One of the simplest methods of protecting assets from potential creditors is transferring title to the marital home to one’s spouse. Creditors of the transferring spouse will thereby be precluded from making claims against the house. When making large transfers of assets between spouses, however, one must be vigilant in not squandering the $3.5 million estate tax credit, since this could ultimately result in an estate tax nightmare.
One must also consider the potential for divorce among spouses or discord among family members. Both could beset an otherwise effective asset protection plan with a host of its own intractable problems. When one transfers title one transfers ownership. Unfortunate as it may be, it is nevertheless true that transferring assets to family members in order to protect assets from future claims potential creditors or litigants is often a decision that the transferor may later regret.
Irrevocable trusts, if properly structured, offer the potential for greater protection, and also permit the grantor (i.e., the person transferring the assets) to retain greater control over the trust property. In comparison, a properly devised by Will offers no asset protection during the testator’s life, for the simple reason that a Will (like a revocable “living trust”) can always be revoked. An irrevocable trust, on the other hand, even if it grants the creator certain desirable powers, cannot be revoked. One formidable estate planning advantage of transferring property into an irrevocable trust is that future appreciation may be taken out of the grantor’s estate. This could result in significant estate tax savings.
One interesting tax phenomenon of an irrevocable trust is illustrated where the transferor of property to the trust retains too few strings to imperil the transfer for gift tax purposes, but too many strings to result in a complete transfer for income tax purposes. Generally speaking, a transfer complete for transfer tax purposes will serve to insulate the property from claims of creditors. Therefore, asset protection is consistent with income tax planning in this regard, since an incomplete transfer for income tax purposes can be beneficial.
An incomplete transfer for income tax purposes will result in the creation of a “grantor” trust. The income tax rules governing grantor trusts provide that income is taxable to the grantor. This may result in tax savings, since if the trust were not a grantor trust, the payment of the tax liability of the trust by the grantor would itself result in a taxable gift to the trust. In the grantor trust context, no such taxable gift results. [One trust provision that would cause trust income to be taxed to the grantor but would not pull the trust back into his estate for estate tax purposes would be the retention of an administrative power, exercisable in a nonfiduciary capacity, to replace trust property with other property of equal value.]
Asset protection can also be facilitated by the use of family limited partnerships. This entity may enable the business owner to protect business assets from the claims of potential creditors. Since the owner would be named the general partner, he would still be entitled to make all business decisions. However, since as a general partner his interest in the partnership could be as little as 1%, the asset protection virtues of the family limited partnership become clear. The general partner can even take a salary for managing the assets of the partnership. If the general partner is sued, only his stake in the general partnership is subject to the claims of creditors.
Combining the virtues of the family limited partnership and the offshore trust can be especially attractive in asset protection.
The concept of trusts dates back to the 11th Century, at the time of the Norman invasion of England. The trust has thus evolved for many centuries in common law countries around the world. Offshore trusts can assist U.S. residents in estate planning, asset protection, preservation of wealth, continuity of a family business, and avoidance of probate.
The basic underpinnings of an offshore trust track those of the domestic trust: a settlor (either an individual or a corporation), who establishes the trust agreement; the trustee, who takes legal title to and administers the assets transferred into the trust; and the beneficiaries, who receive distributions from the trust. Beneficiaries need not be named at the time of the creation of the trust; in that case the trust is termed a “discretionary” trust, i.e., the trustee has the power to determine the timing and identity of beneficiaries.
Under New York law, trust assets can be placed beyond the effective reach of beneficiaries’ creditors by use of a “spendthrift” provision. Typically, the spendthrift clause provides simply that the trust estate shall not be subject to any debt or judgment of the beneficiary. A settlor cannot, however, create a trust containing a spendthrift provision for his own benefit, since EPTL § 7-3.1 expressly provides that “a disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator.”
Since offshore trusts are governed by the law of the jurisdiction in which the trust is created, one could in theory establish an offshore trust which contained a spendthrift provision protecting the settlor, provided the foreign jurisdiction permitted it. In fact, many foreign jurisdictions do permit the settlor to establish a spendthrift trust for the benefit of the settlor. This will place the trust assets farther from the practical (if not also legal) reach of potential creditors, while at the same time granting the settlor powers over and benefits from the trust that could not be achieved using a domestic trust.
