation authorizing the creation of what have become known as Domestic Asset Protection Trusts (“DAPT”). DAPT’s are irrevocable trusts in which the trustmaker can remain a beneficiary and yet be protected against prospective creditor claims. There is the additional potential benefit that the trust can be structured so that future appreciation of trust assets may be excluded from the trustmaker’s taxable estate.
To provide the requisite asset protection, DAPTs must satisfy, at minimum, the following criteria: (1) they must be irrevocable; (2) at least one Trustee (either an individual or corporate fiduciary) must be a resident of the jurisdiction in which the DAPT is being formed; (3) a minimum amount of trust assets (often as little as $10,000) must be located in the jurisdiction (usually held in a bank or investment account) where the trust is formed; and (4) the trust should provide the trustee with complete discretion for making distribution of income or principal to the trustmaker and other beneficiaries (often the trustmaker’s spouse, children or other family members). Note that you do not need to be a resident of the state where the DAPT is being formed to take advantage of these types of trusts; in fact, states that have established these types of trusts have done so with the express expectation that residents of other states will establish the DAPT in that particular jurisdiction, thereby bringing additional investments and business activity into that state.
DAPT’s can also be used in conjunction with, or as an alternative to, a prenuptial agreement. Not only may a prenuptial agreement be set-aside at the whim of a judge, but many people – even those with extreme wealth (see Paul McCartney) – are reluctant to broach the topic of a prenuptial agreement with a prospective spouse, and/or may be reluctant to comply with the asset disclosure requirements for prenuptial agreements. Placing assets in a DAPT in advance of a marriage should protect those assets from inclusion in determining the “equitable distribution” of the couple’s assets in the event of divorce.
One potential disadvantage of DAPT’s is that, even more than a decade after the Alaska and Delaware statutes were adopted, there have been no cases testing whether a judgment obtained in one state (e.g., New York) can be enforced against a DAPT created in another state (e.g., Alaska or Delaware) under the “Full Faith and Credit” clause of the U.S. Constitution. Perhaps the absence of reported cases supports the effectiveness of the DAPT statutes. It is likely that there have been cases where a creditor, faced with challenging a DAPT, may have instead settled on terms favorable to the trustmaker. Inevitably, however, we can expect to see reported court cases determining the scope of creditor protection to be afforded a trustmaker residing in a state that has not enacted DAPT legislation (i.e., New York) who has established a DAPT in one of the eight DAPT jurisdictions.
While no asset protection strategy can be deemed “bulletproof,” the foreign asset protection trust (“FAPT”) provides the greatest barrier to the claims of future creditors. FAPT’s are similar in structure to DAPT’s, but because they are created in foreign jurisdictions such as Nevis, the Cook Islands, the Bahamas, and other similar jurisdictions that are not subject to the Full Faith and Credit clause of the U.S. Constitution, they are widely considered to provide a higher level of asset protection than a DAPT. In addition, foreign nations typically impose more stringent burdens of proof, shorter statutes of limitation and other legal hurdles that tend to discourage a judgment creditor from pursuing their claim (and will often lead to a settlement more favorable to the judgment debtor). A disadvantage of FAPT’s is their higher cost to create and maintain, as well as the discomfort some people have of dealing with a foreign jurisdiction.
Asset protection is a legitimate and valuable part of the planning process. Keep in mind, however, that the time to protect your assets is before an actual or likely creditor claim has arisen. At that point, engaging in any of the above-described asset protection strategies might be deemed invalid under the doctrine of “fraudulent conveyance,” and might expose you and your professional advisor to civil, and possibly even criminal, sanctions.