U.S. domestic trusts in asset-protection planning

Every American adult shares a dubious characteristic — each is a walking litigation target. Part of your birthright is that you may be sued at any time, for any reason, and for any amount. Civil actions range from the serious to the frivolous. Did you offend someone today with something you said? Did you cause someone to suffer sudden whiplash syndrome in the parking lot? Are you a professional facing a disgruntled client or patient? Do you own a company employing someone who did something irresponsible on company time? Did you err on the side of caution, or throw caution to the wind? Each choice you make might be construed as “actionable.” That is, someone might spin a good case, or at least a good story, about how you crossed a line in some way, and why you should now pay dearly for your failing.

Sadly enough, the more money you have the more tempting a litigation target you are. And you are an even riper target if you value privacy in your affairs. The “discovery” phase of litigation will put an end to your uncivil habit of protecting personal information.

So, what can you do? Well, you can hope for a sudden triumph of common sense in the land. You can hope that plaintiffs with ridiculous claims will suddenly feel shame and go skulking into obscurity. You can hope Congress will start returning cash donations from trial attorneys and embark on a frenzy of tort reform. Or, you can seize the opportunity to try to minimize the potential damage caused by these risks and build a protective barrier around your family and business assets.

What is asset protection planning?

Asset protection planning consists of various legal techniques and a body of statutory and common law dealing with protecting assets of individuals and business entities from civil money judgments. Simply stated, asset protection planning is a process of evaluating your assets and repositioning your ownership of those assets in order to effectively protect them from creditors as much as legally possible. When properly structured and implemented, an asset protection plan can protect assets for you during your lifetime, and for your beneficiaries after your death.

Protect your assets before claims arise

The most effective asset protection plans should be put in place long before a claim or liability arises. If an asset protection plan is implemented with the intent to hinder, delay or defraud creditors, or if after the planning your liabilities exceed your assets, it will most likely be deemed a “fraudulent transfer” which can be unwound by a court. Once you have received a demand for payment or been served with a lawsuit, it is generally too late to start an asset protection plan.

It is a common misconception that voiding a fraudulent transfer is the only consequence of late planning. The debtor, as well as the person who assisted the debtor with in the fraudulent transfer, typically the attorney who assisted with the planning, may be held personally liable for any losses and the creditor’s attorney fees. The debtor may also lose any chance of discharging that particular debt in a bankruptcy setting as a result of a fraudulent transfer.

Asset protection planning is not a substitute for insurance

Despite what some people believe, asset protection plans do not generally deter lawsuits, nor are they used to pay the legal fees required to defend against a lawsuit. Asset protection plans are not a substitute for liability or professional insurance, but instead should be used only as supplemental insurance to the extent the risk is insurable. If you are sued, your liability insurance company should be responsible for financing at least a portion of your defense.

Domestic trusts in asset protection planning

One way to place personal assets beyond the reach of potential plaintiffs is to transfer property to a trust for the benefit of your children and grandchildren. Such a trust is commonly referred to as an Irrevocable Gift Trust (“IGT”). The 2014 annual federal gift tax exclusion allows you to give up to $14,000 per person per year absolutely free of federal gift tax. If both spouses join in the gift, you can give up to $28,000 a year free of federal gifts tax.

In addition to the annual federal gift tax exclusion amount, you may make taxable gifts and apply a portion of your lifetime federal gift tax exemption. The lifetime gift tax exemption is the total amount that can be given away over your entire lifetime to any number of people free of federal gift taxes. In 2014, this amount is $5,340,000 ($10,680,000 for a married couple). When you dip into your lifetime gift tax exemption, the amount gifted will in turn reduce the amount that you can give away at your death free from federal estate taxes. In other words, the lifetime federal gift tax exemption is tied directly to the federal estate tax exemption so that if you gift away any amount of your lifetime gift tax exemption, then this amount will be subtracted from your estate tax exemption when you die.