One tax problem which arises when transferring assets to a foreign situs trust is that IRC Sec. 1491 imposes a “toll”charge of 35% on the unrealized gain attributable to the property transferred. There are, however, a two mitigating factors:
First, the taxpayer may instead elect to be taxed on the unrealized appreciation, in which case the normal capital gains rates (which are likely to become quite favorable in the near-term) would apply. Second, if the trust is governed by the grantor trust provisions of the Code, as discussed previously, the income of the trust would remain taxable to the grantor. In this case, there would be no “transfer” to the trust for income tax purposes, and Sec. 1491 would, by its own terms, be inapplicable.
Income tax planning and asset protection serve distinct, but equally important, functions. Income tax planning has as its primary objective the reduction in federal income taxes. Asset protection is a method of arranging one’s assets so as to make them impervious to creditor attack. Asset protection is becoming ever more essential as the litigiousness of U.S. society increases.
The family limited partnership (FLP) can be extremely useful in accomplishing tax and asset protection objectives. The FLP is a financial and legal partnership among family members established for their benefit. The FLP is especially attractive from the practical standpoint since an individual can transfer ownership of assets to family members, yet retain effective control over investment and business decisions by naming himself as the managing partner.
Since partnerships are imbued with extremely favorable income tax attributes, they are now a preferred entity for holding family wealth. FLPs can be used to shift income to family members, such as children and grandparents, who may be in much lower tax brackets. This reduces the incidence of overall taxation.
FLPs also accomplish important asset protection themes, since partnership assets can be placed virtually beyond the reach of creditors. Creditors attempting to reach partnership assets will be stymied since creditors cannot actually levy upon partnership assets. Instead, they must obtain a “charging order.”
A charging order is an interest in the partnership. Since a partnership is a pass-thru entity for tax purposes, a creditor possessing a charging order would be liable for tax if the partnership earned income but made no distributions. Thus, a charging order is extremely undesirable from a creditor’s tax standpoint, and a creditor may be repelled from seeking to attack partnership assets.
Even if a charging order would not deter a creditor (i.e., if the partnership has little or no current income), the FLP can enable family members to protect their assets by reason of the fact that the value of partnership interests held by family members is less — perhaps much less — than the corresponding value of the partnership interests held by the partnership. This reduces the value of the assets for both estate and gift tax purposes, as well as for creditor purposes.
As effective and desirable as FLPs are, they are not without limitations. For example, a court may reach partnership assets by asserting that the partnership’s principal purpose was to avoid creditors (see Avoiding Fraudulent Transfers, May Comment). It may therefore be advisable to implement a mechanism whereby the transfer of FLP interests to an offshore trust can be effectuated.
Under the plan being considered, assets transferred to a FLP would in most instances stay in the United States until the threat of a creditor appears. Once a creditor appears on the horizon, the partnership interests could be transferred to the trustee of a foreign trust. Once so transferred, the assets of the trust would in all likelihood no longer be subject to the United States legal system. Trusts so created are entirely legal; asset protection trusts have been recognized by the IRS as legitimate asset protection devices.
Foreign trusts also accord a measure of privacy to the grantor, and may convery the impression that the creator of the trust is judgment-proof, even if that is not the case. In any event, one seeking to enforce a judgment in a foreign jurisdiction would likely be required to retain foreign counsel, and litigate in a jurisdiction which might be generally hostile to his claim.
Of all offshore jurisdictions, the Cook Islands are generally recognized as a preferred location for an asset protection trust, for these reasons:
¶ There are few currency restrictions in the Cook Islands;
¶ The statute of limitations for fraudulent transfers is short;
¶ Self-settled spendthrift trusts are recognized under Cook Islands law. (Assets placed in a spendthrift trust are protected from creditor’s claims. However, all states in the U.S. prohibit one from creating a spendthrift trust in favor of oneself.)
¶ Rules of local taxation are favorable;
¶ Modern banking and trust facilities exist; and
¶ Judgments of U.S. courts of law or bankruptcy are not enforceable. (Of all offshore jurisdictions, only the Cook Islands appears not to enforce both law and bankruptcy court judgments.)
The law of the trust’s situs controls whether the trust was properly executed. The situs of personal property is the domicile of the owner which, in the case of a foreign trust, would be the foreign trustee. To maximize the asset protecting effectiveness of the trust, the trust should (1) designate the law of the foreign jurisdiction as controlling with respect to all aspects of the trust, (2) be funded with personal or intangible property located in the foreign jurisdiction, and (3) be administered in the foreign jurisdiction by a trustee with no U.S. contacts.
