The Risk-Reward Balance Of Domestic Asset Protection Trusts

In asset protection planning, not all trust instruments are created equal. For example, living trusts and other self-settled trusts, while excellent estate planning devices, are generally useless when it comes to asset protection planning. That is because a trustor of a living trust retains the power to revoke the trust thereby allowing the trustor’s creditors to reach the assets of the trust[1] and trustors of living trusts are also the primary, if not sole, beneficiary of the trust rendering any potential protection of the trust’s spendthrift clause null and void.[2] So then, what types of trusts are effective in asset protection planning? Most people assume that in order for it to be effective the trust has to be offshore. While foreign trusts (trusts domiciled in foreign jurisdictions), especially those of the Cook Islands[3], Nevis[4] and St. Vincent,[5] are effective mechanisms for asset protection planning, a person does not have to fly to a tropical island to set up an effective asset protection trust—several states have effective Domestic Asset Protection Trusts (“DAPT’s”).

Most people concerned with asset protection planning look to protect their own assets and are usually not the beneficiaries of existing trusts (with the exception of inherited family wealth). Consequently, the majority of trusts used in asset protection planning are self-settled. However, the majority of states, including California, have strong doctrines of merger (the rule that says if a debtor holds all equitable interest of the trust through their capacity as beneficiary and all legal interest through their capacity as trustee, then the trust is disregarded from a creditor perspective[6]) and limited anti-merger statutes. Several states buck that trend and now allow self-settled trusts to afford their trustors the protection of spendthrift clauses. Currently that list includes Alaska[7], Delaware[8], Nevada[9], Missouri[10], and Rhode Island.[11]

A DAPT in one of these jurisdictions must comply with the following requirements: 1) be irrevocable and have a spendthrift clause, 2) at least one resident trustee must be appointed, 3) some administration of the trust must be conducted in-state, and 4) the trustor cannot act as trustee. DAPT are a perfect solution for someone who wishes to engage in asset protection planning and is a resident of one of the jurisdictions mentioned above. But if the person resides outside of one of those jurisdictions, the application of a DAPT becomes much trickier.

Trusts are general governed by the laws of the jurisdiction that is designated by the trustor in the trust agreement as the governing jurisdiction, whether or not the trustor resides there or has any assets there[12]. There are two exceptions to that rule: a) states will not recognize laws of sister states that violate their own public policy[13], and b) any real property owned by the trust is governed by the state in which that property is situated.[14] Property owned by the DAPT may be saved from this problem by utilizing limited liability companies of the DAPT jurisdiction.

It is therefore possible that if a case involving a DAPT was litigated in California (or any other non-DAPT jurisdiction), that the court may not recognize the law of the DAPT jurisdiction as against its public policy and apply its own doctrine of merger. The Full Faith and Credit clause of the U.S. Constitution (which states that each state has to give full faith and credit to the laws of every other state[15]) only exacerbates this problem because it also has an against public policy exception. By way of example, you could have a California creditor obtain a judgment against a Delaware trust because the California court disavowed the DAPT as against its public policy, but then have the judgment refused to be enforced in Delaware, because the courts there conclude that enforcement of such judgments violate its own public policy of protecting DAPTs.

This circular problem leads to two conclusions: use of a Domestic Asset Protection Trust for an individual who resides outside the jurisdiction of that trust, is a risk-reward balancing test and asset protection planning is a complicated process that requires legal advice of someone who not only knows the intricate nuances of all of the applicable tools but is well versed in the laws of various domestic jurisdictions.

— By Douglas M. Hanchar, Esq., Barnes Law

Douglas M. Hanchar is an associate attorney with Barnes Law, licensed to practice law in California.

The opinions expressed are those of the author and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice."

[1] Cal. Prob. Code § 18200.

[2] Cal. Prob. Code § 15304(a).

[3] Cook Islands International Trusts Act, 1984.

[4] Nevis International Exempt Trust Ordinance, 1994.

[5] Saint Vincent and the Grenadines International Trusts Act, 1996.

[6] Hill v. Conover (1961) 191 Cal.App.2d 171,180; Ammco Ornamental Iron, Inc. v. Wing (1994) 26 Cal.App.4th 409, 417

[7] Alaska Stat. § 34.40.110.

[8] 12 Del. Code § 3572

[9] Nev. Rev. Stat. Ch. 166.

[10] Mo. Ann. Stat. § 428.005 et seq.

[11] R.I. Gen. Laws §§ 18-9.2.

[12] Rest. 2d Conf. of Laws § 273(b); Uniform Trust Law § 107(1).

[13] Rest. 2d conf. of Laws § 187, subd. (2); Washington Mutual Bank v. Superior Court (2001) 24 Cal.4th 906, 916-17.

[14] Rest. 2d conf. of Laws § 280

[15] U.S. Const., Art. IV, § 1.