Once the IGT is funded, it can pay the cost of the beneficiaries’ education and provide other benefits as provided under the terms of the trust document. From an income tax planning perspective, by giving property to an IGT you can shift the income from your high tax bracket to the lower tax bracket of your children or grandchildren who are age fourteen (14) and older. Unfortunately, children under age 14 must pay most of their taxes at the same rate as their parents.

How does the IGT protect assets? Well, all assets transferred to the trust are no longer in your name or owned by you, and are, therefore, outside the reach of plaintiffs or creditors, whether yours or your children’s. The IGT also has probate avoidance and estate tax reduction benefits. All assets transferred to the trust are no longer a part of your estate. That means when you die, those assets will not go through probate and they will not be subject to federal estate tax no matter how much they might have appreciated.

What if you want to protect certain assets, but you want to retain control over investing the assets and be able to benefit from the assets in the future? Nevada is one of only a handful of states that allow a person to establish an irrevocable trust in which the person is a permissible beneficiary, which is also protected from that person’s creditors. This is commonly referred to as a self-settled spendthrift trust, otherwise known as a Domestic Asset Protection Trust (“DAPT”). Nevada’s DAPT law requires that the person setting up the DAPT, known as the “trustor” or “settlor,” not serve as the trustee. The trustee must be a Nevada resident or bank or trust company having a place of business in the state of Nevada. In addition, the trustee should be given complete discretion in making distributions of income or principal to the trustor.

Many commentators agree that Nevada has the most favorable DAPT law. Each state that has adopted DAPT law has a statute of limitations period that determines how long is necessary between the date of transfer to the DAPT and the date on which the transferred asset will be protected from the trustor’s creditors. The number or years required before the assets are protected varies from state to state. Under Nevada’s DAPT law, a creditor existing at the time of a transfer to a DAPT may not bring an action with respect to the transfer unless an action is commenced within two years after the transfer is made, or six months after the creditor discovers or reasonably should have discovered the transfer. If a creditor arises after the transfer to the DAPT, the creditor must bring action within two (2) years after the transfer is made. Conversely, under the DAPT laws of Alaska, Delaware and Rhode Island, if the creditor is a creditor when the trust is created, the creditor must bring action within the later of four years after the transfer is made or one year after the transfer could have reasonably been discovered. If a creditor arises subsequent to a transfer to the DAPT in these states, it must bring action within four years after the transfer to the DAPT.

Another significant advantage that Nevada has over other DAPT jurisdictions it is that is the only state that does not have any special classes of creditors that can pierce through the DAPT. All states except Nevada have certain “exception creditors” that are allowed to access DAPT assets even though other creditor’s claims are barred by the statute of limitations. For example, many states provide an exception for divorcing spouses, which in some states extends to claims for alimony. A number of states also make an exception for claims of child support. Some states even provide an exemption for pre-existing tort creditors. Nevada’s shorter statute of limitations and lack of exception creditors make it the jurisdiction of choice for creating a DAPT.

The IGT and the DAPT are just two examples of trusts used in asset protection planning. There are numerous other strategies that are beyond the scope of this article. Asset protection planning requires a working knowledge of federal and state exemption laws, federal and state bankruptcy laws, federal and state tax laws, the comparative laws of many jurisdictions (onshore and offshore), choice of law principles, in addition to the laws of trusts, estates, corporations and business entities. The process of asset protection planning involves assessing the facts, circumstances, and objectives of an individual, evaluating the pros and cons of the various options, designing a structure that is most likely to accomplish all the objectives of the individual (including asset protection objectives), preparing legal documents to carry out the plan, and ensuring that the various legal entities are operated properly in accordance with the laws and the objectives of the individual. This process can be very complex and fraught with landmines. If you are interested in developing an asset protection plan, it is critical that you work with competent legal counsel.

Gerald Dorn is an attorney with the firm of Anderson, Dorn & Rader in Reno. Contact him at 775-823-9455 or through www.wealh-counselors.com.