The situs of real property is the location of the property itself. To protect real estate located in the U.S., the real property would therefore have to be converted to personal property by transferring the property to a corporation or partnership in exchange for a partnership interest or stock. Both of these would constitute intangible personal property. The stock or partnership interest could then be transferred to a foreign trust.
Movables, i.e., personal and intangible property, are generally governed by the law of their situs. A court has jurisdiction over intangibles embodied in a document within its boundaries. Intangibles not embodied in a document are subject to the jurisdiction of the state with the most significant relationship. Under the Uniform Commercial Code, in order to attach “certificated securities,” the security must be physically seized. Physically moving stock certificates to a foreign situs can thus be clearly beneficial. Even if the the foreign trust were disregarded, creditors would be unable to realize the value of the stock certificates without physically seizing them.
In general, foreign asset protection trusts are not endowed with special tax attributes which by their nature can legitimately reduce the incidence of U.S. income taxes. Legitimate tax savings which may result occur by reason of the type of entity which is chosen, and the avoidance of transfer taxes through carefully structured transactions, in which the grantor may retain limited control over trust assets.
Because of the secrecy often associated with foreign trusts, the IRS, despite strict reporting requirements, may be unaware of the assets placed in a foreign trust. Some taxpayers may seek to avoid paying taxes on foreign trust income. Foreign trusts are subject to strict reporting requirements by the IRS with harsh penalties for failure to comply. Taxpayers would be ill-advised to seek tax savings by deceiving the IRS, since this could result in criminal or civil liability.
An asset protection trust will be liable for U.S. income taxes. It is advantageous from a tax standpoint also to be recognized as a trust (rather than a corporation) for tax purposes. To be recognized, the entity must lack the corporate characteristics of having associates and an objective to carry on a business, and divide profits.
While it is possible to create a trust in a foreign jurisdiction which has a U.S. situs for income tax purposes and a foreign situs for debtor-creditor (i.e., asset protection) purposes, this may be risky from a tax standpoint, since the IRS will not rule in advance on this issue. It is therefore prudent to comply with reporting requirements as if the trust were foreign for U.S. income tax purposes.
President Clinton’s 1996 proposed tax legislation seeks to tighten the rules for taxing foreign trusts. To ensure that the U.S. collects tax on income earned by foreign trusts, the proposal would implement enhanced reporting requirements by foreign trusts.
Avoiding Fraudulent Transfers
In implementing an asset protection plan, attention must be paid to avoiding fraudulent transfers which could render a transfer ineffective, and subject both attorney and client to sanctions. Warning signs that a transfer may be fraudulent include insolvency of the transferor, lack of consideration for the transfer, and secrecy of the transaction.
Insolvency, for this purpose, means that the transfer is made when the debtor was insolvent or would be rendered insolvent, or is about to incur debts he will not be able to pay.
New York Debtor & Creditor Law, Sec. 275 provides that “[e]very conveyance and every obligation incurred without fair consideration [with an intent to] incur debts beyond ability to pay…is fraudulent.” Fortunately, however, once the determination has been made that the transfer is not fraudulent, later events which might have rendered the transaction fraudulent (if known earlier) would be of no legal moment.
The transfer of assets by a person against whom a meritorious court claim has been made — even if it the claim has not been reduced to judgment — would likely render the transfer voidable. If the claim were not meritorious, then the transfer would probably not be fraudulent, irrespective of the eventual disposition of the claim. For example, transferring title in the marital home to one’s spouse is an excellent asset protection tool, but attempting it when the IRS has just issued a notice of deficiency would probably fail. If the Tax Court had just upheld the deficiency the transfer would almost certainly be set aside, if challenged.
Transfers made without full consideration are especially prone to being characterized as fraudulent, since such a transfer suggests that the property is being held for the same beneficial interests. Therefore, transfers between family members (or even to a partnership) for little or no consideration in the presence of lurking creditors may establish a prima facie case of fraudulent intent.
Aside from avoiding any interest in the transferred property and receiving full consideration, the transferor should also adhere to the usual legal formalities associated with the transfer. Even a legitimate sale, if evidenced only by a flimsy, hastily prepared document, could suggest an element of immediacy, which could in turn support a finding of fraud.